For munis, bond fund or ladder

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For munis, bond fund or ladder

Postby larryswedroe » Thu Feb 07, 2013 4:36 pm

There has been much written about negatives of bond ladders so I thought it time to set the record straight.

http://www.cbsnews.com/8301-505123_162-57567927/are-concerns-about-bond-ladders-valid/
Hope you find it helpful

Larry
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Re: For munis, bond fund or ladder

Postby Grt2bOutdoors » Thu Feb 07, 2013 4:45 pm

If an investor lacks the $1MM or more to build a ladder, what would you advise? Are there some muni funds available that offer higher credit quality than Vanguard offerings? Or is the risk of Vanguard funds compensated by the higher yield?
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Prefer Bond Funds

Postby EDN » Thu Feb 07, 2013 5:04 pm

I still use a fund (DFA Intermediate Muni in particular) for tax-free bond exposure at multi-million dollar levels (or any level). This "avoid the expense ratio" stuff is overrated, I think DFA is at a whopping 0.2%, and there is no doubt in my mind they (and Vanguard) get the best pricing in the business--they have both told me this independently with data to support. Further, if you are doing major loss-harvesting with bonds, I think you are buying the wrong bonds. And, if one bond is ripe for harvesting, they probably all are.

I do believe in sticking with AA or better bonds in the 5yr range while focusing on states with low taxes (they have to pay higher yields to achieve the same after-tax rates and are also the safest), and I also want to shift maturities in the 4-7 year window in response to yield curve changes with new cash-inflows, all of which are done most efficiently in a low-cost fund.

If I were an individual investor I would have no qualms about using the Baird Intermediate Muni Institutional Shares, or even just Vanguard Int'd Muni despite slightly lower credit quality.

I don't think there is anything particularly wrong with bond ladders if all the criteria Larry mentions is met. Just don't think its necessary.

Eric
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Re: For munis, bond fund or ladder

Postby larryswedroe » Thu Feb 07, 2013 5:23 pm

Eric
First, we get the same prices they get. As do basically all patient institutional type investors. Having said that an individual can buy small pieces that a fund would never buy, and pick up significant yield differences.
Second,why would you want to own bonds from states that deliver you lower AT returns, and in Vanguard's case have both call risk and possibly ATM bonds? And in Vanguard's case owning both lower credits and also bonds in sectors we would not buy. Their advantage is at least you are diversifying those risks. I would not buy those type riskier bonds unless in a fund, for same reason I would not buy individual stocks.
Third, there are times when shorter term CDs make more sense in AT returns than munis and a muni fund won't buy them. A ladder can buy what is most appropriate at the time. This happened a lot in past few years.
Fourth. your point on TLH is just wrong. First the curves can shift leaving some bonds with losses and others not. Second,over time you're buying at different rates so it's easy to show you can have some bonds with gains and some with losses (and because we buy the same type bonds for all clients it's easy to arrange swaps so both parties don't pay spreads.


Grt2boutdoors
For taxable bonds you can buy on your own Treasuries, TIPS, and cds and don't need diversification benefit. Funds do offer convenience. For munis I would stick with funds even if have larger amounts if cannot get institutional pricing.

I hope that helps.

Larr
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Re: For munis, bond fund or ladder

Postby Sidney » Thu Feb 07, 2013 5:34 pm

My understanding was that VG eliminated PABs from all their TE funds except the MM and the high-yield.

For those who choose not to hold individual bonds, is there a better option than VG?
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Re: For munis, bond fund or ladder

Postby rkhusky » Thu Feb 07, 2013 5:40 pm

I don't worry too much about A-rated munis. They are probably as safe or safer than AAA-rated corporates.
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Re: For munis, bond fund or ladder

Postby Clive » Thu Feb 07, 2013 5:45 pm

Hi Larry.

with Treasury bonds and FDIC insured CDs, there's no need to diversify because there isn't any credit risk

Treasury bonds may be priced to zero credit risk - but 'defaults' do and have occurred - just indirectly via inflation and taxation.

A bond fund with an average duration of five years has exactly the same risk profile of a bond ladder with an average duration of five years. The reality is that an interest rate move will cause the portfolio's value to rise (or fall) by the same amount whether your holdings are a fund or a ladder. And if the bond manager harvests a gain, he must then reinvest the money at a now lower rate, leaving the fund in the same position, with the exception of having incurred trading costs.

Riding the yield curve? - Buying towards the steepest part of the yield curve, holding for a year or two and then selling and using the proceeds to buy towards the steepest part of the yield curve again can yield higher reward. If yields remain unchanged then the yield curve will fall sharper (price appreciate relatively quicker) than for other points along the yield curve. If the yield curve shifts, you're selling out of what was previously near the best value, that has subsequently become less so (relatively gained), to move to better value (relatively cheaper). But I guess in the strictest sense that shifts the average duration - so in that sense its no longer comparing like for like.
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Prefer to Simplify Complexity

Postby EDN » Thu Feb 07, 2013 6:05 pm

larryswedroe wrote:Eric
First, we get the same prices they get. As do basically all patient institutional type investors. Having said that an individual can buy small pieces that a fund would never buy, and pick up significant yield differences.
Second,why would you want to own bonds from states that deliver you lower AT returns, and in Vanguard's case have both call risk and possibly ATM bonds? And in Vanguard's case owning both lower credits and also bonds in sectors we would not buy. Their advantage is at least you are diversifying those risks. I would not buy those type riskier bonds unless in a fund, for same reason I would not buy individual stocks.
Third, there are times when shorter term CDs make more sense in AT returns than munis and a muni fund won't buy them. A ladder can buy what is most appropriate at the time. This happened a lot in past few years.
Fourth. your point on TLH is just wrong. First the curves can shift leaving some bonds with losses and others not. Second,over time you're buying at different rates so it's easy to show you can have some bonds with gains and some with losses (and because we buy the same type bonds for all clients it's easy to arrange swaps so both parties don't pay spreads.


Larry,

Research I have seen on corporate and muni bonds puts lowest transactions costs at about $5M to $10M lots--a level few individual accounts can achieve with adequate diversification. As for all patient institutional types getting same pricing, data from the Trace system found DFA paid about 32 bps less for bond buys and got 16 bps more for bond sales and earned an extra 18 bps for trading flexibility when compared to similar size trades. ITG Post Trade Analytics puts DFA in the upper 98% on Fixed Income trade ranking relative to their pier universe. Finally, variable maturity in muni bonds is accomplished much easier with portfolio inflows, a luxury not all individuals have but a commingled portfolio often does. Finally, in times of distress (when I need to rebalance intro stocks) I'm much happier to be able to sell high-quality munis at fund NAV without an impact to portfolio characteristics and without "shopping around". With all this going for me, I'm happy to leave a bit of "individual issue tax loss harvesting benefit" on the table.

Finally, there is an intangible benefit of simply owning a fund and being done with it. I'm not sure I have a single client who would prefer the complexity of an individual bond portfolio even if it did net them 20bps per year. We prefer to "Simplify Complexity" :wink:

Eric
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Re: For munis, bond fund or ladder

Postby larryswedroe » Thu Feb 07, 2013 6:20 pm

Rhusky
That may have been true at one time as the rating agencies had different scales for munis and corporates but no longer true.
And if I would buy single As basically would buy a fund, not individual bonds, to me the idiosyncratic risk begins to be too high. One way to address this is to buy A if three years or less and have lower % limitation on max for an issuer. Say 10% for AAA, 5% AA and 2% single A.

Clive
yes but those are not credit risks

Riding the curve is possible with treasuries where market is highly liquid and trading costs low. With munis that is tougher to do. But we do move maturities a bit depending on steepness of the curve. When steeper tend to go a bit longer and vice versa, that is because the evidence demonstrates that term risk has been best rewarded when curve is steep.

DFA doesn't even shift maturities on munis because market is not as liquid. They do what we do which is to use what might be called a modified variable maturity approach. With new cash flows invested at the optimal maturity. Bonds not at the optimal maturity are generally held.

Hope that helps
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Re: For munis, bond fund or ladder

Postby larryswedroe » Thu Feb 07, 2013 6:25 pm

Eric
First you are comparing a patient buyer like DFA with active traders. That is not apples to apples. A patient institutional buyer like us will get roughly the same prices. Our audits show roughly 10 bp or bit higher in price above interdealer. That is say 2-4bp in yield for 5 year maturity. Now impossible to be much below that as no dealer is selling to DFA at a loss. Now there is another part to the story. DFA is competing with lots of other institutional buyers for those larger lots which do get bit smaller markups. In the retail space, say a $100,000 bond, the markups will be a bit higher but the YIELD to the client will also be higher as you don't have the competition for those type bonds from the bigger players.
Second, while larger lots can get better prices to a point, that is not always the case and in fact as I pointed out you can get much better yields with very small lots if patient.
Third, the clients don't do any of the work, the manager does and never once had a client say it was too complex. In fact most prefer it because they control the timing of the cash flows.
fourth, it's not just the TLH, its the wrong states and wrong instruments (CDs vs munis).
Fifth, yes liquidity is an advantage of a fund. Which is why we typically keep some liquidity in funds for both emergency cash needs and rebalancing. Note again, since we buy the same type bonds for all clients it's relatively easy to do swaps (paying dealer a small fee) and avoid the bid-offer spreads.
Best wishes
Larry
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Muni Bonds

Postby EDN » Thu Feb 07, 2013 6:59 pm

larryswedroe wrote:Eric
First you are comparing a patient buyer like DFA with active traders. That is not apples to apples. A patient institutional buyer like us will get the same prices
Second, while larger lots can get better prices to a point, that is not always the case and in fact as I pointed out you can get much better yields with very small lots if patient. Also when we buy we can buy large lots and split them up among various clients since they all hold the same type bonds.
Third, the clients don't do any of the work, the manager does and never once had a client say it was too complex.
fourth, it's not just the TLH, its the wrong states and wrong instruments (CDs vs munis).
Best wishes
Larry


Larry,

I seriously doubt at the level of trades (my data was size adjusted) I mentioned, these buyers don't incorporate some patience and cost consciousness. But DFA (not to mention Vanguard) are managing tens to hundreds of billions of dollars of fixed income, you cannot say there isn't some advantage there. I also don't see why a fund couldn't take advantage of some small lot opportunities.

I know client's don't do the management, my point about complexity was the fact that they must hold a separate account with dozens (I hope) of individual holdings, just one more thing they may not wish to reconcile along with multiple equity-asset class funds, especially when it comes to cash-flows, bond interest, rebalancing, etc.

Finally, I cannot speak for Vanguard, but DFA isn't buying the wrong bonds. They hold the highest quality AA/AAA bonds including those in states with lowest taxes (Texas, for example) who therefore have to pay higher muni yields (but ironically, are at the same time lower risk because lower taxes tend to mean lower indebtedness). As for CDs vs. munis, I'd prefer to avoid early redemption penalties and static NAVs (vs floating prices that may rise during periods of distress for high-quality issues). And on TLH'ing, a 5YR duration means a 5% move for a 1% change in rates. We aren't talking stocks here -- these are very minimal opportunities.

Finally a fund has much more consistent inflows than an individual account, making it much easier to implement a variable maturity approach with new cash-flows.

Again, I am largely indifferent to this individual bond vs fund decision. At the level we're at, its minor if there is a benefit one way or another.

Eric
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Re: For munis, bond fund or ladder

Postby larryswedroe » Thu Feb 07, 2013 7:40 pm

Eric
You can believe what you want but there are not those advantages you think there are. There are others that manage far more FI and DFA is actually a pretty small player in bond space, relatively speaking. Certainly much smaller than Vanguard and PIMCO. I would add that DFA only manages about $2b in munis, and we manage far more than that.

The separate account issue is not an issue at all. There is just another Schwab statement they get. And they don't have to do any of that other work as we do it for them

Re wrong bonds, you misunderstand. It's not the wrong bonds, but bonds from states that make no sense for some investors to hold. For example someone living in Texas should almost certainly not own NY or Cal bonds, but if you buy a national fund you will. And my living in MO for example I should have a preference for MO bonds very frequently. And you cannot in a muni fund buy taxables even if they would provide higher AT returns! A tailored fund can be tailored to the individual's tax bracket, not based on assumptions that might not apply.

As to early redemptions, I assume you refer to CDs (not munis) and they are good to have as they are typically mispriced (way too low). And static NAVs, not relevant, DFA has the same issues as anyone else whether individual bonds or fund. Both use what are referred to as matrix type pricing. Most munis after being in market for a while don't trade much.

Yes TLH is much less opportunity that with stocks, as much less volatile, but it still can matter and matter a great deal, as we may be about to find out.

Yes a fund will have more inflows, to shift maturities a bit. Not sure how much advantage that really has been though.

To me the answer is pretty simple, the only real advantages of a fund are convenience and diversification. With stocks it's virtually a must. With high quality bonds not needed. Even before I got into business I used to build my own ladders buying only new issues because of the advantages. Now I could not loss harvest, so gave that up, but the benefits are or can be significant



Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby AZK » Thu Feb 07, 2013 9:45 pm

How much in fixed income before one should begin to consider buying individual bonds vs. using a fund? 500k? 1M? 2M?

What if half your FI is held in a company 401k? Don't have the option of buying your own bonds.

I suppose you could fill it with stocks and move all your FI to taxable...
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Re: For munis, bond fund or ladder

Postby BermudaAl » Thu Feb 07, 2013 10:02 pm

I chose to use the Vanguard muni funds instead of a bond ladder for the following reasons:

1) I value diversification far more than Larry. Just because the default statistics on AAA bonds are great doesn't mean that will be the case in the future. If you have a ladder, a single default is a disaster. My crystal ball is always cloudy. I never think that the unlikely is impossible.

2) A highly diversified fund can include lower (not low) credit quality bonds which should lead to a higher long term expected return.

3) Most independent bond managers do not have publicly available track records. All this talk about buying bonds the same as the big boys if great, but you can't independently verify it. Anything you could want to know about a fund is online. Lots of smart people analyze what they do.

4) Independent advisors don't do this for free. They may not charge you to manage your bond portfolio but they do charge you for their advisory services. That has more value to some than others. It's hard to beat the price of the admiral shares at Vanguard.

5) There is ample opportunity to take tax losses at the fund level, especially if you track things on a tax lot basis. For the investor, a bond ladder has trading costs to rebalance, a fund does not. Advisors can at times offset those costs by swapping bonds between clients, but not always. Of course all of this tax loss harvesting stuff is simply theory until we have a period where interest rates actually go up :)

6) Partial liquidations of a fund have no effect on the composition of your bond portfolio. Selling a bond in a ladder can change things. You'll have more consistent risk characteristics (things like duration) in a fund.

7) It's far simple to reinvest dividends in a fund than in a ladder.

8) There is far more institutional stability in a firm like Vanguard or DFA than any independent advisor.

9) I'm giving up "control" over the composition of my bond portfolio to a manager in either case (which is good because I find looking at individual bonds dreadfully dull). I'd rather do that at Vanguard where I trust the culture will maintain a consistent approach over decades that at a smaller shop where the people doing this in 5 years may be different than the ones today and the quality control is not the same.

Reasonable people can differ on which way to go. At the end of the day, my bet is there will be no impact on my portfolio whichever way I decide to go. If that is the case, keep it simple. Funds are simple. Ladders are not.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 12:25 am

Bermuda Al
You're right we disagree
First, if we get a financial crisis that goes deeper it will be the weaker credits that default and not the stronger ones, with very high likelihood. So while diversification is helpful it won't stop losses which will likely be far worse than with higher quality bonds, especially in the sectors Vanguard buys. Even in the Great Depression the losses on the kind we buy were close to zero. But yes if you are going down in credit you need a fund.

Second, if you're taking more credit risk than you don't have apples to apples --it's risk adjusted returns that matter. It's same with junk bonds. If you own riskier munis should own less equity then if you own safer munis.

Third, you can verify it, as we have had people do. And I would not make specific claims on a public website if I could not back it up.

Fourth, yes there is opportunity at fund level but with individual securities it's always greater, that is why some use individual stocks if you have a large enough portfolio, in the millions, it's more tax efficient.

Fifth, as to your partial liquidation issue, that is just wrong. You can sell if need be without changing the characteristics, the average maturity/duration. But one should have a liquidity reserve in a fund anyway, which is what we do.

Sixth, the point on simplicity is also wrong. You just use a bond fund to hold the interest until sufficient size to buy another piece of the ladder, as I explained in the post.

Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby Dale_G » Fri Feb 08, 2013 1:42 am

So Larry,

After you do the patient trading and masterfully pick off the bargain priced 100K lots that the big boys aren't interested in, how does it work out for the investor after he/she pays a 1% +/- assets under management fee?

Dale
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Re: For munis, bond fund or ladder

Postby stlutz » Fri Feb 08, 2013 2:03 am

Larry does make a good point that good muni deals are available in small dollar amounts. For an individual who is willing to patient with it, there are actually good deals to be found in $5K-$20K lot sizes if one is willing to buy patiently. Because of the illiquidity of this market, opportunities become available when another investor is desperate to sell.

I don't really understand the idea of buying treasuries/CDs at the short-end and munis at the longer end of the yield curve. If you hold to maturity, eventually your longer term munis become shorter term ones, and then the strategy is no longer in effect. That approach seems much easier using a fund. In fact, it does make a lot of sense--maybe go with Long-Term Tax Exempt and then just use a online savings account for the shorter-term money. Duration and tax-adjusted, that actually does beat just holding Int. Term Tax Exempt by just a bit.

Many of the problems of munis are borne by both individual bond holders and by funds. The market is illiquid and relatively expensive to trade in regardless of who you are. That is why VG's muni bond funds have much lower turnover than their treasury funds.

For me, the fund makes sense--it's easier and it's cheaper. I don't know of any independent advisors who are managing bond portfolios for .1%/yr., which Vanguard does for me. Yeah, they take a bit of credit risk, but that can again be reduced by using the LT Tax Exempt + an online savings account or 1 year CD as discussed above. The VG funds are good enough for me.
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Re: For munis, bond fund or ladder

Postby BermudaAl » Fri Feb 08, 2013 4:03 am

I'm not going to argue with Larry as we just disagree. He's pretty adamant on this subject. Besides, I almost always agree with him. He could retire on the number of his books I've bought to give to friends.

But I will say this - of all of the advice he freely gives on this forum (thank you) this is the one area that the outcome on your portfolio will likely be the same no matter which way you go. Just make a choice and spend your analytical energies elsewhere. There are far worse things one can do than buy a Vanguard Muni Bond fund or build a bond ladder. Neither is a "mistake."
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Re: For munis, bond fund or ladder

Postby rkhusky » Fri Feb 08, 2013 10:31 am

larryswedroe wrote:Rhusky
That may have been true at one time as the rating agencies had different scales for munis and corporates but no longer true.
And if I would buy single As basically would buy a fund, not individual bonds, to me the idiosyncratic risk begins to be too high. One way to address this is to buy A if three years or less and have lower % limitation on max for an issuer. Say 10% for AAA, 5% AA and 2% single A.



The document I remember seeing was dated from 2008, so it is a bit old. Is there any more recent data available that shows default rates for different rated muni and corporate bonds? Although the rating agencies are trying to equalize the ratings, it seems like Vanguard's Interm Tax Exempt has about the same distribution as in the past. I would have expected their distribution to move towards the AAA end, given that there used to be at least a two level discrepancy between muni and corporate default rates. But perhaps that takes time.

The 2008 document showed default rates for A-rated munis were 0.03% and 0.23%, respectively for Moody's and S&P. The AAA-rated corporate default rates were 0.52% and 0.60%, respectively for Moody's and S&P.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 11:03 am

Dale
First, for the client who works with us they have already made the decision that we add more value than our fee (which can be lot lower than 1% for HNW individauls). So there is no cost, only a saving of the mutual fund expense because the alternative would be for us to use bond funds, which we did for the first few years.
Second, for higher net worth individuals with significant bond assets who only want us to manage their bonds and provide no other services we charge a Vanguard like fee for that service.

Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 11:09 am

rhusky
That is about right. With munis though if you eliminate the sectors with low persistence of ratings (health care, multifamily) then there are virtually no losses in AAA/AA munis

Bermuda Al

I did not say there would be huge differences (f sticking with investment grade bonds almost all the risks are rate risks), it's just that there are advantages of individual bonds. I simply pointed out what the advantages are. The advantages aren't opinions, they are facts. Now you can decide that the advantages of a fund outweigh them. Certainly funds do offer diversification (meaningless in Treasury bonds for example) and convenience. But there are advantages of individually owning bonds. I was doing it that way well before I began working in the investment industry because of those advantages.

Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby Levett » Fri Feb 08, 2013 11:51 am

"But I will say this - of all of the advice he freely gives on this forum (thank you) this is the one area that the outcome on your portfolio will likely be the same no matter which way you go. Just make a choice and spend your analytical energies elsewhere. There are far worse things one can do than buy a Vanguard Muni Bond fund or build a bond ladder. Neither is a "mistake."

Gracefully stated, Al. Much appreciated.

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Re: For munis, bond fund or ladder

Postby rkhusky » Fri Feb 08, 2013 12:01 pm

larryswedroe wrote:rhusky
That is about right. With munis though if you eliminate the sectors with low persistence of ratings (health care, multifamily) then there are virtually no losses in AAA/AA munis


I've also read that the vast majority of muni defaults have been in unrated bonds.
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Re: For munis, bond fund or ladder

Postby SpringMan » Fri Feb 08, 2013 12:21 pm

Sidney wrote:My understanding was that VG eliminated PABs from all their TE funds except the MM and the high-yield.

For those who choose not to hold individual bonds, is there a better option than VG?

IMO, Vanguard is best but Vanguard only offers state specific municipal bond funds for just a few states. For example, I live in Michigan where no Vanguard municipal bond is offered. Fidelity does have such an offering, FMHTX, with a ER of .49%. Despite the moderately high ER, I hold some of the Fidelity fund.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 12:36 pm

rhusky
Unrated bonds of course have the highest default rates, but there are sectors that have dramatically higher default rates and much lower persistence of rating. So a AAA rating on a GO is highly like to be AAA 10 years later, but a AAA health care related or multi family related bond is much less likely to still be AAA 10 years later.

Larry
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Last Thoughts on Muni Funds

Postby EDN » Fri Feb 08, 2013 12:45 pm

Larry,

The issue seems to come down to the following:

Expenses--a fund has a .2% expense , a ladder doesn't

Buying Power--a company (DFA) with 30 years of fixed income experience managing $60B in global debt can probably transact at lower prices than an RIA with maybe 10% of those assets in fixed income, probably offsetting some of the ER. Is there an increasing benefit as we go from $60B to $100B or $200B? Probably not, but I image the delta is pretty steep until you get to that point.

Portfolio--both the ladder and the fund (in DFAs case) have AA or better maturities and are set up to avoid high tax states (NY & CA). The ladder can be overweighted to an issuer's home state, but those benefits need to be weighed against less diversification by concentrating in one state and holding dozens vs the fund holding hundreds of bonds in every desirable state. Both the fund and the ladder can be complimented with CDs, a corporate or global fund where opportunities present themselves.

Trading--with a ladder, and without additional or sizeable deposits, you are stuck with your holdings. With a commingled fund, new contributions can be made at the maturity sweet spot much easier and more regularly, allowing for a more variable maturity approach and higher expected risk-adjusted returns. This too can offset some of the ER

Taxes-- while you have the option to TLH individual bonds with the ladder and not with the fund if some small segment of the yield curve moves independently of the market, the delta of individual bond TLH over an entire bond fund TLH in the 5 year duration range seems fairly small. And in an environment of a market-wide yield curve shift, you may want to TLH the entire portfolio which is easier with one fund than dozens of issues

Simplicity--holding one fund makes it much easier to manage, reinvest interest, portfolio contributions, sell odd lots, versus dealing with dozens of individual holdings. I routinely get requests for $10K, $20K, $50K from a portfolio that needs to come from bonds if stocks are down. I don't want to be liquidating small parts of a bond position and wait around to shop for best price.

I know you'll disagree, but as I see it the all-in costs/advantages when everything is considered for a fund like DFA (preferably) or Baird Intermediate Muni outweighs the benefits of separate account management. Of course, of all the things that matter, this is way down the list.

Eric
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Re: For munis, bond fund or ladder

Postby ogd » Fri Feb 08, 2013 2:41 pm

Hi Larry,

There is one point in your article, one that I've heard before, that I can't convince myself is true. It's this one:

Avoiding the impact of hot fund flows

...snip...
The fund, therefore, must buy more bonds in a low-rate environment, lowering the average rate for all investors.
...snip...


On the face of it, this says that there is a fundamental mispricing for a fund that has grown a lot recently (the "hot fund"), vs. one that started with similar holdings but is closed (your bond ladders) -- the older investors in the first fund are getting a bad deal, meaning that newer investors are getting a good deal, meaning that the NAV is too low. I don't buy this. Ultimately, in a liquid bond market, at any point in time, $X buys you a certain amount of future return, and the logistics don't matter (modulo the tax implications).

I think that the problem with the "hot fund" argument is that it assumes a difference between a smaller amount of higher-yielding bonds and a larger amount of lower-yielding bonds (other things equal), a difference that the market does not allow. The logic is actually very easy if we simplify to a coupon-only case: if rates drop to, say, half, old coupons are necessarily priced to 2x new coupons, and the yield per dollar stays constant no matter which ones you buy / hold / sell / whatever. The assertion that being forced to buy new coupons at low yields somehow dilutes returns clearly does not hold water. Adding principal into the picture complicates things, I'll admit, but I suspect that a more complex argument about expected total return per dollar will lead to exactly the same conclusion.

Could you clarify? Where is the mispricing (a.k.a. free lunch) in hot funds? Like I said, I've heard this argument before and I've always dismissed it, but your voice is a lot more respectable. In my mind, bond funds are exactly identical to bond ladders before taxes and expenses, and I'd like to know what, if anything, I'm not understanding.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 2:48 pm

OGd
couple of points.

Should be more clear here. On mark to market basis that must be true, So you're correct. The coupon yields you are now buying at are lower than the coupons in the ladder, but when mark to market the yields should be the same. Having said that you are adding longer duration bonds to portfolio, increasing the term risk of the portfolio. The one advantage is that it adds lots at lower levels so more opportunity to harvest losses. But I'm not aware of any muni funds that harvest losses, and pretty certain Vanguard does not. DFA will consider it if trading costs are low.

The other side of the coin is the greater danger, rates rise and investors sell, that causes fund to sell bonds that are not as liquid and likely incurring significant market impact costs. This is especially true of munis. Likely had effect when Whitney's forecast came out and scared investors who pulled huge amounts from muni funds.

And thanks for raising this
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Re: For munis, bond fund or ladder

Postby ogd » Fri Feb 08, 2013 6:43 pm

Thanks much for the reply, Larry. In the end, it does seem to be mostly about friction costs. Some quick comments:

Having said that you are adding longer duration bonds to portfolio, increasing the term risk of the portfolio.


A strictly fixed-duration ladder (the fair comparison) would have to do the same, I believe. But I agree that an advisor / investor might want to allow duration to decrease without necessarily market timing (e.g. foreseeing withdrawal, or better opportunities in CDs). This is harder to do with mutual funds.

The other side of the coin is the greater danger, rates rise and investors sell, that causes fund to sell bonds that are not as liquid and likely incurring significant market impact costs. This is especially true of munis.


I would expect the departing investors to be the ones taking that hit in the form of a lower NAV when they sell. I don't know exactly how NAV is computed, but the low-liquidity devaluation should in fairness be applied to *all* bonds in the portfolio and the sellers shouldn't be allowed to get a piece of the remaining bonds' value unadjusted for liquidity. For the remaining investors, the fund's value would eventually return to normal.

Likely had effect when Whitney's forecast came out and scared investors who pulled huge amounts from muni funds.


Ah, still smiling about that one. I rebalanced right into the worst of it and made a nice chunk of change. It would be interesting to see an analysis of any mutual-fund effects in that panic, along the lines above (e.g. did higher spreads hurt the long-term value of the funds?). Are you aware of any?
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Re: For munis, bond fund or ladder

Postby larryswedroe » Fri Feb 08, 2013 10:37 pm

Ogd
First, unfortunately when investors create net cash flows all the shareholders bear the trading costs, including market impact of the new flows in. Which is why some funds, particularly in less liquid asset classes impose redemption fees that go to the FUND, not to the fund management company.

Second, while lots of things are possible, here's example, say yield curve is flat. And all bonds in both the ladder and fund are 5%. Now rates collapse to 3%. Both the fund and the ladder, assuming same average maturity, would have same gain and both now would show 3% yield. The fund though now gets lots of new cash. It buys current coupon bonds at 3%. The ladder owns all bonds with 5% coupon while the fund now has lots of bonds with 3% coupon. The fund will have a longer duration, more term risk. The higher coupon provides bit of defense. Not much of an issue but just pointing it out. Note this is one reason for investors to prefer premium bonds. Another is that there are many investors, some by charter and some because of psychology, who won't by bonds at significant premiums. Which is why we love to buy them
(
The big issue is fund flows can cause big market impact especially in times of liquidity crisis and the lower the credit rating the greater the costs will be. This is one reason why junk bond funds have failed miserably at meeting their benchmarks. Frictions can be huge. And all investor bears the costs. So theoretical returns never get earned.

Hope that is helpful

Larry
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Re: For munis, bond fund or ladder

Postby pascalwager » Sat Feb 09, 2013 4:25 am

Larry,

Could you elaborate regarding the following?

For example someone living in Texas should almost certainly not own NY or Cal bonds, but if you buy a national fund you will.


Do you mean that national muni funds are inappropriate for anyone because they include bonds from states other than the investor's home state? I thought that national muni funds added geographical diversification, compared to a state muni fund.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Sat Feb 09, 2013 11:27 am

pascalwager
For those with relatively small amounts a fund is the only good option IMO. And state specific funds are appropriate IMO.
Having said that let's take an example, off top of my head as I don't have actual prices in front of me, but directionally will be right

Let's say you live in Texas a 0 tax rate state. You don't care which state's bonds you buy as there is no tax difference. If you live in high tax state like Cal or NY you care a lot as you don't get taxed on your own state's bonds but you do on other state's bonds. Now the higher tax states tend to have their bonds trading at lower yields than similar rated bonds of same maturity from low tax states because the higher tax rates create more demand.

So a similar rated Cal bond of same maturity might yield say 1.8% vs 2% for a Texas bond (again just making this up). So why would a Texas (Florida, Nevada, and so on) want to own a Cal (or NY) bond? They would not. They can get plenty of diversification buying bonds from the low tax states. But in a national muni fund they often buy bonds in proportion to the outstandings and NY and Cal are the two big issuers so you can own a lot of their bonds.

Owning your own portfolio avoids this issue (which matters even more at higher rates)

Hope that helps

Larry
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Re: For munis, bond fund or ladder

Postby stlutz » Sat Feb 09, 2013 12:03 pm

Actually, this discussion does raise a question for me. Given the liquidity risk and very slightly higher default risk of muni bonds, how much more yield do people here ask for over, say, Treasury bonds of equivalent duration (on a tax-equivalent basis)?
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Re: For munis, bond fund or ladder

Postby dbr » Sat Feb 09, 2013 12:06 pm

stlutz wrote:Actually, this discussion does raise a question for me. Given the liquidity risk and very slightly higher default risk of muni bonds, how much more yield do people here ask for over, say, Treasury bonds of equivalent duration (on a tax-equivalent basis)?


Larry may have a more astute answer, but I am thinking the usual naive answer is as soon as the tax equivalent yield is greater for the one over the other. That will be the standard "calculator" on when to buy muni's.
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Re: For munis, bond fund or ladder

Postby spyman » Sat Feb 09, 2013 2:28 pm

Larry,

In theory the idea of a muni bond ladder makes sense for the reasons you identify. But I am finding it very difficult to watch my mgr build the ladder since this is necessitating the purchase of numerous high quality but long duration bonds (I already owned several muni bonds --500k total --of short to intermediate duration so the longer bonds were needed to complete the ladder). Given how low the yields are right now and how long the duration is of these newly-purchased bonds (since January, I have acquired 10 bonds of 50k each that mature between 2020 and 2024), I am really worried about the prospect of inflation and rising interest rates and what this will mean for my investment. Seems like a terrible time to be committing to long duration bonds. My bond ladder is only 1MM (1/3rd of my overall portfolio which is 60% fixed) so the idea that I will be able to replace the maturing bonds with new ones at higher yields doesn't give me all that much comfort. In hindsight, I wish I had held off for a while in buying the longer duration bonds (to see what happens with rates/inflation) or opted for a bond fund. Once these long duration bonds are purchased, there really is no going back. While I'm sure I could sell them on the secondary market, I suspect I would take a big hit (I'm trying to figure this out now.

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Re: For munis, bond fund or ladder

Postby stlutz » Sat Feb 09, 2013 2:56 pm

Spy--

I know I'm not Larry (fortunately for Larry), but a couple of notes/comments:

Is your advisor constructing a ladder or just buying a bunch of bonds maturing after 2020? Buying a 5 year bond and putting 50% in a savings account and 50% in a 10 year bond are very similar from a risk perspective. It's important not to focus excessively on one single security but on the portfolio as a whole. Many "intermediate" term bond funds will also include short and long dated paper.

The thing to do is to pick a duration to suit your risk profile (many people here target between 3-6 years), and then hold a mix of securities that match that duration. If you have a lot of long-dated munis, then use the other part of your fixed income portfolio to buy a short-term bond fund.

Finally, inflation and rates can always go higher. That's not peculiar to the current situation. Many people (including myself) have been predicting that rates are sure to go up for 4 years now. We've all been wrong. Forecasting inflation is hard. So, a couple of suggestions:

--Figure out the bond duration you want to have for your portfolio as a whole and then stick with it. The exact mix of securities (as long as they are of high quality) doesn't matter that much.
--Google "why QE is not inflationary" just to find some smart people who argue that inflation is not "sure" to go up in the near future. They might be wrong, but it's a problem when we pick one fear and then only read people's opinions who confirm that fear.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Sat Feb 09, 2013 3:09 pm

stlutz
That is great question. You should get some premium because clearly munis have some credit risk and some liquidity risk. Now the liquidity risk might be zero if you have other assets you can access, like emergency reserve. And if you buy only the type bonds I recommend then the credit risk historically has been pretty close to zero. So a small premium should suffice.

spyman
First, as stlutz stated you need to determine the length of the ladder that is appropriate to YOUR situation, including your ability to take the risk of unexpected inflation. Some can take more risk than others. If have less ability to take such risks your ladder should be short. Also IMO you should consider the slope of the curve. When it's steep I would suggest all else equal to take bit more risk, as historically steep yield curves have rewarded investors. If it's flat, stay shorter. A reasonable rule of thumb is say 20bp per year to extend for taxables and say 16 for munis.
Second, personally I am limiting my bonds to 10 years or less.
Third, if you own some commodity exposure that can help hedge some of the risks you are concerned about (so you might think about adding some)
Fourth, I hope your advisor can buy at institutional prices. I would suggest you ask the advisor to show you where the bonds you bought traded in the interbank market. Anyone with a Bloomberg terminal can access this. and if they cannot tell you that would give me cause for concern. If you cannot buy at institutional prices then a fund is likely the better choice.

I hope that is helpful

Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby spyman » Sat Feb 09, 2013 5:55 pm

Thanks stlutz and larry. These are great points. I believe I am getting institutional prices as the mgr is Breckenridge (via Fidelity) and they only manage muni portfolios. No one ever discussed with me what the length of my ladder would or should be and I was too ignorant to raise this before committing. I now believe that the ladder is designed to have an avg duration of 5-6 yrs. This probably makes sense for me but I will discuss this with my Fidelity rep (we have call next week) I don't think I can direct that Breckenridge limit the bonds to 10 yrs or less (if this was what seemed appropriate for my situation) since it's a discretionary account. I don't have a sense of what the yield curve has been but the most recent bond (bought 2/4/13) is an Orange County Florida Sales Tax revenue bond (cusip 684515QX0) with a 5% coupon that matures 1/1/2024 and has YTM of 2.281%. I bought 40,000 at 126.096 so the principal amount is $50,438 and interest of $200. I have ordered but not read Larry's book yet so I'm still figuring out what all this means. I don't have commodity exposure right now. Any suggestions of what I might consider? (I am reading on the forum now the past posts re: CCF) Thank you!!
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Re: For munis, bond fund or ladder

Postby ogd » Tue Feb 12, 2013 1:40 am

Hi Larry,

Just wanted to say thanks for the reply & engagement. I'll think I'll have to digest the subtleties, such as the duration-extending on inflows and the liquidity effects, before my next batch of bond purchases. A thought-provoking article as always.

Cheers!
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Re: For munis, bond fund or ladder

Postby larryswedroe » Tue Feb 12, 2013 10:18 am

spyman
Yes I would assume they are getting institutional prices, but it cannot hurt to ask them to show you where that bond traded in the interbank market.
Anyone with a bloomberg terminal can check the interbank prices with that cusip, as all trades are required to be reported to the MSRB - Municipal Securities Rulemaking Board

Larry
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Re: For munis, bond fund or ladder

Postby magellan » Tue Feb 12, 2013 12:02 pm

larryswedroe wrote:Anyone with a bloomberg terminal can check the interbank prices with that cusip, as all trades are required to be reported to the MSRB - Municipal Securities Rulemaking Board.

Actually, anyone can check prices on reported trades at the EMMA website. Just click the search tab, scroll to the bottom of the page to accept the terms, then start looking up securities.

Here's an example of a randomly selected cusip (scroll to the bottom of the page and hit accept to see the data). Click the trade activity tab to see a list of recent trades and their associated prices.

On a quiet day, you may be able to follow exact blocks of securities from a seller, through multiple dealers, to a buyer. When this happens, you can see the markups applied along the way. For example, between 2/6-2/7 (from the security linked above) you can sort of follow a sale of $25k in face value. The seller gets $107, which seems like a fair price. There are a couple of inter dealer trades, with about 100bp of markup on the second one. Then a buyer pays $110 for those same securities that the seller sold earlier for $107. On some days, you can see large differences in the prices paid by different buyers on the same day. On other days, the spreads are very tight. Sometimes wide spreads are because of small lots, but there are cases that seem to show a large buyer clearly overpaying, compared to other buyers at roughly the same time.

If you peruse the site for a while, you'll see signs of many investors getting what seems like lousy pricing. Larry obviously knows his stuff and I'd bet anything his clients get great execution. You can definitely see many trades on the emma site where customers get treated fairly and markups are almost non-existent. OTOH, the individual bond market is an place where it's easy for investors to get badly fleeced.

Jim
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Re: For munis, bond fund or ladder

Postby jdb » Fri Feb 15, 2013 10:57 pm

As a amateur investor and long time lurker on this site who has been patiently building an individual muni bond laddder for past six years I find this topic fascinating. Lots of good points. My ladder focuses on small lots, not exceeding 20, with diversity in states and types and of course maturities, now cover every state with over 200 issues. It becomes a type of annuity. I do not plan to sell, just to reinvest proceeds in new bonds which I do on almost monthly basis as issues are called or redeemed at maturity. With the falling yields I now focus more on call dates, not maturities. My sweet spot is around 10 years so look for longer term bonds with calls around 10 years. In my unsophisticated opinion in order to focus on call dates the nominal interest rate needs to be above 5% or so for more assurance that bond will be called. I avoid new bonds and bonds issued in past few years with low nominal rates, since higher probability will not be called until maturity. If a good credit bond with over 5% nominal rate not called it is a "don't throw me in briar patch" problem, get benefit of higher rate to maturity. I also avoid issues with derivative debt, consider it sign of sketchy management, only exception a few too big to fail issues. On EMMA can see the spread. Often find I can purchase small lots at less than the prevailing purchase price of larger lots for same issue. Need to carefully review prospectuses and product info on EMMA. If an investor has the time and an interest in geography and finance can be a lot of fun. I do go down the credit ladder on occassion, especially with GO's where feel comfortable with the municipal issuer, though always investment grade. I am not concerned with the "low tax state" vs. "high tax state" issue, far more important to feel comfortable with the credit of the issuer, and in fact often find best credits in the "high tax state" issuers. I sleep better with muni bond ladder, but individual preference. I do buy my corporate bonds and of course stocks through Vanguard index funds . But I do miss the good old days of the "muni bond crisis", when there were lots more great individual muni buying opportunities.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Sat Feb 16, 2013 10:24 am

jdb
First, you point out one of the things many investors including advisors don't understand, that you can actually buy smaller lots at higher yields (even if the spreads in the interbank market are bit wider).
The reason is that when you are buying large lots, say $5-10mm you are competing against all the other institutional investors. When you buy a lot of say $50k-$100K or even higher, the institutional players like mutual funds are not there.
Second, all that matters is the AT return, so you should care about that not the pre-tax yield, taking your state tax situation into account. Not saying you don't but your post could lead one to think that was the case.
Third, call risk generally not rewarded, so while you get the higher yield, you don't typically realize it in return. And people forget that you don't even need rates to fall for calls to be costly. All you need is time, as you roll down the yield curve. Our rule of thumb is at least 80% call coverage, so if you would buy a 12 year bond it should have say at least 10 years protection.
Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby jdb » Sat Feb 16, 2013 11:16 am

Hi Larry. Thanks for your response. Yes, by purchasing smaller lots, and especially if look for bonds from smaller issuers with good credit and no derivative debt from rural largely agricultural areas can often get better yields including smaller spreads by going below radar screen of institutional buyers. Also agree as to AT return. In my case live in "no tax state", Florida, so only issue for me is credit quality and yields to call or maturity. Not sure that I understand the theory behind 80% call coverage. In typical bond purchase for me, say a 25 year water and sewer bond issued in 2005 with call in 2020 rated A1 without insurance and with nominal rate of 5%, would purchase at premium to par for yield to call say 3.5%. But since nominal rate is at 5% or higher I do not focus on years between call and maturity since am statistically assuming will be called. And if not I would be content to receive the higher rate with concomitant higher yield to maturity.
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Re: For munis, bond fund or ladder

Postby larryswedroe » Sat Feb 16, 2013 2:42 pm

jdb
The problem with bonds that have the call feature is that you no longer control the maturity, the bond only gets called when in issuer's favor and the yield pick up has not been rewarded well historically, and the risk doesn't mix well with equity risks. Risk/reward better for non callables. So we want to make sure that we have at least 80% of the period covered without ability to have it called.

Looking only at the yield to the call means you miss the risk that if not called it's either because rates are now higher (so your maturity just extended at the wrong time) or the credit risks showed up and the issuer cannot call it. Either way not good scenario.

Best wishes
Larry
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Re: For munis, bond fund or ladder

Postby magellan » Sat Feb 16, 2013 2:52 pm

Folks managing a ladder of individual bonds may find this bond portfolio spreadsheet helpful.

Jim
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Re: For munis, bond fund or ladder

Postby Bustoff » Sat Feb 16, 2013 7:35 pm

This is out of the blue but does anyone know why Muni bond funds lost 4% in one month back in Feb. 2008 ?
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Re: For munis, bond fund or ladder

Postby baw703916 » Sat Feb 16, 2013 7:53 pm

Basically, this was one of the aspects of the 2008 financial crisis. Municipal bonds, even highly rated ones, are relatively illiquid. In 2008 a lot of hedge funds, etc. had gotten themselves overextended buying municipal bonds on margin. When the crisis hit, they needed to sell quickly to raise capital, but because the securities they were trying to sell were very illiquid, the price plummeted. A good deal for the buyers, though.

The other aspect had to do with a very arcane class of bonds, "auction rate securities". Basically, these are variable rate bonds for which the rates are set periodically by auctions--only in February 2008 everybody was so overextended that there were no auction participants, and so the auction failed. This spilled over into most areas of the muni market.

Here's a paper that discusses it better than I can.

http://www.frbsf.org/economics/conferen ... Han-Li.pdf
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Re: For munis, bond fund or ladder

Postby stlutz » Sat Feb 16, 2013 7:58 pm

More broadly, it should be noted that munis tend to have higher stock market correlation than other types of bonds (even corporate bonds). State/local government finances are dependent upon sales taxes, property taxes etc., and hence their receipts rise and fall with the economy. During downturns, they become greater credit risks. So, their price movements will not always be in line with the Treasury market.
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Muni's aren't Risk Free

Postby EDN » Sat Feb 16, 2013 8:27 pm

stlutz wrote:More broadly, it should be noted that munis tend to have higher stock market correlation than other types of bonds (even corporate bonds). State/local government finances are dependent upon sales taxes, property taxes etc., and hence their receipts rise and fall with the economy. During downturns, they become greater credit risks. So, their price movements will not always be in line with the Treasury market.


Stulz,

That is a very good point. Vanguard Intermediate Muni was down a few percent in 2008 if memory serves. I once looked at a 60/40 with Muni and found that a 65/35 or so with Government bonds (AT) had the same risk and return. Just because you pay taxes doesn't mean munis are a default.

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