Why Tax Free Municipal Bonds May Be Your Best Bond ETF Choice

When comparing bond ETFs, the decision between pursuing higher current income and securing long-term tax advantages requires careful analysis. Two standout funds—the iShares National Muni Bond ETF (MUB) and the Fidelity Total Bond ETF (FBND)—offer distinctly different approaches, with tax-free municipal bonds representing one of the most compelling benefits available to U.S. investors.

The fundamental question isn’t just which ETF performs better, but which aligns with your tax situation and income objectives. While both funds attract income-seeking investors, they represent opposite ends of the bond market spectrum. Understanding these differences can significantly impact your after-tax returns.

The Tax Advantage Game-Changer for Bond Investors

The most powerful distinction between these funds lies in their tax treatment. Municipal bonds held within MUB are exempt from federal income taxes, and in many cases, state and local income taxes as well. This tax-exempt feature transforms the actual economic benefit to investors, particularly those in higher tax brackets.

Consider this scenario: if you’re in a 32% combined federal and state tax bracket, a tax-free municipal bond yield of 3.13% effectively provides the equivalent of roughly 4.6% in taxable yield. This mathematical advantage means that even if MUB’s stated dividend yield appears lower than FBND’s 4.7%, the after-tax reality may tell a different story.

FBND, by contrast, distributes fully taxable income, making it a more suitable option for tax-advantaged retirement accounts (IRAs, 401(k)s) where tax deferral is already built in. For taxable brokerage accounts, however, the tax-free municipal bond structure becomes increasingly attractive as tax liability compounds over time.

Comparing Operating Costs and Income Generation

The cost structure reveals meaningful differences in fund efficiency. MUB charges just 0.05% annually in expenses, while FBND carries a 0.36% expense ratio—seven times higher. Over a $100,000 investment, this amounts to $310 in additional annual costs with FBND.

However, expense ratios tell only part of the story. FBND compensates with higher current income: its recent dividend yield stands at 4.7% compared to MUB’s 3.13%. Over the past year, FBND delivered 2.6% in total return versus MUB’s 1.22%, reflecting the higher-yielding nature of its bond holdings.

This creates a classic trade-off: MUB offers leaner operating costs and tax-exempt compounding, while FBND provides stronger income generation through broader credit exposure. The five-year performance data shows this dynamic at work—a $1,000 investment in FBND grew to $862, while the same amount in MUB reached $922, demonstrating how MUB’s tax efficiency and lower costs provided superior long-term compounding.

Understanding Portfolio Composition and Risk Profiles

The holdings within each fund explain their different return characteristics. FBND maintains 4,459 bond positions with a deliberate tilt toward energy and corporate credit. While 67% of its bonds carry AAA ratings (the highest quality), FBND accepts up to 20% exposure to BBB-rated securities and below, trading safety for yield. This flexibility allows higher payouts but introduces greater default risk.

MUB operates differently, diversifying across 6,163 municipal bond positions with zero exposure to U.S. government debt. Approximately 61% of holdings rank as AA-rated (second-highest quality), with the remainder split between AAA and A-rated bonds. This composition reflects the municipal bond universe’s credit quality distribution.

Maximum drawdown comparisons underscore this risk differential: MUB experienced a -11.88% peak-to-trough decline over five years, while FBND suffered a steeper -17.23% drawdown. For risk-averse investors, the more conservative municipal bond structure provides measurable downside protection.

Bond Market Recovery and Interest Rate Dynamics

The broader context matters significantly. The bond market has been recovering slowly from the 2022 downturn, with gains remaining gradual rather than dramatic. Current interest rate expectations shape future returns: if federal rates decline substantially, existing bonds with locked-in higher yields would appreciate in value.

Municipal bonds historically offer lower interest rates than U.S. government or corporate debt, which constrains MUB’s yield potential. However, this lower-rate environment is precisely what makes the tax-exempt feature so valuable—investors sacrifice some nominal yield in exchange for tax efficiency that, after accounting for tax brackets, delivers competitive purchasing power.

Choosing Based on Your Financial Situation

For high-income earners in elevated tax brackets, tax-free municipal bonds via MUB become increasingly compelling as the tax-exemption benefit grows larger. A household subject to a 37% marginal tax rate experiences substantially greater economic benefit from tax-exempt income than a household in the 24% bracket.

Conversely, investors utilizing tax-advantaged retirement accounts benefit more from FBND’s higher nominal yields since the tax-deferral shelter already exists. Similarly, those in lower tax brackets may find FBND’s higher current income more attractive than the limited tax savings available through municipal bonds.

The decision ultimately hinges on your specific circumstances: Are you investing in a taxable account or within a retirement plan? What’s your marginal tax rate? How much does the lower expense ratio of MUB compound over your investment horizon?

For many investors seeking a higher-risk/higher-yield approach, FBND offers straightforward appeal. But for those prioritizing after-tax efficiency and cost-effective exposure to tax-free municipal bonds, MUB’s combination of low expenses, AA/AAA-rated holdings, and federal tax-exempt status provides a sophisticated solution. The tax advantage of municipal bonds isn’t merely theoretical—it’s a measurable benefit that deserves prominence in your fixed-income strategy.