Muni Bonds in your Bond Allocation

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Muni Bonds in your Bond Allocation

Postby jimt1000 » Fri Jul 26, 2013 9:55 am

I'm thinking of adding a slice of a Muni Bond ETF such as TFI or MUB to my Bond Allocation within my portfolio which will be comprised of a core Total Bond Market ETF (BND). My portfolio account is taxable. I am in a high income tax bracket, but don't plan on pulling any money from this portfolio until after retirement. Questions that I'd appreciate some help understanding:

1. Everyone writes of the benefits of high income people in high tax brackets having Muni Bonds in their portfolio; however, if I'm not going to pull any cash out of my account until after retirement, my income will be my capital gains taxed at 20% or whatever by then (2024). So I wouldn't be in a high tax bracket at the time of withdrawals. Doesn't this dilute the singular bias of munis being preferred for "high income" people since, regardless of tax bracket prior to retirement, we'll all be living and taxed on our capital gains after retirement?

2. Notwithstanding a reply to item 1 above, in comparing Muni Bond yields to their taxable equivalents, on one hand, given the returns of Muni's over the past 5 to 10 years, it seems that Muni's have done rather well. Wouldn't this argue for a rather large slice of your Bond Allocation within your portfolio to be given to Muni ETF such as TFI or MUB?

3. Completely contrary to a positive response to item 2 above, as quoted from a Morningstar analysis, "The Congressional Budget Office projects the 10-year Treasury yield will be at 3.0% in 2015 and at 3.8% in 2016. If yields rise as projected, muni bond funds will have difficulty producing positive returns in the years ahead." If this is the case, doesn't this significantly detract from, or eliminate the argument of, adding a slice of Muni's to your portfolio?

In summary, as fueled by possible responses to the above questions, it seems to me that given the headwinds for Muni's over the next years, it would be best for me to simply stick with my Bond Allocation within my portfolio to be entirely based or included within a Total Bond Market ETF such as BND and forego adding a slice of Muni's.

Any advice or replies are appreciated.
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Re: Muni Bonds in your Bond Allocation

Postby dbr » Fri Jul 26, 2013 10:11 am

jimt1000 wrote:I'm thinking of adding a slice of a Muni Bond ETF such as TFI or MUB to my Bond Allocation within my portfolio which will be comprised of a core Total Bond Market ETF (BND). My portfolio account is taxable. I am in a high income tax bracket, but don't plan on pulling any money from this portfolio until after retirement. Questions that I'd appreciate some help understanding:

1. Everyone writes of the benefits of high income people in high tax brackets having Muni Bonds in their portfolio; however, if I'm not going to pull any cash out of my account until after retirement, my income will be my capital gains taxed at 20% or whatever by then (2024). So I wouldn't be in a high tax bracket at the time of withdrawals. Doesn't this dilute the singular bias of munis being preferred for "high income" people since, regardless of tax bracket prior to retirement, we'll all be living and taxed on our capital gains after retirement?

You are correct about the tax treatment of capital gains, but most of the return from bonds is not in capital gains on average. Bonds pay interest on a regular basis throughout every year. Interest from nominal bonds is taxed as part of your ordinary income. Interest from munis is exempt from Federal tax and from state tax for muni bonds issued in your state. A high tax bracket investor can cut taxes every year by holding munis, especially in high tax states.

2. Notwithstanding a reply to item 1 above, in comparing Muni Bond yields to their taxable equivalents, on one hand, given the returns of Muni's over the past 5 to 10 years, it seems that Muni's have done rather well. Wouldn't this argue for a rather large slice of your Bond Allocation within your portfolio to be given to Muni ETF such as TFI or MUB?

All bond returns in recent years have been pretty good, driven by declining interest rates. Bond returns over the past 5-10 years are absolutely not a predictor of bond returns for the future. On average the current yield is probably the best predictor of future returns. In any case bond returns are going to be a function of interest rate risk which increases with duration and of default risk, which is probably a bit higher for munis than treasuries and less than for corporates, perhaps. In addition one simply computes the after tax situation for one's own tax case.

3. Completely contrary to a positive response to item 2 above, as quoted from a Morningstar analysis, "The Congressional Budget Office projects the 10-year Treasury yield will be at 3.0% in 2015 and at 3.8% in 2016. If yields rise as projected, muni bond funds will have difficulty producing positive returns in the years ahead." If this is the case, doesn't this significantly detract from, or eliminate the argument of, adding a slice of Muni's to your portfolio?

The possibility of rising interest rates detract from adding any kind of bonds to a portfolio, but not necessarily to the point of switching out of bonds altogether. This topic is the subject of dozens of threads that have been ongoing on the forum for some time now.

In summary, as fueled by possible responses to the above questions, it seems to me that given the headwinds for Muni's over the next years, it would be best for me to simply stick with my Bond Allocation within my portfolio to be entirely based or included within a Total Bond Market ETF such as BND and forego adding a slice of Muni's.

The decision between muni and nominal bonds should hinge on the after tax yield to you compared to bonds of similar duration and default risk. Your original generalization that munis are indicated in preference to taxable bonds depends on your tax situation is still true. All the rest of the discussion is about bonds altogether and not about deciding among different kinds of bonds. Also, in a taxable account, if there is a strong favoring of munis based on after tax yield, it would actually indicate not a slice but the entirety of the position going to munis. The argument against that would be one on general principle of never concentrating too much in one single asset class.

I would suggest reading a good book on bond basics such as Larry Swedroe's bond book.


Any advice or replies are appreciated.
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Re: Muni Bonds in your Bond Allocation

Postby dratkinson » Fri Jul 26, 2013 11:45 am

+1



A rising interest rate environment affects all bonds, not just munis.

If we need bonds in our allocation, it's better to buy them (funds/ETFs) when they are on sale... before they rise in value. Going into retirement with lots of cheap bonds is a good thing.

The rate paid today by cheap bonds (funds/ETFs) will rise over time as old issues are replaced.

As bond (fund/ETF) rates rise, so too will their price. But if we have enough in retirement, we can live off the income distribution, so will not need to sell them, so don't care about their future price. Having enough bonds in retirement is a function of buying them when they were cheap during our accumulation years.

Bonds are cheap during a rising interest rate environment. (See first point and repeat for effect.)

What's not to like?



Follow your IPS. By following our investment policy statement and rebalancing our asset allocation with new money (least tax consequences), we are automatically buying what the market has determined to be on sale.

Be patient.
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Re: Muni Bonds in your Bond Allocation

Postby my name » Fri Jul 26, 2013 12:47 pm

I've held Vanguard's tax-free NJ muni bonds for many years and they did incredibly well over the recession, beating other bond funds for me. Many said I had too much NJ or muni's would have a down time, but this fund has been one of my best. Glad I did not change things.

From what I learned, fund tax advantaged 401K and Roth/IRAs, then if money leftover fund taxable accounts in tax free munis and index funds.

Here are some thoughts on bonds from Jane Bryant Quinn with a quote from Vanguard: http://janebryantquinn.com/2011/01/why- ... ual-funds/
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Re: Muni Bonds in your Bond Allocation

Postby grabiner » Sat Jul 27, 2013 12:18 am

jimt1000 wrote:1. Everyone writes of the benefits of high income people in high tax brackets having Muni Bonds in their portfolio; however, if I'm not going to pull any cash out of my account until after retirement, my income will be my capital gains taxed at 20% or whatever by then (2024). So I wouldn't be in a high tax bracket at the time of withdrawals. Doesn't this dilute the singular bias of munis being preferred for "high income" people since, regardless of tax bracket prior to retirement, we'll all be living and taxed on our capital gains after retirement?


This is the advantage of holding stocks in a taxable account; regardless of your tax bracket, most of your gains are not taxed until withdrawal, and then they are taxed at a lower tax rate. If you hold bonds in a taxable account, you pay tax on all the income (taxable bonds) or pay a hidden tax cost (because municipal bonds have lower yields than corporate bonds of the same risk).

2. Notwithstanding a reply to item 1 above, in comparing Muni Bond yields to their taxable equivalents, on one hand, given the returns of Muni's over the past 5 to 10 years, it seems that Muni's have done rather well. Wouldn't this argue for a rather large slice of your Bond Allocation within your portfolio to be given to Muni ETF such as TFI or MUB?


The best estimate of future returns for bonds is current yield, not past returns; if the interest rates on a particular type of bond fell in the past, that type of bond had large gains.

Intermediate-Term Tax-Exempt yields 2.38%, and Intermediate-Term Investment-Grade yields 2.78% for the same duration and slightly more risk. There may be some anomaly in that 2.78%, as the spread between muni and corporate yields is much higher for either short-term or long-term bonds, and Intemediate-Term Bond Index yields 2.54% on Investor shares despite being half Treasuries.

3. Completely contrary to a positive response to item 2 above, as quoted from a Morningstar analysis, "The Congressional Budget Office projects the 10-year Treasury yield will be at 3.0% in 2015 and at 3.8% in 2016. If yields rise as projected, muni bond funds will have difficulty producing positive returns in the years ahead."


The expectation of rising rates is already priced into the current bond yields; investors know that long-term bonds will lose more when rates rise, and thus demand higher yields now. Intermediate-Term Tax-Exempt yields 2.38%, while Limited-Term Tax-Exempt yields 0.87%; that's an extra 1.51% per year you earn for taking the extra risk.
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Re: Muni Bonds in your Bond Allocation

Postby my name » Sat Jul 27, 2013 5:43 am

or pay a hidden tax cost (because municipal bonds have lower yields than corporate bonds of the same risk).


This is not always true. I did my calculations for fed and state tax effect for the Vanguard tax free NJ muni fund and surprisingly they did better than other bonds funds through the recession years. I have not checked in a while and things may have changed. I posted the detail here a couple of years ago and people were surprised.
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Re: Muni Bonds in your Bond Allocation

Postby grabiner » Sat Jul 27, 2013 3:34 pm

my name wrote:
grabiner wrote:or pay a hidden tax cost (because municipal bonds have lower yields than corporate bonds of the same risk).


This is not always true. I did my calculations for fed and state tax effect for the Vanguard tax free NJ muni fund and surprisingly they did better than other bonds funds through the recession years.


I have not checked in a while and things may have changed. I posted the detail here a couple of years ago and people were surprised.[/quote]

The difference is in yields, not in the actual returns. Corporate, municipal, and Treasury bonds of the same effective yield are subject to different risks, but the yield is the best indication of expected future returns (assuming no defaults). The hidden tax cost is most of the difference between the 0.87% yield on Limited-Term Tax-Exempt and the 1.42% on Short-Term Investment-Grade, or the 2.37% on Intermediate-Term Tax-Exempt and the 2.77% (which appears to be anomalous) on Intemediate-Term Investment-Grade; the corporate funds have slightly more credit risk. This is what you lose by holding the muni fund in your taxable account rather than the corporate fund in your IRA.

In 2008, even high-quality corporate bonds took a beating because of increased credit risk; munis did not lose as much unless they were inherently low-quality and backed by now-questionable insurers. Thus NJ Long-Term Tax-Exempt outperformed Intermediate-Term Investment-Grade, which holds corporate bonds and has more credit risk but less interest-rate risk. In 2009, the reverse happened, and the combined 2008-2009 returns of the two funds were equal. Since then, the corporate fund has returned somewhat more, which is what would be expected in normal conditions. If you are going to hold a bond fund in your taxable account as a NJ resident, then the NJ tax-exempt fund is probably the right one.
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