[Editor’s Note: This lengthy guest post was submitted by Travis Hornsby, a former Vanguard municipal bond trader, a blogger at Millennial Moola, and author of 25 Is The New 65: How to Retire Outrageously Early and Do Whatever the Heck You Want. He actually sent this to me from Switzerland in month four of his around the world trip. It’s really long, far longer than most posts on the site, but it is filled with a lot of useful information, so I thought I’d run it anyway. He wrote it as a response to posts I’ve done in the past on muni bonds such as this one from nearly four years ago. I’ve since softened my tone a bit on muni bonds, (mostly once I did the math and realized that bonds actually do belong in taxable for many/most people at these low interest rates,) but I’m still not a huge fan of individual munis as I wrote here. So consider this the “Pro” to my “Con” posts. We have no financial relationship, but if you buy his book from the link above, he gets three bucks and I get a quarter.]

There are a lot of reasons why one might choose Vanguard’s Tax Exempt Bond Funds as the go to destination for their investment in municipal bonds. You get lots of diversification, daily liquidity, professional management, and monthly dividends that, along with their tax exempt status, make them very attractive to high income earners such as physicians. I worked as a trader for the Vanguard Municipal Bond Funds for a couple years and I got to see all the intricacies of the muni market up close. I traded around $8 billion in market value of municipal bonds while I was working there. I am convinced that investing in individual municipal bonds sometimes makes sense in lieu of bond funds and I want to empower you with knowledge so you can consider if this is an asset class where a do it yourself approach is advantageous.

First Question: Do You Have Over $500,000 to Invest Sole In Muni Bonds?

The reason I ask this question is because Munis are not like stocks. The minimum denomination of a bond is 5, meaning you can buy lots as small as 5, but you probably can get more interesting opportunities if you buy in lots of 10-50.  Since each bond usually has a par value of $1000 (although in the listings they say $100 when they mean $1000), if you were able to buy a single bond at par (the amount you get back at maturity) you would need $10,000 to get just 10 of them. To show how large the individual holdings of an average muni portfolio can be, if you saw 100 10 year Maryland 5% coupon bonds at $115, it would cost you 115*10*100=$115,000 to buy them.

Among bond traders, even 100 bonds is considered a very small denomination, so you can see why I think having at least $500,000 to invest is important if you want to get to adequate levels of diversification.  An investor with at least $500,000 might be able to get a good selection from which to choose 10-20 different bonds.

Brokerages know that most people don’t have that $500,000 to devote to munis as an asset class. They also know that people are paranoid about defaults in the sector with high profile names like Detroit, Jefferson County Sewer, and Puerto Rico causing fear for principal return. They will sell you bonds with insurance on them from companies like Assured Guarantee and Nat Re that promise to pay you interest and principal if the bond defaults. If you see random letters prominently displayed next to the name of the issuer it’s probably the name of an insurer. AGM, Nat Re, FGIC, and BAM, are common examples. This insurance usually costs about 10-30 basis points and is not worth the expense for anything in the A category or higher. Default rates for munis in these quality levels are so low they make highly rated corporate bonds look speculative.

Municipalbonds.com states the default rate for munis with A credit quality and above since 1970 has been 0.03%. In many of those cases, investors would have gotten back close to the par value of their bonds, so clearly insurance is not a good value purchase. Furthermore, these insurers went bankrupt in 2007-2009 as they were exposed to subprime mortgages. Hence I think it offers little value in most cases.

Also, if you have $500,000 or more set aside for an investment in tax free bonds you will become the target of upselling fund companies that try and sign you up for “separately managed accounts (SMA).” They are more expensive than Vanguard’s mutual funds but they promise an “individualized” approach. Generally, all they do is hold bonds with shorter maturities in securities of the state in which you reside. Unless you are investing many millions of dollars, the benefit of saving 10-20 basis points (ie 0.1% or 0.2%) in tax savings from state specific holdings is unlikely to be greater than the extra expense of an SMA. So be aware once you have enough money to consider buying individual securities you will be pitched a personalized account product at most companies besides Vanguard (because they don’t operate them). These SMAs (Separately Managed Accounts) might become worth your while once interest rates advance substantially as the tax savings will be greater but that seems like it’s a long way off.

So if you have $500,000 you are clear of the hurdle of being able to assemble a relatively diversified portfolio.

Second Question: How Do Brokers Make Money When You Buy Bonds?

This is where the big potential for cost savings comes into play. The traditional full service brokers charge 2 points on most retail bond transactions. A “point” is equivalent to a percent of the market value. So a typical transaction involves them buying a bond for $98 and selling it to you for $100 (again, actually $980 and $1000.) There is very little transparency into how much commission you might pay when you buy bonds. Most transactions for under $500,000 will be 2 points, but I’ve seen smaller transactions for 50 bonds done for as little as half a point. Even under the full service brokerage model that I consider to be too expensive, if you’re able to buy a bond for half a point commission that’s a better value only taking into account expenses than Vanguard’s mutual bond funds (0.5% over 10 years, ie 0.05% costs being better than 0.10% costs).

[Editor’s Note: This simplistic comparison ignores the fact that the fund also provides liquidity, diversification, and professional management for those 20 basis points, which are a serious value-add for most of us.]

The other more savvy option is to purchase bonds directly through a discount brokerage. Vanguard only charges 0.1% for buying munis on their website if you hold over $1,000,000 in Vanguard mutual funds. Many of you that have the kind of money needed to invest in individual munis might already have that level of assets with Vanguard in your retirement or taxable accounts. Bonds listed on the site are sometimes marked up a little bit. That is, they are listed for a higher price than the current trading value. Think of it as inventory that is often listed at a slightly higher price than the seller is willing to accept. Some investors just pay the offering price, but you should know that sometimes you can buy bonds for cheaper by bidding below the offering level. When bonds are marked up, it is because the seller is hoping a retail investor goes on the site and pays list for the bond. The opportunity to get a good deal on a small odd lot of individual municipal bonds exists sometimes because the asset class is very inefficient and a large investor like Vanguard’s municipal bond funds does not tend to bother with small offerings. It’s best to call Vanguard or your discount brokerage service to help guide you through the process when you try to buy individual bonds.

Third Question: What’s the Best Place to Get a Fair Deal on Munis?

The secondary market in municipal bonds can be a confusing and scary place for someone unaccustomed to operating in it. There are thousands of different issuers, coupons, maturities, and call structures. While regulations mostly ensure you will never get totally ripped off when buying and selling munis (I’m defining “getting ripped off” as being charged more than 5% of true market value), it’s tough to know you’re getting a fair deal.

For this reason I think all municipal bond investors considering buying individual bonds should call their discount broker and see what primary market deals are being brought in the next month. You can subscribe for these deals as a retail buyer and pay the same fees as the big institutional players like Vanguard. The primary market is different from the secondary market in munis since when a bond deal is first brought, the issuer is paying the bank a “takedown,” meaning % of par value for each bond sold. Since the bank doesn’t have to make money from the buyers in this situation to get paid, you can go in for what you want from a large maturity being offered and get a fair deal because the price is being set by the large buyers. If you subscribe for 50 bonds in a 100,000 bond maturity, the institutional buyers like Vanguard set the price so you are in effect getting the big buyer discount since they can’t charge separate prices for retail and institutional investors within the same maturity.

Banks know that retail buyers are obsessed with buying bonds as close to $100 as possible. This is irrational as for the most part you should be indifferent between a $80 bond and a $120 bond as long as both have the same expected returns from different coupon rates. For this reason, know that institutional buyers will usually be buying the 5% coupon bonds because they are the most available and liquid. If you buy a 3% coupon bond at par in today’s interest rate environment don’t expect to sell it for a great price. Institutional buyers are constantly scouring the market for retail sellers of bonds that they have matching positions to, and they do not own as many bonds with non-5% coupons so if you stick with those you are more likely to get a better price if you ever have to sell. There are lots of dealers that autobid retail offerings with large institutional positions so your bond is unlikely to get ignored.

Fourth Question: Why Do Many Muni Bonds Offer More Interest Than Treasuries on a Pre Tax Basis?

Investors often look at the asset class and say, you are getting paid more because of the credit risk since munis are riskier than treasuries. Hence the buyer is making more for taking the chance that there will defaults all over the country. I think the real reason you earn more on municipal bonds on an after tax basis is because of liquidity, not because of difference in credit quality. There are municipal bonds that default. However, like I mentioned earlier a 0.03% default rate for A rated and above municipal bonds does not justify a significant yield premium over treasuries.

One more point about credit quality. When municipal bonds default, they almost never return 0 cents on the dollar. How much did unsecured general obligation Detroit investors receive on their bonds? About 73 cents on the dollar. That’s a far cry from 0. Hence it’s important to understand what the word default means. Even for the extremely distressed securities in Puerto Rico, the market is still expecting recovery values of more than 50 cents on the dollar. It’s important not to equate default with a total loss as bonds almost never get close to 0.

If you look at what happened to munis in 2008, 2011, and 2013, they plunged in value very quickly. The reason is that the market is totally dependent on banks’ willingness to provide liquidity. Unlike corporate bonds, where sovereign wealth funds and professional pension investors act as backstops, the primary buyer in the municipal bond market is a retail investor. Banks buy large amounts of bonds to hold in inventory for investors to choose from and since the financial crisis the amount they are allowed to hold has decreased dramatically. When the banks have trouble or decide to pull back from the muni market, the market seizes up and drops a fair amount. The backstop for the market in 2013 was not banks, rather it was active taxable bond funds that started buying municipals for their accounts as nominal yields headed north of their market’s opportunity set. It was a no brainer for them to buy higher yielding bonds with better credit quality and then sell out of them when the relationship normalized. Just know that municipals are not a safe asset class in terms of being able to sell them easily when you desperately need money and the market is in freefall, but they are very safe in terms of getting paid your interest and principal on time. [i.e. safe, but not liquid-ed]

When the municipal bond market panics, prices can really drop fast. The next time we see AAA or AA bonds offered at $100 with 5% coupons, individual bond buying is likely the better deal by a large amount. Bond funds have their holdings priced by an independent vendor every day, and they are notoriously behind the market in bear scenarios. An individual could easily get a better deal going out and buying bonds on their own in a negative market for munis.

These considerations of liquidity are important for the individual investor. If you buy individual holdings, you should plan on keeping them until maturity. Selling out before that point will require transacting at a price below the fair market value for small retail holdings. If you don’t need to sell, you can take comfort in the low default rates as a large part of your portfolio will continue paying income and preserving your wealth. Meanwhile, the Municipal Bond Fund NAV will probably be significantly more volatile tempting you to sell at the wrong time. Sometimes illiquidity can be your friend.

Fifth Question: What Is The Call Option?

The majority of the new issue municipal market with more than a 10 year maturity will have an embedded call option. That means the issuer can redeem the bond if it’s market value is above the call price (usually $100) at the specified call date. This option is great for the issuer because they get long term financing and get an opportunity to redo the deal in 10 years if they can save money from lower interest rates. This option costs money so you get paid to take higher risk. Many games played by full service brokerage operations involve selling investors on Yield to Call and Yield to Maturity. For example they might offer you a 20 year bond with a 5 year call. They could quote a Yield to Call of 1.75% and a Yield to Maturity of 3.5%. So if you keep the bond for 5 years and it’s taken away, you get 1.75% annualized returns. If it doesn’t get taken away, you would earn 3.5% until it matures in 20 years. While that might sound good in today’s interest rate environment, if you get the yield to maturity return for 20 years that’s not a good thing. That means interest rates have headed higher, your bond is below the call price, and people aren’t going to want to buy it from you because there are plenty of better yielding options available.

If you look at a bond’s call option, it’s best to buy bonds with 9 or 10 year calls because you can get a more fair price on these issues. The primary market will almost exclusively be issuing bonds with 10 year call options, hence another reason why I think this is an overlooked area of investing in individual muni securities. Know that when you see bonds with calls longer than 10 years that those are the core holdings of Vanguard’s long term municipal bond funds.

The other option when considering call options is to keep your bonds within 10 years to maturity so you can purchase non-callable bonds to keep things simple. Really stay away from the bonds with long maturities and short call dates, like a 25 year bond with a 5 year call. If you don’t get redeemed by the call date it is probably due to interest rates being much higher. Your bond would then have a duration of a 25 year bond and will have high volatility. Whatever yield advantage you received over 5 year non callable bonds will look small for the risk you took.

Example Purchase: Georgia Investor in Highest Tax Bracket

The highest tax rate in Georgia is 6%. So if you had a choice between a non-Georgia municipal bond yielding 2% and a Georgia municipal bond for 1.88%, you should be indifferent. Therefore, a portfolio of Georgia municipals has two advantages over a very popular bond fund like the Vanguard Intermediate Term Tax Exempt Fund. Individual bonds do not carry expense ratios and they benefit from the state specific tax exemption. As I write this, the SEC Yield of VWIUX, the low cost Admiral shares version of the Vanguard fund I mentioned, is 1.83%. Since you would pay 6% in state income tax on that yield, your after tax yield in Georgia is 1.72%. The duration of the fund is about 5, meaning you’d lose 5% in market value if interest rates went up by 1% instantaneously. To compare, I went to Vanguard’s secondary market listings of municipal bonds to see what is available in inventory. I searched for Georgia bonds AA or higher with maturities between 8 to 10 years.

I found two bonds that are good examples of what you could buy online. One is for the Upper Oconee Water Authority due in 8 years without a call option yielding 2%. It has a Aa2 rating from Moody’s (that’s the equivalent to AA in S&P). I also found a Georgia GO bond rated AAA due in 9 years that’s being offered at 1.94%. While I could bid a higher yield and try to get them cheaper by calling a Vanguard representative, I will assume for argument’s sake I just buy the offering at list. Both offerings are eligible to be purchased in lot sizes of 10, or around $10,000 each depending on the price of the bond. If we just assumed your portfolio consisted of these two holdings, the duration of the portfolio would be about a 7, so a little more interest rate sensitive than the Vanguard Intermediate Fund, but also higher credit quality. Intermediate Term Tax Exempt has an average AA credit quality, and your portfolio would have an average of AA+. If we bake in a 0.10% commission, it is about 0.01% per year during the life of the bond.You have a 0.24% higher yield than the bond fund, and slightly higher interest rate risk and lower credit risk. Another caveat is the bond fund holds a lot of callable bonds that would drastically increase the fund’s duration in a bearish interest rate environment. Some of these bonds have maturities of 20 years with 5 year calls, so the interest rate risk for the fund looks low but would skyrocket if bonds entered bearish territory.

Keeping your credit quality high and looking for bonds without any fancy names or call options can allow you to build a solid bond ladder to meet specific spending needs rather than watching your principal go up and down in a bond fund. The fund will have greater liquidity and diversification, but the example I showed you is with interest rates at very low levels. When the market gets ugly, the prices for individual bonds on the new issue and secondary market get attractive much faster than the bond funds dealing with stale pricing. Just look for AA and AAA issues so you stay out of trouble and compare them to the Vanguard bond funds to see if you’re getting a better deal. For the average investor that doesn’t want to be bothered with searching for individual bonds, the municipal bond fund is the better choice. For a do it yourself investor though, buying individual bonds doesn’t have to be a daunting task.

Conclusion

Buying individual muni bonds from discount brokers is great for your portfolio if you are high-income, high-net worth investor with little need for liquidity.  The low default rates in municipal bonds make them very attractive as a buy and hold asset class. AAA and AA munis have defaulted so infrequently that they are great bargains for the credit risk you take. Since banks are the primary liquidity providers, you should expect volatility in the market place from time to time and to give up 2% of your bond’s value if you ever needed to sell.

Municipal Bond Funds are subject to more problems than the average investor realizes. For example, you can receive capital gains distributions in years with negative returns. By purchasing individual munis yourself, you can take full advantage of the state tax exemption instead of sacrificing it for more liquidity and diversification. Unless you live in Illinois, New Jersey, and to a lesser extent Pennsylvania, your state probably has a number of high quality bonds without lots of credit risk to choose from. The risk of buying in-state munis while having other financial assets like your home in that same state are mitigated by the fact that munis are much more stable than stocks with extremely low default rates.

There are behavioral finance benefits to buying individual munis as well. The illiquidity of the bonds mean you are likely to sit on them and hold them to maturity. Buying a series of muni bonds to create a bond ladder can be an attractive way to ensure you’re able to meet future expected liabilities. Buying a bond that matures each year from year 5 to 20 for example can give you an annual lump sum to meet your living expenses or goals. If in year 10 all your bonds get called away, you can use that large lump sum to buy another bond ladder. This approach is more comfortable to some people than having one big pot of money sitting in a mutual fund and spending down the principle from it.

So look for bonds from discount brokerages, 5% coupons for better liquidity, non callable bonds inside of 10 years or a call option at least 9-10 years away, AAA or AA credit quality, and no bond insurance included. A buyer with this portfolio is not protecting themselves against rising interest rates or preventing any credit risk. Rather, you are just giving yourself a good shot at success relative to the other option of buying a bond fund. For investors living in states with very high tax brackets not covered by a Vanguard state specific municipal bond fund, check out and see if your state’s bonds are tax exempt there. You could save as much as 0.1-0.3% a year and in this interest rate environment every little bit helps.

What do you think? Do you invest in individual munis? Why or why not? Do the benefits of a muni bond fund outweigh its benefits to you? Comment below!