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Consider Municipal Bond Funds for Your Fixed Income and Cash Investments
By Mr. ToughMoneyLove | September 9, 2008
Warning: Municipal bonds can be boring. But, if you are looking to squeeze a little more yield out of your fixed income and cash-equivalent investments, keep reading.
Freddie Mac and Fannie Mae Keep Us Thinking Ahead
I don’t like what the government has done to the poor shareholders at Freddie Mac and Fannie Mae. The shareholders were not the people who borrowed money that they couldn’t afford to pay back nor were they involved in the decisions to loan money to unqualified buyers. The shareholders (including preferred shareholders) are getting the shaft. But the hard truth is that the move was probably necessary as a long term economic strategy. It’s time to move on and react in a way that favors your own investment outlook.
Yesterday’s announcement caused smart investors to re-think their asset allocations, particularly as to investments that are sensitive to interest rate and credit risks. With interest rates remaining depressed by Fed action, finding reasonably safe places to invest your cash and receive decent yields is a difficult task. Yesterday I talked about high interest rate (5%) online checking accounts offered by some community brick and mortar banks. Some Internet savings bank loyalists questioned my sanity on those thoughts but that’s OK, they can keep their 3% pre-tax yield at ING Direct and its competitors.
Municipal Bond Funds Give You the Tax-Free Edge
Today Mr. ToughMoneyLove wants to mention municipal bond funds, which have been disfavored in recent years because their yields, although tax free, have not compared favorably with other low-risk, fixed income and cash-equivalent investments, including money market funds, CD’s and Treasury funds. The pendulum seems to have swung a little and it may be time to reconsider municipal bond funds in the fixed income and cash portions of your taxable accounts.
Let’s compare trailing yields on two name brand, low cost funds: Vanguard Long-Term Tax Exempt (VWLTX) and Vanguard Long Term U.S. Treasury (VUSTX). VWLTX has a current tax-free dividend yield of 4.62% and an expense ratio of 0.15%. For someone in the 28% tax bracket, that’s an equivalent yield (compared to a taxable bond or fund) of 6.42%. VUSTX by comparison has a current dividend yield of 4.56% and an expense ratio of 0.26%. Both funds require a $3,000 minimum investment. VUSTX is even beating the tax equivalent dividend yield (5.15%) of one of my favorite inflation protected security funds, VIPSX.
Granted that Treasury funds are no-risk investments but the municipal bond fund is close. Considering that the average default rate of high quality municipal bonds is only 0.01%, the risks are negligible and well worth the 1.8% effective interest rate premium. (Earning an additional 1.8% is nothing to sneeze at in today’s economy.) I have listed several other similar tax free muni funds below.
| Fund | Trailing Yield (%) |
Expense Ratio (%) |
Minimum Investment |
| Fidelity Municipal Income (FHIGX) | 4.15 | 0.44 | $10,000 |
| Fidelity Tax-Free Bond (FTABX) | 4.06 | 0.18 | $25,000 |
| Franklin Federal Tax-Free Income A (FKTIX) | 4.52 | 0.60 | $1,000 |
You Can Also Avoid State and Local Income Taxes
If you are in a state with high state and local income tax rates (sorry New Yorkers and Californians), you may want to look for a municipal bond fund that owns bonds issued only in your state, which would be exempt from state and local taxes as well.
If you have the cash to invest in larger lump sums (not me), you can buy individual municipal bonds. A good resource for finding and pricing municipal bonds is on EMMA, a market site published by the Municipal Securities Rulemaking Board. (EMMA also features information about 529 College Savings Plans.)
Watch Out for the Alternative Minimum Tax
If you decide to buy an individual bond, I suggest that you look for a high-yield housing bond. These bonds were given special favorable treatment in the recently passed Economic and Housing Recovery Act of 2008, meaning that the Alternative Minimum Tax (AMT) will not apply to their interest payments. (There are lots of these “tax tweaks” in this 700 page law, most of which are not favorable to folks with money. This tweak is OK.)
Another option if you are concerned about the AMT is to buy a muni fund that owns only non-AMT bonds. T. Rowe Price Tax-Free Income Fund (PRTAX) is one example of such a fund. It yields 4.54%, has an expense ratio of 0.52%, with a minimum investment of $2,500.
Most of these funds have three-year and five-year average annual returns (in addition to dividend yields) in the range of 3-5%. Obviously, if interest rates increase, the market value of these bonds and funds will fall. At that time, you can sell and move into something else or you continue to hold them and collect the high dividend yield on your investment.
The Hard Truth Bottom Line
For best yields on fixed-income and cash equivalent investments in today’s market, you need to think and look beyond your comfort zone of money market funds, CD’s, and Internet bank savings accounts. If you are in a higher tax bracket, municipal bond funds should be on your list of options to consider. Make sure you factor in transaction costs when evaluating this strategy. Also, keep a close eye on what the Fed does because when they start ratcheting interest rates up, you will need to make a move in another direction.
Anyone have other suggestions for higher yielding cash equivalent investments?
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Topics: Investing, Retirement Planning |
September 9th, 2008 at 1:21 pm
Take a look into the corporate bond ETF arena… it’s pretty new stuff and I don’t adequately understand it (yet), but the yields are impressive.
Finding a 5-6% yield w/ the liquidity of an ETF is pretty decent.
Ticker: LQD
September 10th, 2008 at 11:23 am
What do you think of muni/tax-exempt money market funds? At 28% bracket do you think the 1% or so yield is with it?
October 9th, 2008 at 6:58 pm
I think you have horribly underestimated the situation. Many,many municipalities will go bankrupt due to the freeze in credit markets and other economic factors, and when most of your money is flat out lost, you will not think the yield of 6% wass much to brag about. In truth, treasureis are not reliable even themselves, soon enough. The world has never seen a situation like this. If you want to make it trough, I think precious metals are the only way to go.
October 9th, 2008 at 9:08 pm
Gideon: You may be right, considering what has transpired in the 30 days since I wrote that. Certainly if you invest in munis, it better be in a broad based fund that spreads and dilutes the risk of a default. I also agree that this situation is unique although the cooperation among nations is likely to soften the blow compared to what happened in 1929. As for precious metals, they can go down faster than they go up and are a pure fear play. I’m not going there.
October 11th, 2008 at 8:11 pm
thanks for your reply. I don’t think precious metals are a pure fear play though. they are a great hedge against inflation, and with the tremendous new debt we are not burdened with in the USA, they should go up tremendously. Also, the price of paper precious metals on the exchanges os grossly out of whack relatve to physical metal prices, and at some point the paper price will have to go up markedly to better reflect reality.
October 13th, 2008 at 11:32 pm
Hi.
Just hit upon your website this evening.
Thought you might have some insight.
I’ve gotten some great deals on muni bonds recently, as they have raised rates to encourage investors. Money is tight. I think I understand that aspect of it. I assume all the risk, but I’ve also gotten some good rates.
My muni bond fund, however, has in the past 6 months actually lost money, and recently with the events of October, has gone down even more. I am trying to understand this in detail. I assume it’s because people are taking their money out of the fund, so that the value of everyone’s shares is decreasing. I’m wondering if they are doing this because they need the money to live, or because they are fearful for their investment?
Another question I have is how the Fed’s move to shore up banks and improve liquidity will affect muni bond funds and muni rates in general.
Should I hold the fund or exit before my loss becomes much greater?
Thanks,
Jean
October 14th, 2008 at 12:44 am
Jean - Thanks for visiting and your question. I feel bad that just a week after I posted this, the crisis in the credit markets hit fever pitch, causing a sharp decline in the NAV return of muni funds, particulary those that held long bonds or California bonds. I don’t know what fund you are in but if it is heavily exposed to longer bonds and/or California bonds, it will be devalued. In my opinion the loss in NAV occurred after it became apparent that state and local governments would have difficulty with future normal borrowing activities along with every other large credit user. This, in the minds of investors, made it more likely that there would be a higher rate of bond default and they started selling. It didn’t help that the governor of California wrote a very public letter on this very topic. On the other hand, the dividend yields are still very good (3-5% tax free) so unless you have a need for the money now, I would consider holding for the dividend yield. When the credit markets improve from recent rescue measures or if the Fed opens its discount window to state and local government borrowing, I would expect to see a positive change in NAV performance of broad based muni funds. (Anything weighted heavily to California bonds could be an exception.) If state and local governments have trouble getting credit from conventional sources then new bond rates will have to go up to reflect the increased risk. However, if your muni fund showed a steady NAV decline in the six months before 9/15, something else is wrong and it may be time to dump it. What fund do you hold?
October 15th, 2008 at 5:17 am
I read your answer to Jean and am in the same situation she’s in. I have Oppenheimer AMT-Free Municipal Funds and they have declined badly. The yields are great and the fund is well-diversified, but I am worried about the bad reputation this fund has developed. I’ve had this fund for nearly 10 years (it was an inheritance) and this is the first time it’s been in trouble.
October 15th, 2008 at 11:21 am
Shwony: The OPTAX fund you are in is a terrible performer (since early 2007) and is poorly rated by Morningstar. It grossly underperforms other funds in its sector. Because it has a front-end load and high expenses, I don’t expect it will recover any time soon. If you are not satisfied with the yield I would consider getting out of it now.
October 17th, 2008 at 8:10 am
How do you feel about Vangauard Massachusetts Muni bond funds Vmatx and VWSUX ? up untill a month ago they were performing very well.
I have a fair amount of my retirement in there and I am getting concerned. They have declined about 30% in value so selling now would be painful but losing more would be worse.
I don’t need the money now so if they came back to close to my initial investment in 3-5 years no big deal.
October 17th, 2008 at 9:40 am
Steve - Thanks for visiting. This is my take on the muni bond fund situation: Everyone of these funds took a dive beginning 9/15 which is when the worst economic bad news started going public. The reason they took a dive is that panicked sellers called their brokers or 401(k) managers and said “sell everything.” So muni bond funds were victims of panic selling just like a lot of other funds that still had good fundamentals. On top of that you had people like Gov. Schwarzenegger publicly warning the feds that states were in trouble because they could not borrow in the usual fashion. This caused some muni bond fund holders to worry about increased rate of defaults, so they sold on that basis. I think these funds will come back when the fear and panic subsides and your 3-5 year horizon is a good one. Actually, the muni bond funds should come back sooner than other sectors once folks realize that the the default fear is unfounded and that they can still get a very good tax free yield from them. I would keep a closer eye on your VMATX fund because that fund invests only in Massachusetts bonds, which makes it more volatile if Massachusetts starts having financial problems or even discusses the possibility of having problems. Your VWSUX fund is more diverse and therefore should be less volatile. Hope this helps.
October 28th, 2008 at 1:05 am
I have just recently inherited some muni funds and am curious if you have any insight for me about them. I am completely naive about them, and the stock market too. As a newbie to all of this I am finding the learning curve to be quite steep. Any advice is appreciated. Immensely. These are the funds and approx. amount of shares I’ve received:
FKTFX/4,000; ANWPX/800; PCTEX/2500. I am considering selling all shares in ANWPX as it looks like a poor performer?
October 28th, 2008 at 8:14 am
Tigerlee - Thanks for visiting. Let me take a look at your funds and respond a little later.
October 28th, 2008 at 2:55 pm
Hi again,
I notice that you mentioned high-yield housing bonds above. They’ve been selling recently like hotcakes in many states. What is concerning me is the sheer volume of them being transacted and the fact that some extend out into the 2030s and beyond. It seems a bit risky to me that any state can feel confident enough about repayment of that many and with such good rates for so long. Are they risky? As chance would have it, I have some myself, but none extending beyond 2023. Is there some small print somewhere that allows them to be callable? They’re certainly not GO, and many of them say “REV”. How can Hsg. and Comm. Serv. generate revenue? The tomes of paper that arrive regarding my current investments are impossible to wade through, and I’m not finding the specific information I seek. Pages of tabled figures, don’t reassure me. It seems that I may be missing something obvious to better educated individuals, like yourself.
Thanks,
Jean
October 31st, 2008 at 10:25 pm
tigerlee - I’ve looked at the 3 funds you mentioned. First, ANWPX is a managed equity fund, not a muni fund. FKTFX and PCTEX are both muni funds that invest exclusively in Calif muni bonds. That is an advantage if you pay Calif state income taxes because most of the income from these funds will be exempt from Calif income tax. Otherwise, I would prefer more diversity in the bonds. Calif bonds are probably at somewhat higher risk right now. These funds have a nice yield however. Keep in mind that hedge funds etc. have been selling a lot of their muni bond holdings in recent weeks to raise cash. This has helped to drive prices down. Your decision on whether to sell any of these funds must take into account your overall asset allocation, your tax situation, your basis in the funds, and whether you need the income from the funds either now or in the future. If you will show a gain in selling them, this year may be a better year to take that gain because capital gains tax rates may be going up next year.
October 31st, 2008 at 10:31 pm
Jean: Every muni bond has its own terms as to when and if they are callable etc. I agree that it can be complex which is I prefer muni funds over individual bonds. I would not be too concerned about default if the government that issued the bonds has the right to use general tax revenues to repay them. It sounds like some of your bonds do not fall into that category. In that case, you will just have to investigate the financial health of the government and project associated with the bond, then assess that risk against the income you expect to receive. Would it be your plan to keep the bonds until maturity
November 1st, 2008 at 2:14 pm
Yes, I never do other than hold things to maturity. I guess I’ll have to spend the time necessary to completely understand the nature of all the bonds I hold; and figure out how to sell those that I’m not comfortable with. Some of my bonds have insurance, but due to recent events the quality of insurance itself has come into question. And the rating system for bonds may or may not be reliable either. I agree, those that are paid for through general tax revenue would be the safest, but not necessarily the best interest rates. What a mess.
My muni fund, as mentioned above, has tanked to such an extent, that I don’t trust it any more than the stock market.
Thanks for your help.
Jean
November 18th, 2008 at 11:05 am
Hello Sir
Really enjoy your website. Would you kindly comment on rate of defaults with municipal bonds over long term, is it ~4% [especially with the high grade bonds A- and above]
thanks
November 18th, 2008 at 11:41 pm
John: According to data I have read in reliable sources, since 1986, only 34 municipal bonds issued by more than 10,000 governmental bodies rated by S&P have defaulted. This is much lower than your 4% number and is negligible. Thanks for visiting.