Muni Fund for Downpayment and Help Understanding Bond Risks

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Nearly A Moose
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Joined: Fri Apr 22, 2016 5:28 pm

Muni Fund for Downpayment and Help Understanding Bond Risks

Postby Nearly A Moose » Tue Dec 06, 2016 10:42 pm

Dear Bogleheads:

Sorry for the long post; trying to organize all my thoughts at once. I’m looking for some input on which tax-exempt municipal bond fund I should use to hold the down payment on our next house. My question is both about which fund is most appropriate and how to understand potential bond fund risks should interest rates rise.

Basic facts:

-Will contribute $50,000 this December and in December 2017 to a taxable account earmarked for a downpayment
-May need the money as early as Spring 2019 (~27 months from now)
-Marginal tax rate: 49.1% (39.6% + 8.5% DC)
-Goal is get more yield than a CD or savings account
-Willing to accept a little risk to principal, as I think I’m oversaving a bit for this goal and have other reserves if truly needed
-I’'d be selling my current house and would also use those proceeds for the next house
-I'm not relying on any returns over principal for the downpayment; I just like getting more money

Considerations:

I really dislike the idea of just letting money hang out in a savings account. Even with a 1% yield savings account or a 2-year CD, taxes take a huge chunk of those yields. So, I’m very strongly considering a tax-exempt national muni fund. I’m currently considering:
-Vanguard Short Term Tax Exempt (VWSUX; Avg. Duration 1.2)
-Vanguard Limited Term Tax Exempt (VMLUX; Avg. Dur. 2.5)
-Vanguard Intermediate Term Tax Exempt (VWIUX; Avg. Dur. 5)
-A combination of two (but that would put me into investor shares)

If I were to go with the rule of thumb that I should choose a fund duration close to the expected timeline for needing the money, that would suggest the Limited Term fund.

I of course prefer the yield from the Intermediate Term fund. I’m willing to accept some risk to principal. If the value were down by 5% when I went to buy the house (i.e., $5,000 loss from a cost basis of $100,000), I could live with that. If it were down 10 percent, I’d be pretty annoyed but don’t think it would materially affect our ability to buy. Down 15% and it’s possible it affects our purchase decision, especially if that means rising rates have depressed my current house’s value. (But, in reality, I already have a taxable account that is larger than these numbers, so I could just sell from that if I had to, but it’s currently invested in stocks as part of my long-term investment plan and I’d prefer it remain so.)

If you use the rule of thumb that for every 1 percent increase in interest rates, a bond fund drops by a percent equivalent to its duration (i.e., a 5-year duration bond fund would drop 5%), interest rates would need to increase by 4% in 27 months for the Limited Term fund to drop 10% in value, and 2% for the Intermediate Term fund to drop in value. If rates increased by 5% in that period, the Intermediate Term fund would drop by 25%. And so on. A 4 or 5% increase in 27 months strikes me as a very quick runup, but I’ve only been investing in the current low-interest-rate environment, and I think this has happened in the past.

I had originally been thinking I’d be able to tolerate the risk of the Intermediate Term fund, but the above is making me question that and look more closely at the Intermediate Term fund. In doing some online research, I came across this Schwab paper on how bond funds have responded to historical rising interest rate cycles: http://www.schwab.com/public/schwab/nn/articles/Can-Bond-Funds-Make-Sense-When-Interest-Rates-Rise. This article looks at the last four rising interest rate cycles, and quite interestingly, it finds that a short-term bond fund always had a positive cumulative return, and an Intermediate Term fund had positive returns in 3 out of 4 cycles, and lost only 1.7% in total value when it did have a net loss. And these were over periods of 10-25 months with the Federal Funds Rate rising anywhere from 1.5% to 4%. So, this suggests to me that, based at least on these past events, my worst expected exposure with the Intermediate Fund would have been well within my tolerances. That’s confusing to me because it doesn’t seem to mesh with the rule of thumb I mentioned above.

Questions:

Thanks for sticking around this long. My questions, at last:
1. Which muni fund do you recommend (or do you recommend something else)?
2. Can someone help me make sense of the analysis about the downside risk of bonds with rising interest rates?

Many thanks in advance!

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saltycaper
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Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby saltycaper » Wed Dec 07, 2016 12:24 am

Nearly A Moose wrote:
If I were to go with the rule of thumb that I should choose a fund duration close to the expected timeline for needing the money, that would suggest the Limited Term fund.


This is not a good rule of thumb (though it might save some from making a bigger mistake). Problem is, if you choose a fund with a duration close to the expected time you need the money, you will very soon have to sell positions in the fund and move to cash (or a shorter fund) to shorten the duration, as the time you need the money is approaching ever closer, while the duration of the fund is bound by fund's investment strategy and the movements of the bond market. Even then, you are not guaranteed to have a particular number of dollars available to spend, though the likelihood that the number will be far off is limited. That's why "liability matching" is often carried out with instruments that provide a predictable cash flow when the money is actually needed, such as a CD or an individual Treasury bond. Yes, there are other ways, but they are too complicated and uncertain for the average investor, IMO.

Nearly A Moose wrote:
If you use the rule of thumb that for every 1 percent increase in interest rates, a bond fund drops by a percent equivalent to its duration (i.e., a 5-year duration bond fund would drop 5%), interest rates would need to increase by 4% in 27 months for the Limited Term fund to drop 10% in value, and 2% for the Intermediate Term fund to drop in value. If rates increased by 5% in that period, the Intermediate Term fund would drop by 25%. And so on. A 4 or 5% increase in 27 months strikes me as a very quick runup, but I’ve only been investing in the current low-interest-rate environment, and I think this has happened in the past.


This rule of thumb (which is only a rough estimate) doesn't apply to rate increases over a period of time, but rather a rate increase at a single point in time. If rates increased over a period of time, it's not possible to say what the loss will be over the time period without more specific numbers, and there might be no loss at all, but instead a gain.

More importantly, note that "rates" refers to the yield on all of the bonds in the fund and not the rates set by the Federal Reserve. More on this below.

Nearly A Moose wrote:
In doing some online research, I came across this Schwab paper on how bond funds have responded to historical rising interest rate cycles: http://www.schwab.com/public/schwab/nn/articles/Can-Bond-Funds-Make-Sense-When-Interest-Rates-Rise. This article looks at the last four rising interest rate cycles, and quite interestingly, it finds that a short-term bond fund always had a positive cumulative return, and an Intermediate Term fund had positive returns in 3 out of 4 cycles, and lost only 1.7% in total value when it did have a net loss. And these were over periods of 10-25 months with the Federal Funds Rate rising anywhere from 1.5% to 4%. So, this suggests to me that, based at least on these past events, my worst expected exposure with the Intermediate Fund would have been well within my tolerances. That’s confusing to me because it doesn’t seem to mesh with the rule of thumb I mentioned above.


That's because the change in the Fed Funds Rate was not matched by a corresponding change in the yield of the bonds in the funds. One good example would be the 2004-2006 time period. If you look up the yield on, say, the 10-year T-Note, how much did it change between June 2004 and June 2006? Looks like less than 0.5%. Meanwhile the FFR increased by 4%. Changes in the FFR are not really pertinent to most investors. If investors are concerned about the value of their bonds, they should be concerned about changes in the yield on bonds they hold.

Your timeframe is pretty short. I might use the short-term fund for a while if I thought it would make me feel better, but the prospect of making an extra couple-few extra thousand dollars or losing the same isn't really a gamble that draws me in.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

DCinvestor
Posts: 57
Joined: Wed Jun 10, 2015 7:45 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby DCinvestor » Wed Dec 07, 2016 7:04 am

So I recently went through this thought process myself and bought some intermediate-term tax exempt bonds (VWITX) as a test run. I only put about $10K into it. Since that time, the fund value has dropped by about $500 (or 5%). Not a big deal for $10K, but would have been a much bigger deal for 100s of K. That 5% may or may not recover in time for when I buy in a couple of years.

With on-line savings accounts yielding +1% and CDs at +1.3%, I've decided to just go this route and keep it simple. It's just not worth it to chase an extra ~1% yield with any downside risk that could run higher than that.

Just start stockpiling cash into a savings account and sleep well at night. :happy

Nearly A Moose
Posts: 294
Joined: Fri Apr 22, 2016 5:28 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby Nearly A Moose » Wed Dec 07, 2016 9:02 am

@saltycaper: thanks for clearing a few things up for me. I feel like bonds shouldn't be hard, but I still struggle to really understand the mechanics as well as I'd like. You think I should just abandon this effort and buy a CD?

@DCInvestor: thanks. Did you consider shorter term funds? Or was it just not worth the hassle?

DCinvestor
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Joined: Wed Jun 10, 2015 7:45 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby DCinvestor » Wed Dec 07, 2016 6:56 pm

I did consider it, but short term yield is so close to an on-line savings account that it just wasn't worth it for me. Although if you live in DC (as I do), earnings from ANY state's muni bonds are not taxable on your DC return. That can be a nice plus.

DCinvestor
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Joined: Wed Jun 10, 2015 7:45 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby DCinvestor » Wed Dec 07, 2016 7:00 pm

I did consider it, but short term tax exempt bond yields are close to (even less) than an on-line savings account. I may reconsider this decision in the future. If you live in DC (as I do), earnings from ANY state's muni bonds are not taxable on your DC return. That can be a nice plus. You've just got to do the math.

Nearly A Moose
Posts: 294
Joined: Fri Apr 22, 2016 5:28 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby Nearly A Moose » Wed Dec 07, 2016 9:41 pm

DCinvestor wrote:I did consider it, but short term yield is so close to an on-line savings account that it just wasn't worth it for me. Although if you live in DC (as I do), earnings from ANY state's muni bonds are not taxable on your DC return. That can be a nice plus.



Interesting. I do live in DC (love the city despite paying through the nose in all regards for the privilege to live here), and I didn't realize that any state muni bond would be tax free. That's not nothing on an after-tax basis.

DCinvestor
Posts: 57
Joined: Wed Jun 10, 2015 7:45 pm

Re: Muni Fund for Downpayment and Help Understanding Bond Risks

Postby DCinvestor » Fri Dec 09, 2016 6:49 am

In general, I would definitely recommend diversified muni bond funds for taxable bond holdings for high income investors who live in DC (for the significant tax advantages on the bond payments). I just don't know if it's worth the hassle for a down payment you will pay within the next two years.


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