Pros & Cons of Tax Free Municipal Bond Funds

Municipal bonds are debt securities issued by state and local governments. The interest paid by muni bonds is exempt from federal income tax, providing a tax-free income to investors. One way to invest in municipal bonds is through a mutual fund that has a portfolio of the bonds. Municipal bond funds pass the tax-free income through to the funds' investors.

Many municipal funds have minimum initial investment amounts of $1,000 to $2,500, and additions can usually be made in increments of $100. A bond fund provides investment into a diversified portfolio that may own hundreds of different municipal bonds. Individual municipal bonds usually require a minimum investment of $5,000. An investor with $25,000 could only diversify into a maximum of five different bonds. The pricing of individual municipal bonds is not transparent and bond dealers will put a higher markup on small bond purchases, reducing the yield to the investor.

Municipal bond funds are managed by professional fund managers who select the individual securities for the funds. Municipal bonds are issued by governments large and small and it is difficult for the individual investor to evaluate the quality of a specific bond issue. A bond fund will have a team of analysts to evaluate the investment potential of hundreds of different municipal bond issues. Bond funds can also buy bonds in larger amounts, getting better prices and the resulting higher yields.

Municipal bonds funds pay out the portfolio earnings as tax-free monthly dividends. These dividends can be taken as cash or reinvested into more shares of the fund. Individual municipal bonds will pay interest twice a year and do not offer a reinvestment option.

Interest rate risk for municipal bonds is when rates increase, the value of the bonds in a fund's portfolio will decline and the fund share price will also drop. An individual bond can be held to maturity and the investor will receive the full face amount at that time. Bond mutual funds do not have a maturity date. A fund will own a portfolio with bonds of different maturities and a fund investor cannot count on a recovery of principal value at a specific maturity date. Many municipal bond funds own longer maturity bonds, which will have larger price declines if interest rates rise. A rising rate environment can cause the share value of a municipal bond fund to decline faster than the rate of income being paid by the fund.

A municipal bond fund will have expenses to pay for the management and the costs of buying and selling bonds. These expenses are reflected in the published expense ratio of the fund. The expense ratio is the annual percentage of expenses that is taken from a muni fund's gross interest income. This means the expense ratio directly reduces the interest rate paid by a bond fund. According to the Investment Company Institute 2010 Fact Book, the median expense ratio for municipal bond mutual funds was 0.92 percent. This level of expenses will significantly reduce the net dividends paid to investors.