Author Topic: When to use Municipal (tax-exempt) bonds  (Read 11140 times)

Interest Compound

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When to use Municipal (tax-exempt) bonds
« on: November 01, 2015, 09:30:55 PM »
The Municipal bond will always display a lower return than a comparable taxable bond. To compare them, you have to determine the tax equivalent yield.

Step 1: Find the Municipal bond's current return.

Step 2: Determine the taxable bond equivalent return for your tax bracket:

http://www.bankrate.com/calculators/retirement/tax-equivalent-yield-calculator-tool.aspx

Step 3: Subtract your deductions (401k, IRA ...etc)

Step 4: Compare this to the equivalent term taxable bond.

Example: iShares National AMT-Free Muni Bond - 0.25% ER (yearly fee)

Step 1: Find the Municipal bond's current return: 1.64%
Step 2: Determine the taxable bond equivalent return for your tax bracket:

10% tax bracket: 1.822%
15% tax bracket: 1.929%
25% tax bracket: 2.187%
28% tax bracket: 2.278%
33% tax bracket: 2.448%
35% tax bracket: 2.523%
39.6% tax bracket: 2.715%

Step 3: Maxing out 2 401k's = \$36,000.

A combined married salary of \$266,000 - \$36,000 = \$230,000 = 28% tax bracket. This gives a Municipal bond taxable equivalent return of 2.278%

Step 4: Compare this to the equivalent term taxable bond: Intermediate-Term Bond Index Admiral Shares - 0.10% ER (yearly fee) - Return: 2.43%

In this example, the couple is better off with the taxable bond. If the couple in this example have a combined salary of \$447,000, putting them in the 33% tax bracket, the Municipal bond will give them a 2.448% return, while the taxable bond gives them 2.43%. A slight edge, but don't count on it to be consistent, as they are close enough to fluctuate throughout the year. It seems the Municipal bond wouldn't be consistently better until they get to the 35% tax bracket.

I purposely omitted calculating the expected bond returns for the year, and adding that to your income, as yields in the 2% range don't really add much to the discussion. Even if you had \$400,000 invested in Municipal bonds, that's only adding \$8,000 a year to your income.

Hope this helps!

SwordGuy

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Re: When to use Municipal (tax-exempt) bonds
« Reply #1 on: November 01, 2015, 09:34:24 PM »
Given the crazy pension benefits and over-staffing of many cities over the last 3 decades, it would also be wise to check out how well (or how terribly badly!) their pension benefits are funded.

They might choose to go bankrupt in order to get out of their pension obligations, which might also destroy the value of the bonds.

Scandium

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Re: When to use Municipal (tax-exempt) bonds
« Reply #2 on: November 02, 2015, 08:01:48 AM »
Interesting, thanks for sharing.

I went through this with our personal numbers and we're only in the 25% bracket, but didn't get the same conclusion. Yes, Intermediate-Term Bond Index has a higher yield (2.43%) than our tax-equivalent yield (1.84%), but I don't think you're comapring apples to apples. That fund has 50% corporate bonds, and 23% BBB rated. The muni fund (VWITX, Yield = 1.58%) has only 5% rated BBB or lower.

I don't know enough how to rate municipalities vs corporates in risk, but I worry that 50% corporatses would drop with the stock market in a downturn, more than the munis would. Maybe I'm wrong?

If I were to compare it would be to Vanguard Intermediate-Term Treasury Fund (VFITX) - Yield= 1.28%.
https://personal.vanguard.com/us/funds/snapshot?FundId=0035&FundIntExt=INT

This is maybe not fair either, as treasuries are safer than munis, but those are the options I would consider. Instead of corporate bonds I'd rather add more stocks. Unless someone can tell me muni bonds are are risky/volatile as corporate bonds? This might convince me to put my small ER bond holding into treasuries instead.

This made me plot the three funds, and it actually looks like the muni fund is very similar to total bond in 2008. Both had a drop of 8%. Interesting. I'm light on bonds so haven't given this a whole lot of thought, but maybe I need to rethink it some.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #3 on: November 02, 2015, 10:54:32 AM »
Interesting, thanks for sharing.

I went through this with our personal numbers and we're only in the 25% bracket, but didn't get the same conclusion. Yes, Intermediate-Term Bond Index has a higher yield (2.43%) than our tax-equivalent yield (1.84%), but I don't think you're comapring apples to apples. That fund has 50% corporate bonds, and 23% BBB rated. The muni fund (VWITX, Yield = 1.58%) has only 5% rated BBB or lower.

I don't know enough how to rate municipalities vs corporates in risk, but I worry that 50% corporatses would drop with the stock market in a downturn, more than the munis would. Maybe I'm wrong?

If I were to compare it would be to Vanguard Intermediate-Term Treasury Fund (VFITX) - Yield= 1.28%.
https://personal.vanguard.com/us/funds/snapshot?FundId=0035&FundIntExt=INT

This is maybe not fair either, as treasuries are safer than munis, but those are the options I would consider. Instead of corporate bonds I'd rather add more stocks. Unless someone can tell me muni bonds are are risky/volatile as corporate bonds? This might convince me to put my small ER bond holding into treasuries instead.

This made me plot the three funds, and it actually looks like the muni fund is very similar to total bond in 2008. Both had a drop of 8%. Interesting. I'm light on bonds so haven't given this a whole lot of thought, but maybe I need to rethink it some.

Yea, I started going down that path, ended up plotting the funds, and saw the same thing (no big difference). Municipal bonds have their own risks, which are hard to adjust for. So I decided to stay out of it unless they offer a clear advantage. Unfortunately we're not yet in the 35% tax bracket, so Municipal bonds aren't yet an option for us :)

If you compare vs. Total Bond, which is 70% treasuries, Municipal bonds don't have a clear advantage in the example above until the couple have a combined salary of \$187,000. Even then, as you noted, it's not really a clear advantage, since the Municipal bonds carry more risk. The 10 year graph shows Municipal bonds dropped harder in 2008, and still haven't caught up to Total Bond:

Looking further back doesn't change the story:

The Municipal bond fund in the initial example fell even harder in 2008, and also hasn't caught up to Total Bond:

This simply isn't what I'm looking for in my bond holdings.

Scandium

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Re: When to use Municipal (tax-exempt) bonds
« Reply #4 on: November 02, 2015, 11:22:12 AM »
No that is indeed a poor showing for the muni bond funds. I was not aware it was that bad. I just keep a sort of emergency reserve in a muni fund at vanguard now. But in light of this I'm thinking I might swap it into the Intermediate-Term Treasury fund (VFITX) instead next tax year. If I want it safe, I want it very safe.. Everything else go to stocks anyway. I'm unsure about total bond with it's 25% corporates for the same reason.

By the way, total bond is 47% treasuries, and 23% MBS etc according to M*
http://portfolios.morningstar.com/fund/summary?t=VBTLX&region=usa&culture=en-US

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #5 on: November 02, 2015, 11:37:42 AM »
No that is indeed a poor showing for the muni bond funds. I was not aware it was that bad. I just keep a sort of emergency reserve in a muni fund at vanguard now. But in light of this I'm thinking I might swap it into the Intermediate-Term Treasury fund (VFITX) instead next tax year. If I want it safe, I want it very safe.. Everything else go to stocks anyway. I'm unsure about total bond with it's 25% corporates for the same reason.

By the way, total bond is 47% treasuries, and 23% MBS etc according to M*
http://portfolios.morningstar.com/fund/summary?t=VBTLX&region=usa&culture=en-US

Interesting, I stand corrected. Thanks for the info! It looks like Vanguard combines treasuries and MBS and simply says, "70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues)." Mortgage Backed Securities are definitely not treasuries :)

At the risk of going off-topic, if you're considering using the Intermediate-Term Treasury fund (VFITX) for safety with a 1.28% yield, you might want to look into CDs. Kevin M discusses CDs vs Bonds/Treasuries at length on the Bogleheads forum, and just posted a 5 year review on his site:

http://www.kevinoninvesting.com/2015/10/cd-5-year-report-card-part-1.html

This is what yields looked like 5 years ago when he decided to go with CDs:

And this is what happened 5 years later:

While it's important not to confuse strategy with outcome, it seems CDs are simply giving higher yields than treasuries at today's rates, with equivalent safety. Something to think about.

Scandium

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Re: When to use Municipal (tax-exempt) bonds
« Reply #6 on: November 02, 2015, 12:19:53 PM »
Yes that's certainly true. With today's low rates CDs make about as much sense as treasuries! 2.25% seems to be the highest rate on a 5 year. I'll be curious to see what happens to the rates next year and then make my choice. But I'll look more closely at CDs as option.

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Re: When to use Municipal (tax-exempt) bonds
« Reply #7 on: November 02, 2015, 10:20:37 PM »
A few questions, as I have been thinking about adding a 20% slice of this kind of thing to a taxable account (replacing savings account).

1) Why would you buy a treasury index fund, when treasuries trade free at Schwab and Vanguard? You can also do this at Treasury Direct, but I don't know about reselling it there. Isn't the lower cost, lower risk (because the bond is in your name) solution better?

2) Why buy Total Bond at all? It's 40% treasuries, 25% corporate bonds, 23% mortgages, and 5% cash, plus some other minor stuff. You can get treasuries for free. Corporate bonds could be OK for yields, but bad for selling in a down stock market. Mortgages: I have one. Why do I want to buy my own mortgage? I am definitely going to hose the mortgage holder: if rates drop I will refinance, if rates climb I'll cling to it like a rat to a sinking wooden ship, if things just get bad I will walk away as if the house had no copper wiring or plumbing when I moved in. If I wanted 5% cash I'd hold it myself. So... doesn't Total Bond sort of erm... suck? As in, I could have 66% treasuries and 33% Vanguard Intermediate-Term Corporate Bond ETF (VCIT) (if so desired) for a lower expense (0.04%) and better performance?

3) I like the CD thing. In my mind it is between this, a treasury ladder, and I-bonds. I can buy brokeraged CD's for free at Schwab and Vanguard, just like treasuries. Would it show the market value of my CD's? Since I would be buying them in the secondary market, I could also sell them there, but would I be able to know a continuous running estimate of the price? Or are these a high viscosity kind of liquid?

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #8 on: November 04, 2015, 07:53:51 PM »
IMO, you have to consider state taxation. I like a 50/50 combo of Vanguard California Long term Tax Exempt and Vanguard Limited Term Tax Exempt which has most of your bond income as tax exempt from federal and state, but your blended bond exposure is more on the intermediate side.. Could also use short term treasury or even short term investment grade as the diversifier instead of limited term tax exempt. As for why you wouldn't want to buy individual treasuries...who has time for that? The Vanguard funds are cheap enough.
« Last Edit: November 04, 2015, 07:55:36 PM by tj »

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #9 on: November 04, 2015, 08:36:43 PM »
IMO, you have to consider state taxation. I like a 50/50 combo of Vanguard California Long term Tax Exempt and Vanguard Limited Term Tax Exempt which has most of your bond income as tax exempt from federal and state, but your blended bond exposure is more on the intermediate side.. Could also use short term treasury or even short term investment grade as the diversifier instead of limited term tax exempt. As for why you wouldn't want to buy individual treasuries...who has time for that? The Vanguard funds are cheap enough.

Sure, the same analysis can be done for state taxes:

Step 1: California Long-Term Tax-Exempt 2.11%

Step 2&3:

A couple earning \$250,000 a year and maxing out their 401ks, is in the 9.3% California income tax bracket, and the 28% federal income tax bracket:

Tax-equivalent yield: 3.231%

Step 4: Vanguard Long Term Bond Index: 3.96%

The taxable bond is the winner.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #10 on: November 04, 2015, 08:43:55 PM »
IMO, you have to consider state taxation. I like a 50/50 combo of Vanguard California Long term Tax Exempt and Vanguard Limited Term Tax Exempt which has most of your bond income as tax exempt from federal and state, but your blended bond exposure is more on the intermediate side.. Could also use short term treasury or even short term investment grade as the diversifier instead of limited term tax exempt. As for why you wouldn't want to buy individual treasuries...who has time for that? The Vanguard funds are cheap enough.

A couple earning \$400,000 a year has the same answer:

Step 1: California Long-Term Tax-Exempt 2.11%

Step 2&3:

A couple earning \$400,000 a year and maxing out their 401ks, is in the 11.3% California income tax bracket, and the 33% federal income tax bracket:

Tax-equivalent yield: 3.55%

Step 4: Vanguard Long Term Bond Index: 3.96%

The taxable bond is the winner.

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #11 on: November 04, 2015, 08:48:15 PM »
MFJ gives you a lot more room to play with with untaxed income with doubling the brackets and doubling the retirement contribution limits.

I also probably wouldn't recommend Long Term Bond index to anybody. It does seem to suggest that there isn't enough of a spread to use muni's right now.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #12 on: November 04, 2015, 08:53:14 PM »
Hmm...it seems the California "long term" fund only has an effective duration of 6 years. I might need to recalculate this.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #13 on: November 05, 2015, 12:50:26 AM »
Hmm...it seems the California "long term" fund only has an effective duration of 6 years. I might need to recalculate this.

After doing some research:

I believe the comparison between the two "long term" funds is valid.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #14 on: November 05, 2015, 01:07:44 AM »
A few questions, as I have been thinking about adding a 20% slice of this kind of thing to a taxable account (replacing savings account).

1) Why would you buy a treasury index fund, when treasuries trade free at Schwab and Vanguard? You can also do this at Treasury Direct, but I don't know about reselling it there. Isn't the lower cost, lower risk (because the bond is in your name) solution better?

2) Why buy Total Bond at all? It's 40% treasuries, 25% corporate bonds, 23% mortgages, and 5% cash, plus some other minor stuff. You can get treasuries for free. Corporate bonds could be OK for yields, but bad for selling in a down stock market. Mortgages: I have one. Why do I want to buy my own mortgage? I am definitely going to hose the mortgage holder: if rates drop I will refinance, if rates climb I'll cling to it like a rat to a sinking wooden ship, if things just get bad I will walk away as if the house had no copper wiring or plumbing when I moved in. If I wanted 5% cash I'd hold it myself. So... doesn't Total Bond sort of erm... suck? As in, I could have 66% treasuries and 33% Vanguard Intermediate-Term Corporate Bond ETF (VCIT) (if so desired) for a lower expense (0.04%) and better performance?

3) I like the CD thing. In my mind it is between this, a treasury ladder, and I-bonds. I can buy brokeraged CD's for free at Schwab and Vanguard, just like treasuries. Would it show the market value of my CD's? Since I would be buying them in the secondary market, I could also sell them there, but would I be able to know a continuous running estimate of the price? Or are these a high viscosity kind of liquid?

I wrote up a long response to this, then realized it's not on topic for this thread. If you make a new thread with these questions, I'll be sure to reply there :)

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #15 on: November 05, 2015, 07:32:22 PM »
Hmm...it seems the California "long term" fund only has an effective duration of 6 years. I might need to recalculate this.

After doing some research:

I believe the comparison between the two "long term" funds is valid.

You are only looking at yield though. Has the % of appreciation of the NAV been equivalent?

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #16 on: November 05, 2015, 09:01:53 PM »
Hmm...it seems the California "long term" fund only has an effective duration of 6 years. I might need to recalculate this.

After doing some research:

I believe the comparison between the two "long term" funds is valid.

You are only looking at yield though. Has the % of appreciation of the NAV been equivalent?

My understanding is that the vast majority of bond gains (and therefore taxes) comes from its yield. After reviewing the difference between "Returns after taxes on distributions" and "Returns after taxes on distributions and sale of fund shares" for these two funds, this seems to be the case. A much bigger chunk is taken out for taxes on distributions, but taxes on sale of funds shares barely matter.

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Re: When to use Municipal (tax-exempt) bonds
« Reply #17 on: November 06, 2015, 12:45:17 AM »
A few questions, as I have been thinking about adding a 20% slice of this kind of thing to a taxable account (replacing savings account).

1) Why would you buy a treasury index fund, when treasuries trade free at Schwab and Vanguard? You can also do this at Treasury Direct, but I don't know about reselling it there. Isn't the lower cost, lower risk (because the bond is in your name) solution better?

2) Why buy Total Bond at all? It's 40% treasuries, 25% corporate bonds, 23% mortgages, and 5% cash, plus some other minor stuff. You can get treasuries for free. Corporate bonds could be OK for yields, but bad for selling in a down stock market. Mortgages: I have one. Why do I want to buy my own mortgage? I am definitely going to hose the mortgage holder: if rates drop I will refinance, if rates climb I'll cling to it like a rat to a sinking wooden ship, if things just get bad I will walk away as if the house had no copper wiring or plumbing when I moved in. If I wanted 5% cash I'd hold it myself. So... doesn't Total Bond sort of erm... suck? As in, I could have 66% treasuries and 33% Vanguard Intermediate-Term Corporate Bond ETF (VCIT) (if so desired) for a lower expense (0.04%) and better performance?

3) I like the CD thing. In my mind it is between this, a treasury ladder, and I-bonds. I can buy brokeraged CD's for free at Schwab and Vanguard, just like treasuries. Would it show the market value of my CD's? Since I would be buying them in the secondary market, I could also sell them there, but would I be able to know a continuous running estimate of the price? Or are these a high viscosity kind of liquid?

I wrote up a long response to this, then realized it's not on topic for this thread. If you make a new thread with these questions, I'll be sure to reply there :)
Thanks. At this point my interest is mostly academic, and my answers to my own questions are 1) I already use ETF's so treasuries don't seem to take more work than those, 2) I have no interest in Total Bond, 3) CD's seem like potentially the best idea, I was reading up on Bogleheads (or I-bonds for the ultimate in risk free investing).

On topic, my wife is choosing between physician and physician assistant, depending on how that goes I may never need to worry about municipal bonds. And we live in a state with no income tax.

candymaldy

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Re: When to use Municipal (tax-exempt) bonds
« Reply #18 on: November 08, 2015, 10:04:46 PM »
Of course if you are in the 39.6% tax bracket, and using current yields, then you can get an additional 30 basis points of return before you even factor in state taxes.

So for high income individuals, Muni's are truly a no brainer in the bond bucket. Saving 30 basis points in taxes is every bit as advantageous as saving 30 basis points in fees.

They both compound just the same.

We all have to do our own math.

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #19 on: November 08, 2015, 10:07:08 PM »
Of course if you are in the 39.6% tax bracket, and using current yields, then you can get an additional 30 basis points of return before you even factor in state taxes.

So for high income individuals, Muni's are truly a no brainer in the bond bucket. Saving 30 basis points in taxes is every bit as advantageous as saving 30 basis points in fees.

They both compound just the same.

We all have to do our own math.

If you were in the 39.6% bracket, you probably could retire yesterday.

candymaldy

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Re: When to use Municipal (tax-exempt) bonds
« Reply #20 on: November 08, 2015, 10:26:15 PM »

Of course if you are in the 39.6% tax bracket, and using current yields, then you can get an additional 30 basis points of return before you even factor in state taxes.

So for high income individuals, Muni's are truly a no brainer in the bond bucket. Saving 30 basis points in taxes is every bit as advantageous as saving 30 basis points in fees.

They both compound just the same.

We all have to do our own math.

If you were in the 39.6% bracket, you probably could retire yesterday.

And?

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #21 on: November 09, 2015, 07:10:20 PM »

Of course if you are in the 39.6% tax bracket, and using current yields, then you can get an additional 30 basis points of return before you even factor in state taxes.

So for high income individuals, Muni's are truly a no brainer in the bond bucket. Saving 30 basis points in taxes is every bit as advantageous as saving 30 basis points in fees.

They both compound just the same.

We all have to do our own math.

If you were in the 39.6% bracket, you probably could retire yesterday.

And?

And such people aren't going to be the target demographic of this forum.

candymaldy

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Re: When to use Municipal (tax-exempt) bonds
« Reply #22 on: November 09, 2015, 07:58:15 PM »
Why?  I didn't realize there was an income cut-off for mustachians. I also didn't realize that there was a target demo, other than people simply looking to maximize happiness.

MMM's wisdom seems fairly universal to me. But maybe I missed the post where he laid out demographic exclusion criteria.

Interest Compound

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Re: When to use Municipal (tax-exempt) bonds
« Reply #23 on: November 09, 2015, 09:27:13 PM »
Let's keep this thread on-topic please. The point of the thread is to show people how to determine if they should use Municipal bonds. No matter which tax bracket they happen to be in.

candymaldy

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Re: When to use Municipal (tax-exempt) bonds
« Reply #24 on: November 09, 2015, 09:37:48 PM »
Right. And the point is that for high income mustachian's municipal bonds are a no brainer (assuming they value higher returns.)

tj

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Re: When to use Municipal (tax-exempt) bonds
« Reply #25 on: November 25, 2015, 07:54:09 PM »
Looks to me like muni's or taxable bonds are a wash for someone in the 25% + 9.3% state brackets.

VCADX, SEC yield = 1.67%, tax equivalent yield for fed and state =  2.445%
BND, SEC yield = 2.43%

I'd probably go for BND for greater diversification. If interest rates go up and NAV drops like everyone is saying, then you can always Tax loss Harvest that into a muni fund at that point.

JinBoston

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Re: When to use Municipal (tax-exempt) bonds
« Reply #26 on: December 09, 2015, 03:55:43 PM »

Disclaimer: I know very little about municipal bonds.

But do you think the safety is that much better compared to the much higher yield and only 15% tax on blue chip dividend stocks such as JNJ, KO, HSY, etc.    You can also pass them on to your children with no capital gains tax if things go well.

Scandium

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Re: When to use Municipal (tax-exempt) bonds
« Reply #27 on: December 10, 2015, 07:20:20 AM »

Disclaimer: I know very little about municipal bonds.

But do you think the safety is that much better compared to the much higher yield and only 15% tax on blue chip dividend stocks such as JNJ, KO, HSY, etc.    You can also pass them on to your children with no capital gains tax if things go well.

If you want low volatility? Yes it's a different world. Yes the stocks can go up more (Well duh!). But if using bonds for stability and capital preservation then no stocks are a suitable substitute (I believe there is another thread about this..).

Going back to late 90s was actually interesting too.
« Last Edit: December 10, 2015, 07:44:02 AM by Scandium »

JinBoston

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Re: When to use Municipal (tax-exempt) bonds
« Reply #28 on: December 10, 2015, 03:06:51 PM »

I agree that municipal bonds have very low volatility in price, so if you want to be able to sell them whenever, they are far safer.

Is the *income* they provide safer?

Scandium

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Re: When to use Municipal (tax-exempt) bonds
« Reply #29 on: December 11, 2015, 07:20:37 AM »

I agree that municipal bonds have very low volatility in price, so if you want to be able to sell them whenever, they are far safer.

Is the *income* they provide safer?

Pretty much per definition yes. Bond interest payments are a legal obligation, only out being a default. And then bond holders are first in line for the liquidated assets. Dividends can be cut at a whim with no legal ramifications. And in a recession they are.

Too lazy to look up the charts though. But I do know that after a decade the "dividend aristocrat" list only have something like 30% of the original companies on it. So you'd have to have sold 70% of your portfolio then? What happened to these?

Lastly. During accumulation you shouldn't care about income. Income is bad. It's taxed. If you want income later the you could always buy all dividend stocks then (not that I think you should). I never understood the point of buying dividend stocks during accumulation. You can always roll VTSAX into 100% JNJ stocks later (obviously most applicable in an IRA I guess).