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New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 1:12 am
by Carol88888
Would I be taking on more risk if I were to use the New York Tax exempt in lieu of the total bond index in a 3 fund portfolio?

How did the tax free fund perform during the great financial crisis?

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 2:14 am
by Theoretical
Honestly, a moderate amount of extra risk with a couple of nasty sticking points. The two biggest relate to increased interest rate risk and single-state credit/governance risk.

One, you reduce your bond diversification by a lot, switching from a fund with treasuries, agency MBS, and corporates to a fund that has a single state's municipal bonds. Reducing diversification is fine...if you're going into treasuries, agency bonds, or CD's, but single state governance can bring its own set of risks, especially around long-term liabilities.

The increased interest rate risk is the bigger concern here, as most longer municipal bonds are callable, which is typically used when interest rates are lower than the bond's interest rate. Where that becomes a problem is that the bond issuer will not call the bond when interest rates are higher than the bond's interest rate. This is where the concept of bond convexity comes in, which is that a positive convexity instrument like a Treasury has lower duration than its maturity, but if interest rates spike, instead of being exposed to the risks of a 6-7 year duration, you could be looking at closer to a 10-15 year duration and the losses that come from it.

Second, the GFC is not the only crisis you need to be worried about. It did a little worse than the Muni Fund average at -3.69% in 2008, but that's nothing compared to the equities. An inflationary crisis would bite it harder, again because it's a long-term bond fund instead of an aggregate with intermediate duration. The same is true if there was a major breakdown in NY governance, or items like public pensions became unfundable (not a wild risk).

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 2:19 pm
by Theoretical
Plus, I'd take a look at this report of the fiscal rankings of the states. New York does not do well, especially for long-term liabilities, though it's about average in terms of pension liabilities. It's no New Jersey, but it's also no Nebraska in terms of fiscal health.

https://www.mercatus.org/system/files/f ... 017_v7.pdf

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 2:39 pm
by Carol88888
Thank you so much for the detailed reply. I will look up the information about the status of New York's liabilities. I know it's possible for a single state to get in trouble.

Also, I was surprised to hear you describe the New York fund as "long term". I was thinking it was more like an intermediate duration. Maybe 5-7 years. But maybe that counts as long term.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 4:13 pm
by Theoretical
Carol, it's a function of the bonds being callable. From Morningstar:

Code: Select all

1 to 3 Years	0.62	
3 to 5 Years	1.47	
5 to 7 Years	2.29	
7 to 10 Years	6.39	
10 to 15 Years	25.25	
15 to 20 Years	23.56	
20 to 30 Years	33.80	
Over 30 Years	6.52
http://portfolios.morningstar.com/fund/ ... ture=en_US

It doesn't make much difference if longer term interest rates stay the same, but if they also go up, then all of the low coupon long-term munis issued in the last few years will not be called in a few years, causing the duration to increase, perhaps by a lot.

It also has about 35% in bond sectors that historically have higher default rates: health care, housing, industrial and miscellaneous revenue.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 9:28 pm
by sport
A related question: A single state tax exempt fund holds not only bonds issued by the state, but also bonds issued by cities, towns, counties, airports, hospitals, etc. How does this affect diversification concerns and creditworthiness?

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 9:53 pm
by Theoretical
It depends on how the bonds are secured. If it's a general obligation bond, then you have to look at both the state and locality's financial health. If it's a revenue bond, you need to look at what it's doing.

Historically, transportation, school district, water/sewer, and electricity bonds have been some of the least likely to default and typically have provided a bit of a risk premium over GO since the funds supporting them are narrower streams. I suspect you'll see that reverse in the coming years, at least for well secured essential services bonds in states not too heavily indebted.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sat Feb 03, 2018 10:35 pm
by grabiner
Carol88888 wrote:
Sat Feb 03, 2018 2:39 pm
Also, I was surprised to hear you describe the New York fund as "long term". I was thinking it was more like an intermediate duration. Maybe 5-7 years. But maybe that counts as long term.
Long-term muni funds have more interest-rate risk than is indicated by the duration, because most munis are callable. The duration of a bond incorporates the probability that it will be called. If interest rates rise, callable bonds are less likely to be called, so their duration increases.

If you want intermediate-term duration, a good way to do this is to put half your bonds in your state's long-term fund, and half in Limited-Term Tax-Exempt. This improves diversification because only half your bond are in your state, but more than half your bond income is exempt from state tax.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 3:44 am
by Carol88888
Are you saying that the stated duration of 6.6 years by Vanguard will be increased when the bonds are no longer callable? That is really something I didn't understand.

Of course, all this depends upon long term rates going up significantly. The yield curve could flatten couldn't it?

I do sort of like the idea of half long term/ half limited term. Or maybe half long term, half money market to really hedge it. Sort of my own bar bell stategy.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 3:47 am
by Carol88888
Are you saying that the stated duration of 6.6 years by Vanguard will be increased when the bonds are no longer callable? That is really something I didn't understand.

Of course, all this depends upon long term rates going up significantly. The yield curve could flatten couldn't it?

I do sort of like the idea of half long term/ half limited term. Or maybe half long term, half money market to really hedge it. Sort of my own bar bell strategy.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 9:22 am
by dbr
What is your bond allocation? If you are 20% bonds, I wouldn't worry about it. It also won't make much difference across any selection of bond funds. If you are 80% bonds it would be a very bad idea to put all of it in single state munis.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 9:37 am
by retiredjg
Carol88888 wrote:
Sat Feb 03, 2018 1:12 am
Would I be taking on more risk if I were to use the New York Tax exempt in lieu of the total bond index in a 3 fund portfolio?
Yes, but I think you may be asking the wrong question.

Tax Exempt bonds are only useful if you are holding bonds in a taxable account and if you are in a high tax bracket. Even then, the better choice is to hold a broad bond fund (like Total Bond but there are other good choices) in a 401k or IRA.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 9:41 am
by dbr
retiredjg wrote:
Sun Feb 04, 2018 9:37 am
Carol88888 wrote:
Sat Feb 03, 2018 1:12 am
Would I be taking on more risk if I were to use the New York Tax exempt in lieu of the total bond index in a 3 fund portfolio?
Yes, but I think you may be asking the wrong question.

Tax Exempt bonds are only useful if you are holding bonds in a taxable account and if you are in a high tax bracket. Even then, the better choice is to hold a broad bond fund (like Total Bond but there are other good choices) in a 401k or IRA.
Agree. This might be a case where the whole portfolio should be posted in order to put comments in context.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 9:46 am
by retiredjg
One quick answer to your original question, Vanguard rates each fund on a risk scale from 1 to 5. Total Bond is rated a 2 and the NY muni is rated as a 3.

Re: New York Tax Exempt Fund instead Total Bond

Posted: Sun Feb 04, 2018 11:52 am
by Theoretical
Are you saying that the stated duration of 6.6 years by Vanguard will be increased when the bonds are no longer callable? That is really something I didn't understand.
Municipal bonds typically have a period of non-callability from 7-10 years after issuance. Then the issuer has the option but not obligation to call in the bond at par or greater, depending on the bond terms.

These non-called bonds still have the option to be called in but no debt holder would buy back 4% long term bonds if they have to now pay 4.5% for the same remaining length.