For munis, bond fund or ladder

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baw703916
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Re: For munis, bond fund or ladder

Post by baw703916 » Sat Feb 16, 2013 7:38 pm

stlutz and Eric,

I think though that a lot of the divergence between munis and Treasuries had to do with the flight to safety boosting the prices of Treasries. I think that for munis a lot of the reason for the price drop was liquidity, not credit risk (at least for things like highly rated GO bonds). As an example, TIPS actually went down too, even though credit risk wasn't an issue (but TIPS are much less liquid than nominal Treasuries). There also were some examples of general weirdness in the muni market (pre-refunded munis having higher yields than Treasuries, insured munis selling for less than the underlying credit rating of the issuer would imply--insurance can become worthless, but not be a negative).

Brad
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Re: For munis, bond fund or ladder

Post by jdb » Sat Feb 16, 2013 9:41 pm

Thanks Larry, for your comments. Most perplexing aspect of investing in individual muni bonds is the call options. In my limited experience the bonds with best yields and credit tend to have call options at least several years before maturity if not longer. You are right of course, a call option is not the friend of the investor, it is at the issuer's option, and if not exercised because then prevailing interest rates are higher than bond or credit problems, not good news for investor. OTOH, not sure why the yield to maturity of bond should not compensate investor for additional duration. At time of purchase an investor knows both yield to call and yield to maturity. Ideally would be satisfied with both yields so should be neutral whether bond is called or goes on to maturity. Way that I deal with this in muni bond ladder is to seek out bonds on secondary market with higher nominal rates and with acceptable yield to call so that probability higher that call option will be exercised and if not exercised there is significantly higher yield to maturity than yield to call, especially if significant time between call option and maturity. Appreciate your thoughts. Thanks again.

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Re: For munis, bond fund or ladder

Post by larryswedroe » Sun Feb 17, 2013 12:14 am

jdb
Few thoughts, yes the higher yield is there, but as I said, there is no evidence I've seen that it has been rewarded and some clear evidence it has not. And why take it? If it was such a good idea why don't investors right calls on Treasuries they own and take in the extra income, yet you NEVER hear anyone recommend that but they will buy callable bonds or MBS.
Second, definitely not right about being satisfied with yield to maturity vs yield to call. Reason again being that if it's not called likely a problem.
Third, there is one benefit that the higher yield from call does bring is that it gives you bit shorter duration, so hedge a bit against rising rates (but of course then it won't be called and you're stuck with the longer maturity.

And yes of course in flights to LIQUIDITY (as opposed to credit quality flight) munis can get hit. Have seen yields go to like 120% or more of Treasuries in past, eventually even attracting tax exempt buyers, and hedge funds doing arbs.

And I don't believe the highest grade munis have higher correlation with equities, with exception of relatively short periods of flight to liquidity. The kind of munis I recommend have had virtually zero credit losses.

Bottom line IMO this is reason to avoid, and another reason to avoid funds which love callable bonds because it allows them to show higher YIELDs attracting investors who don't know what they don't know.

Best wishes
Larry

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stratton
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Re: For munis, bond fund or ladder

Post by stratton » Sun Feb 17, 2013 1:14 am

larryswedroe wrote:And I don't believe the highest grade munis have higher correlation with equities, with exception of relatively short periods of flight to liquidity. The kind of munis I recommend have had virtually zero credit losses.
An example of high quality munis in a Morningstar chart.

Notice the Baird Intermediate Muni, which was 85% prerefunded muni bonds at the time, holding up pretty well in late 2008 as opposed to Vanguard's Intermediate Term Tax Exempt which was a little lower credit quality not doing as well.

Prerefunded is typically done with Treasuries so for intents and purposes they are tax exempt Treasuries.

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Munis Aren't Treasuries

Post by EDN » Sun Feb 17, 2013 9:34 am

stratton wrote:
larryswedroe wrote:And I don't believe the highest grade munis have higher correlation with equities, with exception of relatively short periods of flight to liquidity. The kind of munis I recommend have had virtually zero credit losses.
An example of high quality munis in a Morningstar chart.

Notice the Baird Intermediate Muni, which was 85% prerefunded muni bonds at the time, holding up pretty well in late 2008 as opposed to Vanguard's Intermediate Term Tax Exempt which was a little lower credit quality not doing as well.

Prerefunded is typically done with Treasuries so for intents and purposes they are tax exempt Treasuries.

Paul
Paul,

That fund is a special case (as you note) where the vast majority of holdings are backed by treasuries. But a look at the Fall of '08 still shows a decline in price (versus a gain in treasury/government bonds). And while it earned 5% or so for all of 08, that was still 60% lower than, say, Vanguard Intermediate Treasury or DFA Intermediate Government as examples of 2 funds with similar durations on the taxable side.

Eric

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Re: For munis, bond fund or ladder

Post by larryswedroe » Sun Feb 17, 2013 9:57 am

Since there was no credit risk with these bonds (pre refis) it obviously was a liquidity crisis, as even TIPS were hit (same reason). Should you not own TIPS for that reason. And basically the kind of bonds I recommend you get the same type result. It's basically a short term event. And the only issue you have is should you not buy munis and own Treasuries to avoid that risk? Of course not. Just need to be aware of the risk and be disciplined investor

Best wishes
Larry

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Re: For munis, bond fund or ladder

Post by Akiva » Sun Feb 17, 2013 10:12 am

Clive wrote:
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.
You don't even have to say this. The US has technically defaulted twice in the last 100 years. Investors were fortunate to not lose much money in either event, but it isn't like they are absolutely risk free. They just have less risk than anything else, and there's the assumption that if a serious default happened on treasury debt that you'd be just as SoL with other dollar denominated debt or stocks.

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Re: For munis, bond fund or ladder

Post by DaveS » Sun Feb 17, 2013 10:13 am

Larry: Thank you for a very informative series of posts. I set up a muni ladder during the 90's. But since I retired I am just letting it pay off and putting whatever I don't need into a national muni fund. I live in a no income tax state. Your right about not needing the CA bonds, but the tiny difference in payout isn't worth keeping the ladder in place. I also note that every individual muni I own has had it's rating go down slightly since I bought them in the 90's. Every one, but my lowest is still single A. I don't have to worry about that with a fund. Dave

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Re: For munis, bond fund or ladder

Post by afan » Tue Feb 19, 2013 10:35 am

This has been a fascinating discussion, but I am left with two questions that seem critical to me.

1. Is there any data on risk adjusted return to the bond ladder approach vs. a mutual fund of the same duration? After expenses, transaction costs, taxes on capital gains, tax loss harvesting, etc? Where can I find it?

2. Where can I find public independently audited results for bond ladders? Larry describes many potential advantages, but it is not clear how much difference they make in the real world, and I don't know where to go to see the effects. Are we talking about an extra 1% annual return? Half a percent? Less, more?

Thanks
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: For munis, bond fund or ladder

Post by Akiva » Tue Feb 19, 2013 11:04 am

afan wrote:This has been a fascinating discussion, but I am left with two questions that seem critical to me.

1. Is there any data on risk adjusted return to the bond ladder approach vs. a mutual fund of the same duration? After expenses, transaction costs, taxes on capital gains, tax loss harvesting, etc? Where can I find it?

2. Where can I find public independently audited results for bond ladders? Larry describes many potential advantages, but it is not clear how much difference they make in the real world, and I don't know where to go to see the effects. Are we talking about an extra 1% annual return? Half a percent? Less, more?

Thanks
I'd assume that Swedroe's firm and other firms like it could provide you (or at least potential clients) with this information. Maybe there are some academic studies as well, but I'm not familiar with them. This sort of question isn't really the sort of thing a typical finance professor is interested in.

I will say that *mathematically* it is much more plausible to claim that this sort of thing adds value than claiming that you can beat the stock market by superior returns forecasting. (Because in the latter case, even under very optimistic assumptions about forecasting ability, the portfolio math is such that there just isn't much room for a stock manager to change things in a way that leads to out-performance.) Furthermore, from an empirical and theoretical standpoint, the sorts of pricing anomalies that Swedroe is saying you can take advantage of are well established and understood.

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Re: For munis, bond fund or ladder

Post by larryswedroe » Tue Feb 19, 2013 11:16 am

afan
First, a fund and a ladder with the same risk characteristics should produce the same returns. You don't need data to show that
Second, the value added of a ladder can come simply from saving the fund's expense ratio, tax efficiency and (with munis) buying smaller lots that can have higher yields and ability to control credit and call risks, and also to eliminate trading costs due to hot money flows. Those things are easy to show.
Third, as to data, since it is not a fund, every investor will have a different return based on their state location, tax rate, maturity structure, etc.

Best wishes
Larry

afan
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Re: For munis, bond fund or ladder

Post by afan » Tue Feb 19, 2013 2:47 pm

Thanks both of you.

Akiva,
I agree that this does not seem to pose any interesting theoretical issues. I suppose one might wonder whether there are pricing inefficiencies somewhere, but without a clear idea of what they might be, it could be tough to get such a study published.

That said, there is a difference between saying that, in principle, one could exploit these opportunities and concluding that, in practice, the realized returns after expenses and taxes were higher with the ladder. Only data can answer the latter question.

Larry,

Again, I am asking about realized returns after expenses and taxes. Neither of these would be priced, so for the ladder to have higher risk adjusted realized returns it would need to beat the fund option on these factors. Again, one would need data to know whether that actually happens.

For an induvidual investor to do it himself he would have to believe the advantages outweigh his higher transaction costs. For an individual to hire someone to do it for him he would have to conclude that the fees to the advisor and the advisor's transaction costs would leave the ladder as the better option. If one expected, say, a 2% annual return boost before costs then it would be easy to rationalize the belief that it would be worthwhile after costs. If one expected a 0.2% return boost before costs then it would appear to be unlikely to be worth the effort and expense.

To the extent that one actually does engage in tax loss harvesting wouldn't that increase the complexity of the tax returns? For a fund, one enters only the reported net capital gain. For the ladder, one would have to report each transaction.

Since the ladders will differ for each client based on income, state tax rates, and risk preferences, one would have to study the realized returns of a series of ladder portfolios, in each case accounting for tax effects and more hassle at tax time. If one saw a large benefit to the ladder in the real world, then it would sound appealing. If the benefit appeared to be small, then it is probably not worth it.

Which comes back to the question of real world results and the magnitude of realized benefits of the ladder approach. Since one can get the fund management and reporting almost for free, the savings should have to come from the tax advantages. They would have to be large to generate a realized benefit, particularly after discounting for the tax filing complexities.

So...how large are the benefits of the ladder?

Thanks
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: For munis, bond fund or ladder

Post by larryswedroe » Tue Feb 19, 2013 3:41 pm

afan
an individual doesn't have to believe anything along the lines you suggest since any difference in higher transactions costs is either non existent (in Treasuries or Cds where it's actually lower) and tiny at best in munis--our cost is about 2-4bp in yield, so how much lower are you going to be? On other hand you can clearly buy bonds with higher yields in the smaller lots.

As to hiring an advisor. First if hiring an advisor anyway, there is not a cost but a clear savings. Now if that is the only reason to hire an advisor the fee should be very low because that is all they are doing is building and monitoring a fixed income portfolio.

As to complexity of tax returns: yes you report each transaction but so what? you get that on a form with all the transactions. There is no hassle nor more complexity.

And like I said, the benefits depend on lots of issues, so impossible to generalize. It even depends on what state you live in

Larry

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Re: For munis, bond fund or ladder

Post by afan » Tue Feb 19, 2013 4:41 pm

Larry,

[quote]our cost is about 2-4bp in yield[/quote]

I think you are talking about transaction costs for a firm running a $ billion plus bond portfolio. I was talking about an individual doing with a portfolio of, say, $1M. Would that 2-4bp yield loss still apply?

Hiring someone to do it: I think you said the cost just for that would be comparable to a Vanguard mutual fund, which would be about 0.12% for the Vanguard Admiral Intermediate Term Tax Exempt. I suppose you could say that, effectively instituted, there would be all gain with the ladder. Same expense ratio, somewhat higher yield customized to each investor, and perhaps some tax benefits. No losses due to less diversfication, no execution failures, and the tax loss harvesting might make defray some of the cost. But one would have to see it in action to find out whether it worked as planned.

The tax filing thing is a genuine concern for me. I have a very expensive tax preparer (me), and anything that extends the time invested in getting the taxes done has a real cost. If I end up with a few hundred dollars more per year, but have to spend an extra hour filling out tax forms, it is not worth it.

That is why some idea of the magnitude of the advantage would be important. Since it is more complex for taxes for sure (unless one does no TLH), and it is by definition less diversified, there has to be some payoff.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: For munis, bond fund or ladder

Post by larryswedroe » Tue Feb 19, 2013 5:14 pm

afan
That cost applies to the bonds we buy for individuals with typical lots in the 100-300k range, though some are larger and some smaller. Personally I prefer buying the small odd lots when I can get them as I don't care about liquidity issues for that portion of the portfolio (might have higher costs if needed to sell)

Re relative to Vanguard. So if you hire an advisor anyway you are saving money via the ladder and adding value in other ways as well. The yield would likely be higher on an all else equal basis. but not higher per se since we don't buy bonds Vanguard will buy (callables and lower credit risk).

It's no different re taxes as you get a form from the custodian and the advisor (I assume) showing the gains by transaction and summary. All the work already done to calculate the cost basis and the gain.

Sorry cannot be more specific.

Larry

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Re: For munis, bond fund or ladder

Post by BermudaAl » Thu Feb 21, 2013 5:26 am

I look at a few dozen of actual laddered bond portfolios when I was making the fund/ ladder decision. I also spoke with the investor/client in each case. Some were people I knew and others were references supplied by various managers I was considering. It was a ton of work to go through this analysis.

As Larry said, the returns were all slightly different as each portfolio was slightly different. I emphasize "slightly." In general, the performance of laddered portfolios of high quality bonds of the same duration tend to be tightly clustered. If they weren't, there'd be all sorts of people claiming they can "pick them" and there is tons of data that shows the main driver in bond performance differences for similar portfolios are expense ratios, not manager skill.

Larry mentions the "if you are going to hire an advisor anyway...." Many people on this forum don't and won't. An advisor will usually cost you substantially more than 12bps Vanguard charges for Admiral shares, but you'll get other benefits as well. I am not intending to address the "Should you have an advisor question" but I am pointing out that if you don't, nobody will do this for free. The portfolios I looked at usually paid management fees that were double, triple or higher than the Vanguard Admiral shares expense ratio until you starting getting into portfolios over ten million. Even then, it was tough to get the cost down to Vanguard's levels and nobody beat it.

Long-term, most of the portfolios I saw of the type that Larry mentions (very high quality bonds vs high quality bonds) did slightly worse than the similar Vanguard funds over time - something one would expect given the funds' slightly lower credit quality. These were real portfolios from real bond managers. Once again, I emphasize "slightly." Look at the chart in Stratton's post above and you'll see the pre-refunded high quality Bridgeway fund trails the Vanguard fund slightly over the last 5 years, though it did better in 2008 which one could argue is when you needed it.

I think most analytical investors want to see actual real world data on real accounts. I know when a manager can't deliver that, it's a big minus for me, especially given the easily accessible data on mutual funds. There's too much smoke and mirrors in the separate account investment world and too many people talk the talk but then don't quite manage to do what they say. As an investor, "theory", no matter how accurate, is hard to evaluate. I also think people in general do better on costs when they know every number is public and being scrutinized. Lots of firms use AIMR complaint reporting and Morningstar evens tries to rank separate account managers using their infamous backward looking "star ratings" applied to a bell curve distribution of separate accounts.

At the end of the day I concluded performance would be about the same in either case for portfolios with the same characteristics. I actually expect slightly better performance over time form a fund due to their ability to take slightly more credit risk because of their diversification. But that's small and I don't think the gap is wide enough to have any impact on rebalancing effects.

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Re: For munis, bond fund or ladder

Post by BermudaAl » Thu Feb 21, 2013 5:35 am

afan,
Vanguard has a white paper on bonds vs bond funds. You can find it here: http://www.vanguard.com/jumppage/researchpapers/.

On page 7 they have trading data for muni bonds for 3 days in August and Sept 2012. There is a vast difference on spreads for smaller trades vs bigger trades. I think it would be hard to do this yourself cost-effectively on a $1MM portfolio. A firm Like Larry's can aggregate trades to gain size.

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Re: For munis, bond fund or ladder

Post by larryswedroe » Thu Feb 21, 2013 9:58 am

BermudaAl
I would just add the following
A) the gross return in munis is not the right way to look at it, it's AT return, so you have to take into account the differences in state taxes
B) there are often times when mixing taxable and munis in same portfolio will make sense--we had been buying many CDs for taxable accounts in last few years for some clients
C) Yes we can aggregate bond purchases, but also as I noted while the spreads might be slightly smaller for very large blocks (not our costs are only about 10-20bp in PRICE over the interbank market, so it cannot be much lower, that's 2-4bp in yield for typical portfolio) that is not what matters. It's the YIELD to maturity. So you might say pay 10bp in spread more for a small lot than a huge lot, but the yield might be higher anyway because you are not competing with the institutions. I have seen bond buys at 20-30bp and even more higher in yield on odd lots.

The important thing is you really don't need to see historical results. All you need to see is the costs of the trades, which someone should be able to show you, the spreads they pay. The portfolio will get the return of the risks you wanted, term and credit. So what you want to do is the due diligence on the ability to buy at thin spreads

Best wishes
Larry

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Re: For munis, bond fund or ladder

Post by Trurl Klapaucius » Tue Aug 06, 2013 1:28 pm

Hi Larry,
Another issue to consider is the degree to which a fund’s muni bond holdings carry their own (underlying) ratings, or are insured and are given the rating of the insurance company. If a large portion of the fund’s holdings are insured by a single company, then the bonds will by simultaneously downgraded if the insurance company is downgraded. This potential lock-step downgrade of a portion of a fund’s holdings amounts to, in effect, a lower degree of overall diversification compared to that of a fund holding similar, but uninsured, bonds. The problem is amplified if the entire bond insurance industry is downgraded, as occurred during the financial crisis of 2008.
The same issue, of course, applies to bond ladders; but it is much easier for an individual constructing a ladder to keep track of insurance coverage. Conversely, I find it very difficult to determine what portion of a fund’s holdings are insured by what company. This information isn’t readily available from the prospectus or web-site. It is a daunting task to look-up each of a fund’s holdings on EMMA for this information, and the fund’s holdings may have changed by the time you are finished.
You may wish to include this issue on your list of factors that favor muni bond ladders over funds.
Best wishes,
Trurl

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Re: For munis, bond fund or ladder

Post by Call_Me_Op » Tue Aug 06, 2013 1:51 pm

Larry,

With respect to the section entitled "Avoiding the impact of hot fund flows", this seems like a simpler explanation of "Sell-Off Risk" that we have been debating on this board for months to years. I think you are just saying that the fund is forced to buy low and sell high because of the "hot money" crowd and this affects all investors in the fund. But why, if I don't sell, am I affected by the temporarily low prices that exist when the "hot money crowd' sells? This still is not clear to me.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: For munis, bond fund or ladder

Post by larryswedroe » Tue Aug 06, 2013 5:20 pm

Call Me Op
You are impacted because the fund may have to incur large market impact costs to sell in forced situation, certainly more than one would pay as a patient seller. The same thing happens to small cap funds in small cap bear markets. All shareholders bear the costs of such transactions. It's why DFA won't run retail money--at least among the reasons why--the institutions don't want to bear the expenses of hot retail money and by working with advisors the money is more disciplined. In fact in 2008 DFA I believe was the only fund family to have net positive inflows
Larry

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Re: For munis, bond fund or ladder

Post by magellan » Tue Aug 06, 2013 6:20 pm

Call_Me_Op wrote:But why, if I don't sell, am I affected by the temporarily low prices that exist when the "hot money crowd' sells? This still is not clear to me.
I'm no expert, but I'd guess as a holdout you'd get hit with side-effects from the frantic selling. Some of a fund's "better" securities may get flushed at bargain basement prices while less attractive securities are held because the manager knows they could never unload their dogs during a crunch (think Mortgage backed securities in 2008).

The choice between what gets flushed and what stays in the portfolio isn't just based on what's best for the folks left behind, it's partly based on what can be used to raise the cash that's needed immediately without showing any undue stresses in the fund that may cause more panic redemptions.

Jim

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Re: For munis, bond fund or ladder

Post by stlutz » Tue Aug 06, 2013 9:30 pm

The so-called "sell-off risk" only applies if the fund is mis-valuing the securities in its portfolio. If a bond can only be sold for $100 but the fund (or more specifically, their pricing service), says that the bond is worth $110, then shareholders who are holding onto the fund are hurt by redemptions as those who are selling are getting paid more than their shares are actually worth. If the fund says that the bond is only worth $100, then there is no penalty for shareholders who do not sell. I suppose that is one advantage of the ETF structure--the market price is more reflective of what bonds can actually be bought/sold for.

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Re: For munis, bond fund or ladder

Post by ogd » Tue Aug 06, 2013 11:24 pm

larryswedroe wrote:Call Me Op
You are impacted because the fund may have to incur large market impact costs to sell in forced situation, certainly more than one would pay as a patient seller. The same thing happens to small cap funds in small cap bear markets. All shareholders bear the costs of such transactions. It's why DFA won't run retail money--at least among the reasons why--the institutions don't want to bear the expenses of hot retail money and by working with advisors the money is more disciplined. In fact in 2008 DFA I believe was the only fund family to have net positive inflows
Larry
Hi Larry,

It would be interesting (and make that risk seem worth worrying about) if you could:
1) quantify it -- a specific instance of market impact costs meaningfully hurting the long term shareholders
2) explain why ETFs aren't a solution to this problem, or why they don't outperform funds after sell-offs. With ETFs the sellers bear the market impact costs.
3) explain why Vanguard's prospectus language allowing them to force redemptions in-kind isn't another solution.
magellan wrote:Some of a fund's "better" securities may get flushed at bargain basement prices while less attractive securities are held because the manager knows they could never unload their dogs during a crunch (think Mortgage backed securities in 2008).

The choice between what gets flushed and what stays in the portfolio isn't just based on what's best for the folks left behind, it's partly based on what can be used to raise the cash that's needed immediately without showing any undue stresses in the fund that may cause more panic redemptions.
That would seem to be a matter of choosing your fund wisely. As a long-term shareholder, I'm not asking to be favored, just not get ripped off for the sake of short-term performance.

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Re: For munis, bond fund or ladder

Post by larryswedroe » Tue Aug 06, 2013 11:29 pm

two things

Bond is bid at 100 and offered say at 100.2. Now in sell off bid-offer spreads widen as liquidity dries up and ability to sell larger amounts goes down at SAME TIME. So you can mark it at 100 but when you go to sell the large amount you might get 99 as market impact in a forced sale. Now all shareholders lose. And your sale drives all prices lower. Liquidity providers get paid a lot for providing it, and sellers pay a lot to get it in sell offs.

BTW-this is as magellan stated what happens sometimes is that the highest quality stuff must be sold because the market for the weaker credits dries up first in flight to quality. Example, Lehman had to sell their TIPS because the junk could not be sold and TIPS got crushed and yields rose dramatically while Treasury yields did not.

Larry

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Re: For munis, bond fund or ladder

Post by Call_Me_Op » Wed Aug 07, 2013 5:31 am

If this increase in the spread is pocketed by the broker, that would clearly represent a cost to all shareholders. If its just a market impact cost - meaning the value of the bonds is temporarily depressed during the sale - I guess that's also a cost if the prices recover at the end of the day when the NAV is calculated. Redemptions are at the closing price. So perhaps these are two mechanisms for the "Sell-Off Risk." I guess we still don't have concrete examples that quantify this risk.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: For munis, bond fund or ladder

Post by billyt » Wed Aug 07, 2013 5:41 am

If this "Sell Off Risk" appears, does it mean that a bond index fund would under perform its index? If so, we should be able to check for historical examples.

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Re: For munis, bond fund or ladder

Post by Call_Me_Op » Wed Aug 07, 2013 5:42 am

billyt wrote:If this "Sell Off Risk" appears, does it mean that a bond index fund would under perform its index? If so, we should be able to check for historical examples.
I think the effect is muted or non-existent in index funds.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: For munis, bond fund or ladder

Post by billyt » Wed Aug 07, 2013 6:13 am

OK, what kinds (or specific) funds does "sell off risk' have a potential for significant impact. I think muni's and TIPs were mentioned in this thread, is that right?

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Re: For munis, bond fund or ladder

Post by Call_Me_Op » Wed Aug 07, 2013 6:36 am

billyt wrote:OK, what kinds (or specific) funds does "sell off risk' have a potential for significant impact. I think muni's and TIPs were mentioned in this thread, is that right?
Yes, any funds likely to have significant potentially-illiquid holdings. Really, anything except for nominal treasury funds - but I would not think the effect is significant with index funds because they tend to be hold mostly high-quality bonds. The TIPS liquidity issue in 2008 may have been an isolated event - we do not know.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: For munis, bond fund or ladder

Post by larryswedroe » Wed Aug 07, 2013 7:00 am

Call me op
This issue is not isolated. Small/micro cap funds have been hit with this type expense in past. It hurt Bridgeway's micro cap fund for example.
Larry

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Re: For munis, bond fund or ladder

Post by billyt » Wed Aug 07, 2013 7:07 am

Thank you Larry. I was specifically inquiring about what Vanguard bond funds I should be worrying about for "sell off risk"

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Re: For munis, bond fund or ladder

Post by larryswedroe » Wed Aug 07, 2013 7:13 am

Billy
Well it depends on what you mean about "worry"
What people don't know is that the liquidity in the muni market has come way down as result of financial crisis. The reason is bank's don't want to tie up capital so they have all cut back on the amount of inventory they are willing to hold. That means when want to sell large amounts price impact can be big.
Is the risk here as great as with a micro cap stock--no
Are index funds more vulnerable? I really don't know. I would guess they are less at risk than active fund because they might have more stable cash flows, more patient investors. But I don't know that for a fact. And sell of risk higher in stocks than say in munis. I do know that DFA benefited from the sell off in 2008 as they were the only equity fund family with net inflows, allowing them to be at times a seller of liquidity as opposed to a buyer. The ability to trade patiently is a plus, especially in sell offs.
Hope that helps
Larry

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Re: For munis, bond fund or ladder

Post by Call_Me_Op » Wed Aug 07, 2013 7:43 am

larryswedroe wrote:Call me op
This issue is not isolated. Small/micro cap funds have been hit with this type expense in past. It hurt Bridgeway's micro cap fund for example.
Larry
Hi Larry,

What I meant by my comment is that I don't know if TIPS will ever experience that type of illiquidity again. I realize that other types of securities can and have experienced illiquidity issues.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: For munis, bond fund or ladder

Post by yukon50 » Wed Aug 07, 2013 10:40 am

Larry,

What do you think about the current muni yield curve? I noticed Vanguard LT Tax Exempt has a 3.3% yield.

Also, aren't muni yields lower than treasuries? Why are they higher yields than treasuries right now?

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Re: For munis, bond fund or ladder

Post by larryswedroe » Wed Aug 07, 2013 10:53 am

Call me op
I tend to agree but never treat the unlikely as impossible---having said that there are a lot more TIPS out there now, so market more liquid.

Yukon
Credit risk and liquidity risk and legal risks (bankruptcy rights) and risks of tax changes are all impacting muni yields.That is why you see it

Larry

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Re: For munis, bond fund or ladder

Post by ogd » Wed Aug 07, 2013 10:19 pm

Hi Larry,

For the record, I remain wholly unconvinced that there is any validity to the market impact / hot money argument when applied to Vanguard municipal funds. See my post above for my reasons.

Given the low expenses of these funds (0.12%) and the extreme amount of work (or advisor fees) that they save the investor, I cannot bring myself to believe that there is any reason to own individual munis directly. I would need to see some strong evidence to the contrary. This matters to me, as I have muni fund holdings in the mid 6 figures and growing fast.

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Re: For munis, bond fund or ladder

Post by Trurl Klapaucius » Thu Aug 08, 2013 3:15 pm

jdb wrote: Most perplexing aspect of investing in individual muni bonds...
jdb,

Like you, I construct my own bond ladder. I began this process in 1994, and am generally satisfied with the results. For me, the most perplexing aspect is figuring out taxes due on “tax-free” munis. Here is an article helpful in this regard (although it was written in 2003, so it is somewhat dated):

http://www.investinginbonds.com/learnmo ... ubcatid=60

I find accounting for “market discount” on bonds purchased in the secondary market to be particularly challenging. As the author states in the article “These calculations are very complex… In many cases, the information supplied on Form 1099… or through IRS Publication 1212 may be insufficient (or inaccurate)…” This has been my experience, as well. Reducing basis for amortized premium, because capital loss is not allowed for a tax-exempt bond, is also no walk in the park for me.

How do you handle these difficult calculations? Do you have an easy solution? Especially around tax time, I am tempted to give-up my ladder in favor of the simplicity of a fund.

Best wishes,

- Trurl

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Re: For munis, bond fund or ladder

Post by larryswedroe » Thu Aug 08, 2013 3:35 pm

Trurl
Starting this year the custodian you use (assuming you use one) should be able to provide that information
And yes it is very complex
Larry

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Re: For munis, bond fund or ladder

Post by Beagler » Thu Aug 08, 2013 8:19 pm

It's kind of surreal to read a thread where Larry is acknowledging the value of active management of a fixed income portfolio.
“The only place where success come before work is in the dictionary.” Abraham Lincoln. This post does not provide advice for specific individual situations and should not be construed as doing so.

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Re: For munis, bond fund or ladder

Post by jdb » Thu Aug 08, 2013 9:28 pm

Trurl Klapaucius wrote:
jdb wrote: Most perplexing aspect of investing in individual muni bonds...
jdb,

Like you, I construct my own bond ladder. I began this process in 1994, and am generally satisfied with the results. For me, the most perplexing aspect is figuring out taxes due on “tax-free” munis. Here is an article helpful in this regard (although it was written in 2003, so it is somewhat dated):

http://www.investinginbonds.com/learnmo ... ubcatid=60

I find accounting for “market discount” on bonds purchased in the secondary market to be particularly challenging. As the author states in the article “These calculations are very complex… In many cases, the information supplied on Form 1099… or through IRS Publication 1212 may be insufficient gg(or inaccurate)…” This has been my experience, as well. Reducing basis for amortized premium, because capital loss is not allowed for a tax-exempt bond, is also no walk in the park for me.

How do you handle these difficult calculations? Do you have an easy solution? Especially around tax time, I am tempted to give-up my ladder in favor of the simplicity of a fund.

Best wishes,

- Trurl
Good questions. But in speaking of market discounts you are speaking ancient history. Almost all bonds that I have purchased last few years are at premiums to par so when hold to maturity not adverse tax effect. And in answer to your question it is complex with bonds bought at discount, I give my tax accountant records to extent have them and let him try to decipher it. But should get easier going forward with new rules requiring custodian reporting. By the way, am finding that in small lot muni market getting interesting again with seeming distress sales below prevailing price points starting to appear on screens again, so am getting more active in market but sticking to shorter duration of less than 7 years non callable. Detroit debacle as unfortunate as it is may give rise to buying opportunities in better managed muni bonds issuers.

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Re: For munis, bond fund or ladder

Post by wshang » Thu Aug 08, 2013 11:03 pm

After seeing this comparision of ER's of muni bond funds and a per annum cost of individual bonds, I feel it necessary to pipe up and remind the group:

"Portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges are not included in the expense ratio. "
http://www.morningstar.com/InvGlossary/ ... ratio.aspx

Owners of individual bond ladders pay the commission once. Although Larry used 10 years as the top rung of the ladder, longer dated bonds are even cheaper to own on a per annum basis. My personal buying experience has been better than mentioned on this forum. There are several times a year, due to spurious events which lead to buying opportunities in munis, especially in lots less than $50k. The market is opaque and illiquid enough for EMH not to always hold in this part of the universe.

Finally, I'll mention this since this was not mentioned earlier. Zero coupon muni bonds generally pay higher rates for similarly dated bonds and avoid the problem of reinvestment risk. They form the backbone of my ladder.

Larry's book is at my bedside and I'm very glad to have come across it from this forum long ago as well as profited from his advice.
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Re: For munis, bond fund or ladder

Post by larryswedroe » Fri Aug 09, 2013 7:43 am

Note that what most investors don't know is that you can amortize the premiums on munis you buy (except in home state) and you get the deduction. So if not doing that you should be. Most CPAs don't appear to know that, Another advantage of owning individual bonds--funds don't provide that information of course. This can be worth many thousands depending on how much you own. Big deal
Larry

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Re: For munis, bond fund or ladder

Post by jdb » Fri Aug 09, 2013 8:27 am

[quote="wshang"]Finally, I'll mention this since this was not mentioned earlier. Zero coupon muni bonds generally pay higher rates for similarly dated bonds and avoid the problem of reinvestment risk. They form the backbone of my ladder.quote]

Interesting comment about zero coupon bonds, I avoid them, not so much out of credit concern but psychological, I like the debt instruments which I hold to pay accrued interest at least annually. So you and I are a little like Jack Sprat and his wife (not sure who is which), we are both dining at same buffet of secondary small lot muni bond market but with completely different diets.

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Re: For munis, bond fund or ladder

Post by wshang » Fri Aug 09, 2013 8:54 am

jdb wrote:
wshang wrote:Zero coupon muni bonds generally pay higher rates for similarly dated bonds and avoid the problem of reinvestment risk. They form the backbone of my ladder.

Interesting comment about zero coupon bonds, I avoid them, not so much out of credit concern but psychological . . .
Why they have higher rates is a mystery to me, but your commentary on risk is noted and probably true. The other aspect I suspect is muni bond funds have to payout regular interest and probably avoid zero's as a result. I consider that aspect of my muni ladder a feature, not a defect.

Best luck to you in maintaining a default free ladder!

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Re: For munis, bond fund or ladder

Post by Trurl Klapaucius » Fri Aug 09, 2013 9:04 am

jdb wrote:
But in speaking of market discounts you are speaking ancient history. Almost all bonds that I have purchased last few years are at premiums to par so when hold to maturity not adverse tax effect. And in answer to your question it is complex with bonds bought at discount, I give my tax accountant records to extent have them and let him try to decipher it. But should get easier going forward with new rules requiring custodian reporting. By the way, am finding that in small lot muni market getting interesting again with seeming distress sales below prevailing price points starting to appear on screens again, so am getting more active in market but sticking to shorter duration of less than 7 years non callable. Detroit debacle as unfortunate as it is may give rise to buying opportunities in better managed muni bonds issuers.
jdb,

Thanks for your response.

With bond prices falling, “market discount” may not be confined to ancient history. A quick glance at this morning’s market activity on EMMA (http://emma.msrb.org/MarketActivity/RecentTrades.aspx) reveals that 11 of the most recent 25 non-zero-coupon trades (44%) had a price less than 100, although undoubtedly many of these are within de minimis.

Regarding the new reporting rules, as far as I can see, section 6045(g) of the Internal Revenue Code (http://www.law.cornell.edu/uscode/text/26/6045) only specifies that adjusted basis be reported, not “market discount” on munis. So, I don’t expect the new rules to help in this regard.

Regarding Detroit, will it create a buying opportunity or a contagion? NPR had an interesting report yesterday: http://www.michiganradio.org/post/if-de ... -flint-too. Here is an excerpt: “while much of Detroit’s debt is owed to private lenders, Flint mainly owes its debt to the state”. I wonder to what degree this relates to Michigan’s governor’s support for Detroit’s bankruptcy filing, but not Flint’s.

- Trurl

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Re: For munis, bond fund or ladder

Post by Trurl Klapaucius » Fri Aug 09, 2013 10:18 am

larryswedroe wrote:Note that what most investors don't know is that you can amortize the premiums on munis you buy (except in home state) and you get the deduction. So if not doing that you should be. Most CPAs don't appear to know that, Another advantage of owning individual bonds--funds don't provide that information of course. This can be worth many thousands depending on how much you own. Big deal
Larry
Hi Larry,

As usual, we “grasshoppers” eagerly await every pearl thrown to us, but often struggle to fully comprehend the meaning of “the Master”.

I see how amortizable bond premium will lower taxes for taxable bonds, because it offsets taxable income; but I don’t understand how it results in tax savings for tax-free bonds, where it only offsets tax-free income. From IRS Pub 550: “If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year… You cannot deduct expenses you incur to produce tax-exempt income.”

Your (opaque) follower,

- Trurl

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Re: For munis, bond fund or ladder

Post by larryswedroe » Fri Aug 09, 2013 2:46 pm

Trurl
Your correct that not applicable to FEDERAL taxes but you can amortize premiums for state purposes.


We have also bought taxable munis as well and there you can amortize premiums since they are taxable at Fed level

Larry

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Re: For munis, bond fund or ladder

Post by Trurl Klapaucius » Mon Aug 12, 2013 6:28 am

larryswedroe wrote: ...you can amortize premiums for state purposes.
Larry,

Yup, there it is, right in IRC Section 265(a)(1). I had no idea.

Thanks!

- Trurl

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Re: For munis, bond fund or ladder

Post by larryswedroe » Mon Aug 12, 2013 7:07 am

Trurl
And this is a big advantage for those in states with taxes and buy individual bonds.
Most CPAs don't even know this in my experience
And because many don't like to buy bonds at premiums (they don't understand) or cannot by constraints they tend to trade at bit higher yields
Larry

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