Larry, et al: Value in Municipals?

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penumbra
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Larry, et al: Value in Municipals?

Post by penumbra »

I've been following the TIPS threads with great interest, and have purchased a considerable amount because of the attractiveness of current yields.

For those with room for bonds in taxable accounts, would you say that AAA muni's have as compelling values as TIPS at this time? I know there is less risk in government securities, but I read that yields are compelling as well.

If so, do you keep maturities shorter for muni's than you might for TIPS? How far out would you feel comfortable buying muni's in this environment?
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Post by larryswedroe »

absolutely, and it wont last much longer IMO. Spreads have already come in quite a bit but still a lot more to go.

Just stay at the very highest end of the credit spectrum--and only by based on underlying rating or prerefied bonds backed by Treasuries
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cato
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Post by cato »

I recently started buying California Muni CEFs. These use leverage and were badly bruised by the Auction Rate securities fiasco.
The result is they now trade at 20%+ discounts to NAV and feature yields over 7%. That's for average AA-rated portfolios.

I think TIPs and Munis are a great complement to each other. The Munis give you the best after-tax yields in decades, while the TIPs cover some of the inflation risk. For my part, I use both TIPs and an inverse long-bond fund to hedge the duration and inflation risk in the Munis.

If you want to play it safer, you could buy a VG Muni fund like VCAIX or VCITX, though the average ratings for them is actually somewhat lower and they only yield 4.5-5%.
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cato
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Post by cato »

I forgot to add: I carefully examine all the holdings of the Muni bond funds. Beware of bonds whose ratings are trumped up by "insurance."

Insurance from AMBAC, MBIA, et al, isn't worth squat, IMO. If the rating is based on that, you don't want it. As Larry mentioned, pre-refunded or u.s. govt guaranteed are the best way to go.
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daryll40
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Post by daryll40 »

Larry,

I believe, that like me, you have a fairly large helping of municipal bonds. In my case I have the Vanguard Pa Insured Fund and the Vanguard Limited Fund.

My concern is inflation. Don't you think that there is a much-greater-than-before chance that all of this will end in big-time inflation? And that 4 or 5 percent municipal bonds will get decminated? The Limited Fund only as a 2.5 year duration and the Pa Fund, similar to the Vangard's national long term muni fund has a duration of about 7 years I believe. They are called "long term" but actually are "intermediate" it would appear.

But even at that, averaging my two funds, similar to what an individual bond ladder would be like I believe, gives a 4-5 year duration for the total portfolio...inflation would clobber that. No?

Or am I silly to worry about inflation in this new world?
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Post by larryswedroe »

Daryl

First, I completely agree that while the short term risk is deflation the long term risk is clearly inflation--due to the large injection of both monetary and fiscal stimulus. And with a one-sided, potentially veto proof party controlling the white house and Congress it is possible any sign of fiscal responsibility could go out the window--possible (I hope not).

So yes I think it is possible and one should build that risk into the plan. But that is always true as crystal balls are always cloudy. That is why I recommend TIPS as the preferred holding for tax advantaged accounts--pretty much only fixed income asset you need. And then if hold munis, stick to the intermediate part of the curve which is generally the sweet spot anyway. Finally, if using intermediate term munis which have more inflation risk then consider adding some CCF to hedge that inflation risk. If you don't get the inflation--great as your munis will do fine. But if you do then the CCF will help hedge that risk to some degree at least
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Post by baw703916 »

One the other hand, if future fiscal policy were to include an increase in marginal tax rates, then tax free income would be at a premium, and municipal bonds' market values ought to go up, so owning them would be a good move.

Best wishes,
Brad
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baw703916
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Post by baw703916 »

larryswedroe wrote: And then if hold munis, stick to the intermediate part of the curve which is generally the sweet spot anyway.


Larry,

I'm curious what duration/maturity you define as intermediate.

The reason I ask is that Vanguard's TE Bond funds tend to have much shorter average maturities than their taxable counterparts. For instance, the Long-Term Tax-Exempt Fund has an average maturity of about 12 years and an average duration of about 7 years, but the Long-Term Index Fund (taxable) has an average maturity of 20 years and an average duration of about 10 years.

I know you prefer individual bonds to funds, but does a 12 year maturity/7 year duration strike you as long-term or intermediate term?

Thanks and best wishes,
Brad
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Post by daryll40 »

larryswedroe wrote:Daryl

First, I completely agree that while the short term risk is deflation the long term risk is clearly inflation--due to the large injection of both monetary and fiscal stimulus. And with a one-sided, potentially veto proof party controlling the white house and Congress it is possible any sign of fiscal responsibility could go out the window--possible (I hope not).

So yes I think it is possible and one should build that risk into the plan. But that is always true as crystal balls are always cloudy. That is why I recommend TIPS as the preferred holding for tax advantaged accounts--pretty much only fixed income asset you need. And then if hold munis, stick to the intermediate part of the curve which is generally the sweet spot anyway. Finally, if using intermediate term munis which have more inflation risk then consider adding some CCF to hedge that inflation risk. If you don't get the inflation--great as your munis will do fine. But if you do then the CCF will help hedge that risk to some degree at least
Larry,

Thank you for responding and addressing my concern. I appreciate your advice. My bonds are pretty much set up as you suggest, although my IRA is in the Vanguard TIPS Fund versus individual TIPS. I don't understand CCFs but I guess I need to learn!

Anyway, I keep asking about inflation but it seems that people are only focused on the current deflationary scenario. It just seems to me that the odds are high that this will all end in inflation.
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Post by larryswedroe »

Brad
I would say intermediate is basically around 5 years maturity

Darryl
Yes most people focus on the noise which at the moment is deflation. But smart investors plan for long term horizons and what risks can show up and then build portfolios to hedge those risks.
hurshaw1
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what about default risk?

Post by hurshaw1 »

I keep reading about tax revenues dropping and governments needing to make big cuts in budgets. Where I live (NY state) they are projecting HUGE deficits, state city and local. To date, politicans have not been able to agree to cut spending or raise taxes -- what a useless bunch, but I digress...
Won't deficits at the muni level lead to higher risk of default, even for AAA issues? What happens when they can't repay or sell new debt? What am I missing.
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Post by larryswedroe »

Yes the risks are higher which is among other reasons why all yields are trading at records vs Treasuries, but even in Great Depression AAA munis held up well and we are not going to have a Great Depression IMO. Doesnt mean there may not be any losses and there may be some temporary defaults too where payments are delayed. But IMO ultimately AAA muni portfolios will prove to be prudent investments. Not guaranteed of course or there would be no risk and they would be trading at about 65% of Treasuries not 120+%
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taking on risk in bond investments

Post by hurshaw1 »

Larry-

If I understand your response, you are saying that yes the risk is higher, and we are being compensated for it. I would like to ask a more general followup on bond risk and returns in general:

I have what I once thought was a nicely diversified portfolio of bond funds; Vanguard Total bond market, VIPSX(TIPS), a muni fund and a highly rated foreign bond fund...but instead of the stability I had hoped for to offset the declines in equities, I have seen share price declines here too, even in a declining interest rate environment.

Suppose one wants to use bonds to diversify and provide stability to a portfolio -- are there some bond classes that no longer play that role as their risk increases? In these times, are there lessons for bond investors as well?

I have maintained my allocation --perhaps foolishly-- and have not run to the safety of Treasuries and CD's, but am wondering if B&H applies to bonds as well as stocks. I may be off the original topic, and the horse may already be out of the barn...but could some diehards weigh in on the appropriateness of various bond classes in this environment, if the objective is to reduce risk and volatility?
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Post by larryswedroe »

hurshaw1

IMO the only fixed income assets one really needs are Treasuries and AAA/AA munis. No real need for anything else and likely to do worse--especially owning risky assets like high yield debt, preferred stocks, EM bonds and convertibles. If you want more return than these instruments provide just tilt your portfolio more to size and value and you will get the returns in more tax efficient manner and will be more diversified and the you lower the cost of your fixed income investments too
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Post by bb »

Larry, Others,

I am familiar with the arguments for slice and dice on equities
vs just "owning the whole market" via the total stock market
index. Is your recommendation for only needing TIPS and munis
the equivalent of slice and dice for equities?

Why don't you recommend just buying the total bond fund for
most people? Seems like Jack Bogle indicated there would be
nothing wrong with having just a total stock fund, total bond
fund, and cash.

Brian
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Post by ilan1h »

I am curious if any of you are choosing to invest in the national muni funds rather than state specific funds? Obviously you get more of a tax break when you invest in the munis that are specific to your state; however, this comes with more concentrated risk. I feel that it is fairly safe to assume that with a national fund there is almost a zero risk of calamitous losses. However, if you are invested only in your state there is a much greater risk of default (still small, but greater than national).
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Post by larryswedroe »

Brian, if you read my bond book and my alternative investment book you will learn why IMO you don't need any of the other assets and IMO are better off without them. MBS for example which make up a significant part of the TBM have embedded puts and calls which IMO don't really make sense---if they did then investors would do that with Treasuries and I don't know any one that does.

Corporates have call risk which I don't like for variety of reasons, and they have equity risks which are better taken with equities.

And any hybrid like junk, EM bonds, converts, preferreds is not an efficient way to get the same expected return and there is virtually nothing unique with converts, junk and preferreds--at least with EM bonds you do get some diversification benefits but risks tend to show up at wrong time

So stick with what I recommend--Treasuries (mostly TIPS) and munis. All you really need. In this case simple IMO is actually best
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Post by oneleaf »

Hi Larry,
During a flight to quality as extreme as we are seeing today, do you think there is a point where someone might be better off switching their nominal treasuries to the highest rated investment grade bonds?

I understand there is some equity risk in even the highest rated corporate bonds. However, in this environment, I wonder whether a 60/40 stock/treasury allocation could be improved if it was, say, 55/45 stock/corporate-bond allocation.

Is there a point where the price of safety has been bid up so high that one might want to reduce their exposure to the highest end of the safety-spectrum? Or do you think the efficiency of the 60/40 stock/treasury (as in the example above) allocation still holds true?

BTW, in today's environment, the decision to go 60/40 stock/TIPS would be a very attractive situation. So perhaps for the purpose of this question, it would be best to also assume that TIPS have also been bid up so high as to offer anemic real yields during this flight to quality.

Thanks for your comments.
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Post by richard »

oneleaf, nominal treasuries have increased in price, so as part of normal rebalancing you could sell some treasuries and buy stocks.

I don't have any objection to highest quality short corps, but if you follow general barbell investing (low correlation extremes rather than middle of anything or rather than broad market), treasuries (or TIPS or munis) plus equities is better than any sort of hybrid, including corps.
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Post by larryswedroe »

one leaf

Of course we all have cloudy crystal balls and there does seem to be huge liquidity premiums in corporate bonds--but that is IMO mostly only an illusion-----you have the same liquidity premiums now in stocks. So especially since we cannot know the future, and most people are risk averse, I think that the best strategy is to lower BETA and raise tilts--keeping expected return the same but cutting fat tail risk. I don't know anyone that is really unwilling to give up the good fat tail opportunity to at same time get rid of the bad fat tail risk---yet few people do it because they don't understand this issue

Finally, the only place corporate risk has been rewarded has been the short term---but again, even there perhaps you would have been better off with equity tilts. The only other thing I would say is this, now you have less of the call risk with longer term corporates--in effect they are now all "fallen angels"---and thus the risk/reward is now better in that you have more of the upside of equities than you did better as prices well below par---but of course you are still limited by the par on the upside and you are not with equities.

I hope that is helpful
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Post by hurshaw1 »

Could someone please explain the terms "good fat tail opportunity" and "bad fat tail risk", to help me follow the discussion? thanks
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Post by SmallHi »

To the OP:

a) its not really necessary to perform all sorts of relative value analysis in the fixed income markets. Choose your equity/fixed split...as the rebalancing between the two will capture most of the dislocations in risk/expected returns. (for example, if there is a significant "yield pick up" today in longer dated munis relative to short term, you can bet that "liquidity risk" is also baked into Small Cap Value stocks -- and you are better off taking your risks in stocks, not bonds)

b) in each segment of the bond markets, the rules are basically the same -- keep it short and high quality. You can do 99% of what needs to get accomplished with ST Bond Index and Ltd Term tax exempt.

c) extending out further in maturity or lower in credit quality is unnecessary in a balanced portfolio framework. Longer term/lower quality behave a lot like the risks effecting smaller companies (liquidity) and value stocks (econmic cyclicality)

d) be very careful "diversifying" or "reducing risk" with asset classes with ultra high volatility. Nothing wrong with them, just have rational expectations. Eventually (sometimes at worst possible time) the law of averages catches up with you. If you want to reliably lower risk, you have to add low risk. Corporations, endowments, hedge funds -- they all made the same mistake: expecting the magic of investment alchemy to always bail them out (just cobble together a hoard of high risk/return assets with historically low correlations and you've got yourself a free lunch)*

sh
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Post by Sidney »

Larry - any rule of thumb (ballpark) on what the equivalent equity-ST Treasury mix would be if one were to move out of short term investment grade bonds?

Thanks,

Sid
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Post by larryswedroe »

hurshaw

The left tail is the black swans showing up that lead to crises--bear markets. The right tail is the bull market that exceeds expected returns.

Sidney--ST investment grade bonds ON AVERAGE have very little equity risk, probably just a few percent. The problem as people are now learning is that the equity like risk increases in times of crisis.

For intermediate bonds I would say something like for investment grade 10%, Vanguard high yield (one notch below) more like 20-25%, and for real junk could be more like 40%+, depending on how deep.

The longer the term the more equity like and vice versa

Sorry don't have a better (more exact) answer for you. Hope that helps
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Post by oneleaf »

Larry,
Thanks for the explanation. Appreciate it as always!
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Post by ilan1h »

larryswedroe wrote:one leaf

Of course we all have cloudy crystal balls and there does seem to be huge liquidity premiums in corporate bonds--but that is IMO mostly only an illusion-----you have the same liquidity premiums now in stocks. So especially since we cannot know the future, and most people are risk averse, I think that the best strategy is to lower BETA and raise tilts--keeping expected return the same but cutting fat tail risk. I don't know anyone that is really unwilling to give up the good fat tail opportunity to at same time get rid of the bad fat tail risk---yet few people do it because they don't understand this issue

Finally, the only place corporate risk has been rewarded has been the short term---but again, even there perhaps you would have been better off with equity tilts. The only other thing I would say is this, now you have less of the call risk with longer term corporates--in effect they are now all "fallen angels"---and thus the risk/reward is now better in that you have more of the upside of equities than you did better as prices well below par---but of course you are still limited by the par on the upside and you are not with equities.

I hope that is helpful
Larry has been saying this for years; but only now do I truly appreciate it. Only TIPS, treasuries and munis have avoided the carnage. With many of the others the "risk showed up at the wrong time"
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Post by Still Learning »

ilan1h wrote:
Larry has been saying this for years; but only now do I truly appreciate it. Only TIPS, treasuries and munis have avoided the carnage. With many of the others the "risk showed up at the wrong time"
TIPS prices have been extremely volatile in 2008, especially as real rates skyrocketed in recent weeks and TIPS prices dropped. This even though TIPS are Treasurys and are as safe as other Treasury debt,

Munis have also been very volatile with numerous concerns (bond insurance fundamental failure, overstated quality ratings, leveraged funds financing problems, flight to quality Treasurys, asset liquidation by institutions, deterioration of issuer fundamentals, to name a few)

In addition to Treasurys performing well in 2008, looks like GNMAs were good too.

Going forward though, at some point there could be a massive exodus from Treasurys, now paying very low rates (near zero for bills), to other assets. Many other assets have yield spreads (over Treasurys) that are at historic levels. In a massive exodus, Treasury prices could drop like a stone. WSJ discussed this point today.

S L
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Post by larryswedroe »

still learning

Let's hope that Treasury prices drop like a stone--but for right reasons: The liquidity crisis ends and people move to risky assets again.

What we don't want is Treasury prices falling because of inflation risks
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Post by Still Learning »

Larry wrote:
Let's hope that Treasury prices drop like a stone--but for right reasons: The liquidity crisis ends and people move to risky assets again.
I meant the good aspect of Treasurys falling - signs that the financial system is off life support and moving to the recovery room. While the patient improves it won't be long until worries about inflation revive.

Folks that went to Treasurys (and other low interest, liquid, safe havens) need to be vigilant for the coming tide change. When it does change the yield curve will go up and Treasury prices will fall, possibly significantly.

S L
Lemon99
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Re: Larry, et al: Value in Municipals?

Post by Lemon99 »

penumbra wrote:
For those with room for bonds in taxable accounts, would you say that AAA muni's have as compelling values as TIPS at this time? I know there is less risk in government securities, but I read that yields are compelling as well.

If so, do you keep maturities shorter for muni's than you might for TIPS? How far out would you feel comfortable buying muni's in this environment?
LarrySwedroe wrote: Quote

"IMO the only fixed income assets one really needs are Treasuries and AAA/AA munis". And ------Quote
"Just stay at the very highest end of the credit spectrum--and only by based on underlying rating or prerefied bonds backed by Treasuries".

Lemon99 wrote:

With the market continually going down I never bought any bond funds and have been instead taking money from the Vanguard MM Fund and buying CD's at Navy Fed. Credit Union and Penfed and my local bank for mostly 4&5% rates but still have too much in the Tax-Ex. MM at the low rate.

I do not understand about the bond funds like I should and perhaps should just stick with the CD's although it is a pain to use several banks to keep the amount FDIC safe if one is going out more than one year and a possibility of the $250,000 reverting back.

However, with regard to the bond funds my question is:

If my marginal tax rate is 28% then should I go with the tax-exempt bond funds?

Looking at the intermediate-term tax exempt(VWITX) it does have 3.5% at BBB and 0.4% at NR.
The limited-term tax exempt fund(VWITX) has 4.0% of BBB, 0.1% at BB, and 0.4% at NR.

Otherwise the bonds in both funds are AAA/AA.

So if I should go into a bond fund should I worry about these small %s or is this what you meant, Larry, when you said, "just stay at the highest end of the credit spectrum"?

Thanks.

Lemon99
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Post by larryswedroe »

Lemon

Even at low brackets now munis attractive because of the large liquidity premium

And while I would not buy the bonds below AA, the amount is fairly low and well diversified, and remember that a A muni has historical default rate FAR FAR below that of Single A corporate.
Lemon99
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Post by Lemon99 »

Larry,

Appreciate your reply, Thanks

Lemon
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