How to Invest in Tax-Free Bond Funds

Tax-free bond funds can save you money.
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A tax-free bond fund can be a good choice for investors in high tax brackets. Bond funds are mutual funds composed of many different bonds, much the same way stock mutual funds are composed of many different stocks. Tax-free bond funds invest strictly in bonds that are free of taxes, such as municipal bonds. While the yields are generally lower than with taxable equivalents, tax-free proceeds can mean that investors wind up with more money in the end. But, as with all investments, it pays to learn as much as you can about tax-free bond funds before you make an investment.

Step 1

Contact several companies that offer low cost mutual funds and ask to speak to a bond specialist. Let the specialist know you are interested in a tax-free bond fund.

Step 2

Review the prospectus for each fund you are considering. Some fund companies make information on their tax-free bond funds available on their websites, while others will send you a prospectus on request.

Step 3

Review the yield of each fund, as well as the performance of that fund over several different time periods. Also check the expenses associated with each fund. Since the yields on tax-free bond funds tend to be low, high expenses can really eat into your return. Look for a fund with a good return and a low expense ratio. The returns on bond funds vary along with interest rates, but you can compare the current yield on the fund to what CDs and money market accounts are paying. The expense ratios on bond funds vary as well, but you should try to keep the expenses well under 0.50 percent. Anything higher than that will really eat into the return on the fund.

Step 4

Check the average duration for each bond fund before making a final decision. A fund with a high average duration will be more affected by increases in interest rates than one with a shorter duration. Assessing interest rate risk is an important part of investing in any bond fund, and the average duration plays a big role in the amount of interest rate risk you are taking. Look for a bond fund with an average duration of one to three years. Bond funds with a higher average duration will be more sensitive to changes in interest rates.

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