Municipal Bond Questions

If you buy a mutual fund that invests exclusively in municipal bonds, you will avoid the hassles of managing individual bonds yourself, and you won't have to evaluate the risk of individual bonds.

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Any of the big brokerage platforms (E-Trade, etc) should be set up to let you buy bonds. But, why bother with individual bonds, as opposed to a muni bond fund? I think individual small-potatoes investors are always going to be at a disadvantage compared to big institutional buyers in the bond market, both in terms of buying at the right price and in research to evaluate the risks of various issues. Plus a bond fund gives you more benefit of diversification than you could get from buying a few individual bond issues on your own.

FWIW, I have the biggest chunk of my bond allocation in VMATX. Hard to beat that 0.12% expense ratio.

-Sandra the cynic

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The first thing to think about is your tax bracket. In the lower brackets, you are likely to have more money at the end of the day with corporate or treasury bonds than muni's. The issue is not how much taxes you pay, but how much you have left after paying taxes.

That's the rub. Individual muni bonds are hard to evaluate. Also, for individuals, the bid-ask spreads can be high.

Buy a muni bond fund if you decide you really want munis. Vanguard has some first rate ones with low expense ratios. I'm sure there are others. Two things to look for:

1) Low expense ratios. High costs will eat your returns. 2) Average duration. This one you will have decide for yourself. Short duration funds will have little change in principle, but lower yields. Longer durations will have more change in principle value, but higher yields.

-- Doug

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It also depends on the state to a certain extent. If the OP is in a mid to small state with a state income tax, there's probably not a low-cost state muni fund available. If so then, then the state bite comes into play. If in a no-income-tax state, or in one of the biggies like CA or NY, then not a concern.

You also have to be careful of alternative minimum tax with munis. Some are exempt from that, others aren't. Funds will normally include the AMT exposure in the literature.

Brian

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Individual bonds are somewhat complicated to understand and buy compared to stocks. For a stock, there is pretty much a standard price at any given time that you can discover by going on the internet. Also, there is a known commission to pay for buying or selling a stock. The price of bonds is not as transparent and there may be no commission to purchase them. That doesn't mean there is no cost. The cost is built into the price that you pay for the bond and that in turn determines the yield you get from the bond. Different brokers/ dealers could charge different prices, meaning you would get different yields by buying the same bond from different dealers. The markup that the dealer gets is generally not disclosed. It could be, say, 1/2%,

1%, 2% etc. Some brokerages that are not themselves dealers may charge a (relatively small) commission which is in addition to the unknown markup that you are paying the dealer that the brokerage is getting the bond from. Other brokerages may have their own inventory of bonds that they own. In that case, they are acting as dealers. Also, some bonds have call features that you should be aware of.

There has been some advice to buy a bond mutual fund. That may be a good idea, but you should realize that the value of the fund can go up or down depending on the change in prevailing interest rates. If you have an individual bond, its value also fluctuates but when it matures you get all of your investment back. Bond funds never mature as there are always new bonds being bought.

I am not trying to influence you one way or another, just trying to point out some facts.

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I hate bonds and especially bond funds. I am told I have to have them "for a balanced portfolio" and "not to have short term money in the market." But if I look at the opportunity cost (how much more money I would have made if all my money was in stocks) over the past 5 years, this is a very expensive proposition. And when we have a bumpy market, as we have now, my bond funds have lost money in the last 12 months while my agressive portfolio is up 15%.

I am considering buying AAA laddered individual bonds. That will reduce the sensitivity to interest rates. Fidelity has a pretty good fixed income program.

Frank

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I can understand why someone who wishes reduced volatility would include bonds (today, short-term bonds.)

But for those of us long-term investors (horizon 10+ years) who don't give a hoot about volatility, I say get back to me when Bank of America is offering 10% on a six-month CD.

-HW "Skip" Weldon Columbia, SC

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Really? Why do you think so?

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Perhaps so, but that's a very "hindsight" way of going about things. If we're playing by those rules, I am still be angry that I didn't bet the entire nest egg on The Giants in Superbowl XLII.

5 years ago you had no way of knowing what the market was going to do. Had it tanked, you might be belly-aching because you had so much equity exposure and got burned. That's the very essence of a "balanced portfolio". Returns are mitigated in both up and down markets. Like Skip said, if you have a long enough time horizon to ignore volatility, you may be able to get away with having little or no bonds.

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SPY in Jan 2000 - $145.75, today, $138.90 You can always find a bad period or good one to prove your point, but that doesn't negate the fundamentals. Joe

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Minor nitpicking:

1) The value of an individual bond fluctuates, but if you sell it, you are at the mercy of your broker-dealer again and the transparency and bid-ask spreads for small scale bond buy/sell transactions makes that an expensive proposition. So if you buy individual bonds, do plan to hold them to maturity. 2) When they mature, you do not necessarily "get all of your investment back" but rather, you realize the yield to maturity implied by the price you paid when you bought it. If you bought them at par (ie. you paid $100 per $100 face value), yes, you get all of your investment back. But if you bought them at a premium, you do not - if you, say, paid $110 per $100 face on a bond that matures in 10 years, you only get $100 back at maturity (plus a coupon payment). That extra $10 was, effectively, returned to you a little at a time over the 10 years you held the bond (via higher interest payments).

I'd be pretty hesitant to bother with individual bonds for a bond portfolio holding less than $100k. And if it's meant to constitute a permanent part of the portfolio (ie. one plans on *always* having at least a certain percentage of bonds in the portfolio), then there's not much reason to worry about the fact that a bond fund never matures.

If you have specific future cash needs (ie. some large purchase at a specific date), a selection of bonds which mature on that date may make some sense, though if you are talking about relatively short periods (ie. under 5 years), it's probably easiest to buy some CDs which mature just when one needs it (and that way one also gets FDIC protection).

That's a rather "cherry-picked" period. You're including

2003, for example, when the total stock market return was 31+%, but excluding 2002, 2001, 2000 - a period over which the stock market lost almost 40% and during which had you had some bonds, your losses would have been a lot smaller.

In the very long run, a balanced portfolio has, in the past, made less than an all stock portfolio. But the amount by which it's lowered one's volatility is quite suprising.

A sample portfolio I ran recently, over 13 years, with

50% stocks and 50% short-term corporate bonds had this surprising result - total return on the pure stock portfolio averaged 11.13% with a standard deviation of 17.9%. (That's a *lot* of bouncing around).

The 50/50 portfolio averaged 8.83% with a standard deviation of 9%. Yes, that's 2.3% less annual return, but the worst down year (2002) had a loss of only 7.4%, and the 2000-2002 period had the portfolio's total loss over that period at less than 10% rather than the 40% for the all-stock portfolio.

Even at 75/25, the avg ret is 10%, std dev 13.4%, and the 00-02 downturn cost a cumulative 24%, rather than 40%. Give up one tenth of the long term annual return (10 vs. 11%) in exchange for having 60% of the downside in the worst period. That's a pretty interesting proposition, no?

(That was with a short-term corporate fund. With a Lehman Index bond fund, the volatility dampening is almost identical, but the hit on total returns is actually *smaller* - long-term return on 50/50 goes to 9.33% with std dev at 9.24%.)

If you're sure you're ready to ride out potential 40% losses (recovery from which requires a 66% return - can you wait that long?), then by all means, go all stock. But if you're not prepared to ride out losses of those size, seriously consider a broader asset-class diversification.

Most of the folks I know who really have the stomach to ride out 40% drops without losing much sleep have other sources of income (like pensions) on which to rely (or have very little assets in the first place, like kids just starting out).

Doing my best to avoid subject creep in this thread:

The original poster is a retired federal employee and he's looking to invest for income. So a "tastes great vs. less filling" battle over asset allocation is of little interest to him. He's at the stage in his life where he wants somebody to send him a check every month and he's looking for the most tax efficient way to accomplish that.

He should bear in mind that state tax rules for retirees may be DIFFERENT from the rules for those in the workforce. The taxation of Social Security and federal pensions varies from state to state, for example. So it may be that these payments are worth more (or less) than he thought they would be to him on an after tax basis. He should figure this out first.

If he's still interested in an income oriented invested, and he's a FERS retiree (vice a CSRS retiree) he should know that it's possible to convert some or all of the money in his TSP account to an annuity that pays him so much a month for life. The interest rate used to convert the present value into a stream of payments varies from month to month, but usually it's a pretty efficient way to purchase an immediate annuity. See

If after working through these issues the original poster is still interested in munibonds I concur with those who have recommend he focus on AFTER tax return. And that means he needs to calculate his "combined marginal tax rate." If he doesn't know what that is, or how to calculate it he should let us know and somebody will explain.

I also agree that unless he has hundreds of thousands of dollars to invest in munis it's best to go with a bond fund, preferably a state specific fund so that all the dividends will be double tax free. (Unless he lives in a state with no or low state income tax, in which case one of the big national munibond funds would be just fine.) There are also "closed municipal bond funds." These are more complex and require more study. But they can be a good option for some investors.

The original poster should NOTE WELL that the value of his principal will FLUCTUATE in a bond fund. If interest rates go up, the value of his principal will DECLINE. If he can tolerate that,great. But it's a mistake to think of munibond funds are savings accounts with a higher interest rate. I'm always amazed at the number of retired people that invest for income who call the financial advice programs in a panic when the value of their principal declines in a bond fund. Yes, I know it's only a paper loss. But it still freaks them out. That tells me they were clueless about the risks going in.

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