## mimicking duration of total bond using municipal bond funds

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boglebrain
Posts: 113
Joined: Sat Mar 15, 2014 9:55 am

### mimicking duration of total bond using municipal bond funds

I've asked about the optimal makeup of short, intermediate, and long term bonds for the bond portion but trying to come to a better answer. I'm trying to get at something quantitative and thought I could try to mimic the total bond fund average duration.

1. I want to use municipal bonds in my taxable accounts given both federal and CA taxes.
2. I think it make sense to mimic the average duration of the total bond market. Currently it is 6.1 years (see https://personal.vanguard.com/us/funds/ ... 0584#tab=2)
3. If I use national limited term, CA intermediate and CA long I can reconstruct this average duration by appropriately weighting them.

National Muni limited term: 2.4 years (see https://personal.vanguard.com/us/funds/ ... =INT#tab=2)
CA intermediate: 5.3 years (see https://personal.vanguard.com/us/funds/ ... =INT#tab=2)
CA long: 7.2 years (see https://personal.vanguard.com/us/funds/ ... =INT#tab=2)

4. There are various solutions to the weighting. In this formula below a = % of bonds in short; b = % intermediate. Note that long will be 1- (a+b).

a * 2.4 + b * 5.3 + (1-(a+b))*7.2 = 6.1

This describes in a line and simplifies to 1.1 = 4.8 a + 1.9b

This yields the following solutions:

short med long
5.0% 45.3% 49.7%
10.0% 32.6% 57.4%
15.0% 20.0% 65.0%
20.0% 7.4% 72.6%
23.0% -0.2% 77.2%

As you can see you have to keep the short term fund below 23% in order to find positive values for the % medium and the % long.

Is there a flaw in this approach? I realize that bonds are really meant to have some stability and you can use for rebalancing. What I've read before is many people settle for the bulk in the medium term funds but this shows to get to average duration of the total bond fund you need to have much more in long and very little in short.

Is there something fundamentally different about the average duration of different classes of bonds (e.g. treasuries or corporate bonds) that also enter into the total bond fund?

I'm kind of inclined to do something like 15% short, 20% medium and 65% long as I can weather the time horizon for the bond to recover price in an increasing rate environment...and then I'll get a higher yield in the meantime. Then with 35% of bonds in short/medium that can be used for emergency or rebalancing.

Note that if one is not comfortable with that amount focused in one state you can add intermediate/long term national municipal bond funds.

Thoughts?

Dale_G
Posts: 3139
Joined: Tue Feb 20, 2007 5:43 pm
Location: Central Florida - on the grown up side of 81

### Re: mimicking duration of total bond using municipal bond funds

If you wished, you could also use 0% short - 58% intermediate and 42% long. It probably won't matter much which of the solutions you use, but I prefer to keep things simple.

Dale
Volatility is my friend

TD2626
Posts: 637
Joined: Thu Mar 16, 2017 3:40 pm

### Re: mimicking duration of total bond using municipal bond funds

I read over this thread. Interesting math and ideas.
Dale_G wrote:
Sat Oct 07, 2017 9:13 pm
If you wished, you could also use 0% short - 58% intermediate and 42% long. It probably won't matter much which of the solutions you use, but I prefer to keep things simple.
The short-term bonds are for stability, though, and even if overall risk level is maintained having is it the case that having some short term bonds in an emergency (to supplement FDIC-type savings) could be reasonable?
boglebrain wrote:
Sat Oct 07, 2017 7:07 pm
Note that if one is not comfortable with that amount focused in one state you can add intermediate/long term national municipal bond funds.
Having all munis in a single US state or territory can be risky (e.g. Puerto Rico). There's more to bond risk than duration risk, there's also credit risk. Vanguard's California bond funds are thought to be fairly high-grade but that doesn't mean they have zero credit risk. Is the state-specific risk compensated by the tax drag avoided by those bonds not having state-level taxes? If so, why? If not, what would an adequate split be between state-specific and national munis? Hard questions, of course, and just some stuff to think about. I'm not an expert and I don't know what the answer might be.

Also, this portfolio would have a lot of funds. Slicing and dicing bonds is fairly complex. Is the (possibly small?) benefit of having a (possibly?) slightly better allocation worth the hassle adding many funds? I don't know one way or the other.

jhfenton
Posts: 3685
Joined: Sat Feb 07, 2015 11:17 am
Location: Ohio

### Re: mimicking duration of total bond using municipal bond funds

I wouldn’t find it worth the trouble to use all three funds. I’d use the CA long and the national limited-term. That’s what I do in Ohio. (We don’t have an OH intermediate fund anyway.) Using the CA long fund makes most of your interest state tax exempt; the national limited term gives you some low-volatility munis to sell if you need to cash some out on short notice (and some geographic diversity).

welderwannabe
Posts: 846
Joined: Fri Jun 16, 2017 8:32 am

### Re: mimicking duration of total bond using municipal bond funds

I am not currently in the short-term fund. I moved my short-term taxable money into the municipal money market. It is 82bp right now versus 91bp for the short term fund.The MM yields very close to the same amount as the short term bond but has principal stability in the face of rising rates (if you believe they are rising, some do and some don't). Just some food for thought.

Edit: I realize you are looking at limited-term instead of short so my above statements may not be as helpful as I had hoped!
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

mega317
Posts: 2569
Joined: Tue Apr 19, 2016 10:55 am

### Re: mimicking duration of total bond using municipal bond funds

jhfenton wrote:
Sun Oct 08, 2017 6:53 am
I wouldn’t find it worth the trouble to use all three funds. I’d use the CA long and the national limited-term.
Same if all my bonds were in taxable. I don't see the benefit to holding all three.
Is there something fundamentally different about the average duration of different classes of bonds
I'm not sure what you're asking here but I am taking it as an opportunity to point out that not all long bonds are created equal, or even comparable. California's long-term fund duration is 7 years, the long-term bond index is 15 years, long-term treasury is 17 years. Plot those funds alongside Vanguard total bond. The CA long-term fund is much much closer to total bond than any of the long-term funds.
short med long
5.0% 45.3% 49.7%
10.0% 32.6% 57.4%
15.0% 20.0% 65.0%
20.0% 7.4% 72.6%
23.0% -0.2% 77.2%
What are the weighted SEC yields on all these combinations? I bet it's really close. I think you are overthinking this.