Muni bonds vs treasury bonds- Am I looking at this correctly?

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FIby45
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Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by FIby45 » Mon Nov 04, 2019 4:23 pm

Take two funds:

Treasury Fund- VFIUX w current 30 day yield at 1.61%
Muni Bond Fund- VWIUX- current 30 day yield at 1.59%

Assume taxes as follows: 11.3% state marginal, 35% federal marginal, and 3.8% NII taxes.

Treasury effective yield to this investor: 1.61% * (1-3.8%-35%) = 0.993% . This essentially pulls out the federal and NII which would be due to find an effective rate the investor will actually get to keep.

Municpal yield to investor: 1.59% * (1-11.3%) = 1.41%. The effective rate once removing the state taxes which need to be paid.

So the municipal is paying this investor: 1.41% - 0.99% = 0.42% more interest over treasuries. Obviously there is a bit more risk than treasuries which I'm unsure the 0.4% compensates him for the added risk.

Assumming this is held in taxable account- and the investor plans on a $300k up front purchase of bond fund, with $10k monthly purchases moving forward- are the munis the way to go?

Am I missing something in this calculation?

Historically what has been the spread between munis and treasuries? I guess with an ongoing strategy included the spread could widen making muni fund more attractive?

(Sorry for third person, I was originally posting this somewhere else)

bluquark
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by bluquark » Mon Nov 04, 2019 4:39 pm

FIby45 wrote:
Mon Nov 04, 2019 4:23 pm
Assume taxes as follows: 11.3% state marginal, 35% federal marginal, and 3.8% NII taxes.
Yes, at this tax rate, munis are a good idea in taxable account.

11.3% is a California tax bracket, I assume you live in California? Vanguard also offers California muni funds which also cut out the state tax: VCAIX (intermediate-term) and VCLAX ("long"-term, although still pretty intermediate compared to long-term treasuries). Personally, my core bond holding is VCLAX.
So the municipal is paying this investor: 1.41% - 0.99% = 0.42% more interest over treasuries. Obviously there is a bit more risk than treasuries which I'm unsure the 0.4% compensates him for the added risk.
In my opinion, 0.42% is more than fair compensation. The muni fund average credit rating is AA, only one notch below the treasuries. It is nationally diversified and any plausible muni catastrophe scenario tends to be regional. Also, the treasury fund has one year higher duration (more interest rate risk).

Munis are a "free lunch", because the tax break is only available to individual investors, and there is not enough wealth in retail high-tax-bracket accounts to fully equalize the tax-equivalent yields.
Historically what has been the spread between munis and treasuries? I guess with an ongoing strategy included the spread could widen making muni fund more attractive?
I don't know, but note that because bond funds rarely have much in the way of unrealized capital gains, you can easily change your holdings later if the spread becomes less attractive.

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Artsdoctor
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by Artsdoctor » Mon Nov 04, 2019 5:16 pm

With your marginal tax rates, municipal bond funds would be very attractive.

In answer to your question, a 10-year muni historically will pay about 80% of a 10-year treasury. However, that ratio has changed (and will continue to change periodically) so that you are now getting closer to similar yields.

Intermediate-term bond funds have traditionally been the workhorse of fixed income investing. There are cases to be made for short-term and long-term bond funds, but the longer the maturity (and the longer the duration), the more volatile the fund will be with changing interest rates. In a low rate environment, you'll be more sensitive to loss as interest rates increase. As a general rule of thumb, you'd want to be investing in funds that have an average maturity that matches your need for the money (for example, if you anticipate spending all of the money in 2-3 years, you'd avoid a fund with an average maturity of 5-6 years).

Your state marginal rate looks like you're a CA resident. If so, you should consider the CA intermediate-term tax-exempt bond fund (VCADX). Many investors recommend diversifying away as much risk as possible and might recommend 50% in the national fund (VWIUX) and 50% in the CA fund.

Some experts would recommend against holding a large percentage of your fixed income holdings in munis. Ideally, you'd hold your munis in your taxable accounts and your taxable bonds in your retirement accounts. Again, the concept would be diversifying your credit risk.

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FIby45
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by FIby45 » Mon Nov 04, 2019 5:28 pm

Artsdoctor wrote:
Mon Nov 04, 2019 5:16 pm


Your state marginal rate looks like you're a CA resident. If so, you should consider the CA intermediate-term tax-exempt bond fund (VCADX). Many investors recommend diversifying away as much risk as possible and might recommend 50% in the national fund (VWIUX) and 50% in the CA fund.

I am indeed in CA.

VCADX current SEC 30 DAY 1.43%, which would have no tax due, is nearly identical to the effective rate of VWIUX (1.42%) for tax brackets listed. If I was bumped up one more tax bracket in CA it might make more sense, but the diversification of VWIUX I think wins out for me.

Would you agree?

bluquark
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by bluquark » Mon Nov 04, 2019 5:40 pm

Artsdoctor wrote:
Mon Nov 04, 2019 5:16 pm
Many investors recommend diversifying away as much risk as possible and might recommend 50% in the national fund (VWIUX) and 50% in the CA fund.

Some experts would recommend against holding a large percentage of your fixed income holdings in munis. Ideally, you'd hold your munis in your taxable accounts and your taxable bonds in your retirement accounts. Again, the concept would be diversifying your credit risk.
Personally, I believe such recommendations are excessively paranoid. Risk should be viewed on a whole-portfolio level and any risk you can take with a muni fund is tiny compared to the risks being routinely taken on the equity side. Whereas the yield premiums by going into riskier munis are on the order of 0.5%, which is medium-sized.

They don't make muni funds that are anywhere near as risky as corporate junk bonds, long-term treasuries or EM bonds, so as long as you avoid individual munis, it's hard to go "too far" in loading up on risk in the muni space. And according to my spreadsheeting, stocks should go in tax-advantaged space at the top bracket as long as bond yields are below 6% (which the yield curve is telling us is likely going to be the case for decades).
VCADX current SEC 30 DAY 1.43%, which would have no tax due, is nearly identical to the effective rate of VWIUX (1.42%) for tax brackets listed. If I was bumped up one more tax bracket in CA it might make more sense, but the diversification of VWIUX I think wins out for me.

Would you agree?
Yes, if there is zero spread, may as well go into the more diversified one for now, even if the benefits of diversification are tiny.

However, consider also VCLAX (California long-term), VWLUX (national long-term), and VWALX (national high-yield). Look at the "duration" and credit rating distribution for a quantitative measure of the risk taken by these. You'll see that they are considerably safer than non-muni bonds with the words "long-term" or "high-yield" in the name.

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Artsdoctor
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by Artsdoctor » Mon Nov 04, 2019 5:53 pm

In order to compare your total return, using the SEC yield is a reasonable starting point. I'd argue that you want to also look at the distribution yield as well since that will also give you a reasonable idea of taxes which you'll pay. There are plenty of threads on SEC yield versus distribution yield which you might find helpful.

I personally wouldn't use the word "paranoid" as it was stated above, but perhaps choose "conservative" as a better representative descritor. You'd probably want to understand that some people recommending diversification throughout the fixed income world are professionals who are well-regarded. You can choose to invest differently, of course. However, I'd only recommend that a relative newcomer take into consideration what investment professionals, and not just arm-chair posters, have to offer.

bluquark
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by bluquark » Mon Nov 04, 2019 6:04 pm

Sure, I just recommend assessing the probability and severity of scenarios raised to justify conservative recommendations instead of just following the conclusions.

Professionals often implicitly take into account behavioral/sleep-at-night effects of risks when making recommendations for their clients' self-managed portfolios. Also they sometimes tailor their recommendations to the worst case -- residents of a small state with unbalanced pension obligations and whose state bonds are only available for purchase as individual munis. So, without necessarily contradicting the substantive concerns behind it, one-size-fits-all types of bond recommendations may be biased towards safety.

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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by grabiner » Mon Nov 04, 2019 9:54 pm

FIby45 wrote:
Mon Nov 04, 2019 5:28 pm
VCADX current SEC 30 DAY 1.43%, which would have no tax due, is nearly identical to the effective rate of VWIUX (1.42%) for tax brackets listed. If I was bumped up one more tax bracket in CA it might make more sense, but the diversification of VWIUX I think wins out for me.
My recommendation for mitigating the diversification issues is to split 50/50 between Vanguard Limited-Term Tax-Exempt and Vanguard CA Long-Term Tax-Exempt. This gives an overall intermediate-term duration, with half your bonds in CA, but more than half your bond interest exempt from CA tax.
Wiki David Grabiner

babystep
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by babystep » Tue Nov 05, 2019 12:38 am

OP, I went through similar situation. I did read many posts from Grabiner and other experts but couldn't decide for many days. I finally ended-up with Vanguard Tax-Exempt Bond ETF 30 days SEC is 1.71. https://investor.vanguard.com/etf/profile/VTEB

I gave weight to simplicity i.e. single fund vs two funds and diversification (already living and working in CA).

I would be eager to learn from what you decide for my future bond buying.

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FIby45
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by FIby45 » Tue Nov 05, 2019 8:34 pm

I went with VWIUX 50% and VCADX 50% at member recommendations.

Thought TEF are the same for me, maybe when they (inevitably) raise the tax rates in CA the fund will gain some value.

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Artsdoctor
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by Artsdoctor » Tue Nov 05, 2019 8:43 pm

babystep wrote:
Tue Nov 05, 2019 12:38 am
OP, I went through similar situation. I did read many posts from Grabiner and other experts but couldn't decide for many days. I finally ended-up with Vanguard Tax-Exempt Bond ETF 30 days SEC is 1.71. https://investor.vanguard.com/etf/profile/VTEB

I gave weight to simplicity i.e. single fund vs two funds and diversification (already living and working in CA).

I would be eager to learn from what you decide for my future bond buying.
One thing you need to bear in mind, though. The mutual funds described above accrue interest on a daily basis. This allows tax-loss harvesting to be done relatively easily. However, if you hold a tax-exempt investment, such as VTEB, the interest is not accrued daily and you are subject to the 6-month rule when it comes to tax-loss harvesting. Personally, I find this rule intrusive and off-putting so I avoid tax-exempt funds (or ETFs) which do not accrue interest daily. It may not matter to you so would not influence your decision.

https://www.bogleheads.org/wiki/Tax_loss_harvesting

babystep
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Re: Muni bonds vs treasury bonds- Am I looking at this correctly?

Post by babystep » Tue Nov 05, 2019 11:35 pm

Thanks FIby45. It is good to know the 6 months rule. Thanks for explaning it, Artsdoctor.

I am linking the thread where Artsdoctor and others have explained about the rule.
viewtopic.php?t=248335

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