Swedroe's 20 basis point rule and VG Tax Exempt Muni Funds

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
RooseveltG
Posts: 669
Joined: Sun Sep 07, 2008 2:56 pm
Location: The Rust Belt

Swedroe's 20 basis point rule and VG Tax Exempt Muni Funds

Post by RooseveltG » Mon Jul 29, 2013 2:01 pm

I recall Larry Swedoe recommending that one should gain 20 extra basis points in yield for each additional year of duration.
Here is the calculation for Vanguard's tax exempt bond funds (if I am understanding this correctly):

Short, Limited, Intermediate
Yield 0.42%, 0.87%, 2.37%
Duration 1.2, 2.4, 5.5
Extra 20 basis
points/yr yield= 0.66% required yield to buy limited fund over short, 1.29% required yield to buy intermediate over short and 1.49% required yield to buy intermediate term over limited.

This suggests a much higher reward (and a much greater duration risk) for extending to an intermediate duration.

Any perspectives on this aspect of choosing a bond fund would be appreciated.

Roosevelt.

User avatar
G-Money
Posts: 2867
Joined: Sun Dec 09, 2007 7:12 am

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by G-Money » Mon Jul 29, 2013 2:13 pm

First, make sure credit quality is comparable. Swedroe's rule of thumb assumes an apples-to-apples comparison on all other risk factors.

Second, my recollection was that the Vanguard long-term muni fund had a yield in the 3% range, with a duration around 7 years. If so, and assuming the credit-quality is still comparable, the long-term fund may also merit consideration.

Like all things investing, which one you choose depends on need/willingness/ability to take risk.

If this fund is being used for money needed in a year, you probably don't want to take much interest rate risk, and the short-term fund would be the best choice of the muni funds (and a MM/savings account might be better still).

If you're think the next time interest rates rise you might be starting another of the unnumbered bond-panic threads that has been posted on this forum over the last 2 months, then you'd probably want a shorter-duration fund.

If you can tolerate the increased risk of a longer-duration fund, and think the extra yield is adequate compensation for it, then go wild and take the intermediate or long-term fund.

And if you can't make up your mind, aim for the middle. :)
Don't assume I know what I'm talking about.

larryswedroe
Posts: 16002
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by larryswedroe » Mon Jul 29, 2013 3:43 pm

that 20bp rule applies to TAXABLES, so munis should be lower hurdle, say 16 or so.
Larry

User avatar
Topic Author
RooseveltG
Posts: 669
Joined: Sun Sep 07, 2008 2:56 pm
Location: The Rust Belt

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by RooseveltG » Mon Jul 29, 2013 4:31 pm

Larry: Thank you for the clarification.

The million dollar question and probably one without an answer: Are investors extending to intermediate maturities being adequately compensated for the duration risk?

Roosevelt.

User avatar
G-Money
Posts: 2867
Joined: Sun Dec 09, 2007 7:12 am

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by G-Money » Mon Jul 29, 2013 5:25 pm

RooseveltG wrote:The million dollar question and probably one without an answer: Are investors extending to intermediate maturities being adequately compensated for the duration risk?
The market prices for bonds of all durations shows what the market thinks is adequate compensation for the risk (regardless of whether the spread is greater or less than Larry's 16- or 20-bp/year rule of thumb).

We'll only know if the market was right in hindsight.
Don't assume I know what I'm talking about.

letsgobobby
Posts: 12080
Joined: Fri Sep 18, 2009 1:10 am

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by letsgobobby » Wed Feb 19, 2014 12:42 am

VWITX has a yield of 2.14% and duration of 5.4 years, whereas VWLTX has a yield of 3.21% and a duration of 7.2 years. Thus according to Larry, long term is a no brainer compared to intermediate in this case?

Credit quality is not identical, with VWITX having 6% fewer AAA and 6% more A compared to VWLTX, but each having 46-48% AA.

User avatar
grabiner
Advisory Board
Posts: 25412
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Swedroe's 20 basis point rule and VG Tax Exempt Muni Fun

Post by grabiner » Thu Feb 20, 2014 9:27 pm

letsgobobby wrote:VWITX has a yield of 2.14% and duration of 5.4 years, whereas VWLTX has a yield of 3.21% and a duration of 7.2 years. Thus according to Larry, long term is a no brainer compared to intermediate in this case?

Credit quality is not identical, with VWITX having 6% fewer AAA and 6% more A compared to VWLTX, but each having 46-48% AA.
I think the main issue here is the convexity of these durations. Many municipal bonds are callable, and the duration of a callable bond depends on the probability that it will be called. Consider a 30-year bond which is callable after 10 years. If rates fall in the first five years, the bond is likely to be called, and its duration will be close to five years, reflecting that likelihood. If rates stay the same in the next five years, the bond will be called, decreasing its duration to zero; however, if rates rise in the next five years, the bond will not be called, and will become a 20-year bond which is very sensitive to interest-rate increases.
Wiki David Grabiner

Post Reply