My November column in Physicians Money Digest gives several reasons why I think it is usually a better idea to use a good, low-cost municipal bond fund or funds rather than trying to pick individual municipal bonds yourself or hiring an advisor to do it for you. Here's an excerpt:
Municipal bonds are attractive to many physician and other high income investors because their dividends are usually federal income tax-free and sometimes even state income tax-free. After-tax, these bonds often have a higher yield than a more typical treasury or corporate bonds. I occasionally run into investors and advisors who advocate using individual municipal bonds rather than a good municipal bond mutual fund. In this column, I will discuss four reasons why this may not be a good idea for you.
Bond Funds Are Cheaper
The first reason to use a good municipal bond fund is that it is far less expensive. Vanguard, the low-cost leader among mutual fund companies, runs its municipal bond mutual funds at expense ratios of just 12-20 basis points (0.12-0.20% per year). That’s a cost of 12-20 dollars per $10,000 invested. That is a bargain for the professional management, diversification, and economies of scale that these large funds provide, and far less than it would cost you to assemble an inferior portfolio….
The main reason individual bond pickers use to sell their services to individual investors is a faulty argument. They argue that by buying individual bonds, and holding them to maturity, there is no interest rate risk. This is the risk that comes from rising interest rates. When interest rates rise, bond prices fall, just as when interest rates fall, bond prices rise. If you just hold the bond for 5-30 years until it matures, the bond picker argues, then you get exactly what you were guaranteed- a dividend every quarter and all your money back at the end. On the other hand, the Net Asset Value (NAV, or price per share) of the bond fund fluctuates every day in the bond market. The bond picker incorrectly believes there is no interest rate risk with individual bonds.
Read the rest here, and then come back and let me know what you think. If you invest in muni bonds, do you use a bond fund or purchase individual munis? Why did you choose one or the other? If you use individual bonds, what have you done to keep costs down and achieve adequate diversification? Comment below!
Loading ...Update: This image from Dimensional was sent in by financial advisor Jeff Hall demonstrating the heavy transaction costs of buying individual muni bonds.
So would you rather buy them yourself and pay 1-2% or would you rather pay 10-20 basis points a year and have a fund buy them paying 0.1-0.3% a year? These costs really matter in our low interest rate environment.
Thanks for the info. I still feel relatively ignorant on bonds in general. I’ve started investing some after-tax money in Vanguard’s intermediate tax-exempt fund. Individual bonds weren’t a reasonable option at this stage but it’s still good to drive home the points. #2 in particular is a good one to remember.
If you know you will need the money in a certain amount of years isn’t it better not to get bond fund. For example if I need the money in 3 years there is a good chance short term rates will be going up and there will be a signficant drop in value of the fund by that time, whereas if I just term out the bond then I will have my full value. For much longer term bonds or if rates drop then it might be a different situation but most experts are expecting short term rates to rise.
Of course, those “experts” have been expecting rates to rise for 6 years. I wonder how long experts in Japan have been expecting rates to rise. If you need the money soon, a short term, high quality bond avoids the risk of not having the sum expected (although you still run interest rate risk and default risk) but a bond fund with duration shorter than the time period until you need it would also serve just fine. A CD is another option for that situation which can even be FDIC insured up to a certain amount.
I just finished reading Why Bother with Bonds by Rick Van Ness, because I was always confused about bonds.
I highly recommend it – it’s a nice afternoon read and was very enlightening. Some pearls:
1) One should not necessarily seek diversification with bonds. For instance, it’s ok to just hold treasury bonds, high-quality corporate bonds, or FDIC insured CDs. Risk may pay off with equity, but not with bonds. In fact, the author makes a convincing case for CDs. Since CDs cannot be bought by institutional investors, there are plenty of opportunities for higher rates than can be achieved by highest-quality corporate bonds or treasuries, with essentially no risk if FDIC insured.
2) One of the most important factors when evaluating a bond fund is its duration, which is the average length to maturity of bonds that the fund holds. If/when interest rates increase and the price of the bond fund goes down, you will recoup your money at the time of duration because the bond fund will re-invest its coupons in higher interesting earning bonds. Therefore you should not invest short-term needed money in a fund that has a longer duration compared to the time-frame in which you would need the money. For instance, if you expect to need the money in 6 years be sure to only invest in funds that have a 6 year or less duration.
I just finished it as well. The review will run in a couple of weeks.
Better to create a portfolio of individual muni bonds in 5k denominations
Vanguard long term muni fund yields 2.2
You can buy long term munis close to 4%
Assuming you will not need the money, go with individual munis
At maturity you get all your principal so int rate fluctuations are meaningless
Have done this fir 40yrs
Bonds do get called and then you need to reinvest
How have the total returns for your muni portfolio over the last ten years compared to a low cost muni fund of similar duration?
I addressed most of your points in the post itself. First, if you buy them in $5K denominations you’re going to get killed on spreads. Second, what munis can you buy that a professional running a good muni fund cannot? If yours yield 4%, and the ones in a fund yield 2.2%, then you are taking more risk than the fund is, either term risk or credit risk (probably both.) Third, while you do get all your principal back, you’re still running interest rate risk. If rates go up, the value of your bond drops just as much as the ones in the fund. If rates go down, and your bonds get called, then you’re forced to reinvest at a lower interest rate. That’s hardly meaningless.
Like with anything in investing, if you save enough you can make up for less than optimal investing decisions. But when it’s so easy to just buy a very low cost fund, you’ve got to have a very unique reason to justify trying to do it yourself. If you just can’t get the riskier muni bonds you want in a fund, that might be reason enough for you.
How do you decide if a state-specific bond fund is worth it? I’m in KY (6% tax) and we have Dupree KY Tax-Free Income (KYTFX). It’s 0.57% ER seems reasonable, but higher than VG’s 0.20%. Duration (4.8 vs 4.7) and yield (1.47% vs 1.64%) are similar. What else should you compare? It would be nice to have money invested locally, along as it’s not at a large premium. Thanks.
The nice thing about local is that you may get a break on state and local taxes too. Otherwise, I see little benefit. But if there is a state-specific bond fund, I’d certainly give it serious consideration for at least a portion of your asset allocation.
I always bought long term munis 25-30yrs and bought them regularly
the vanguard muni long term has an average maturity of 16yrs
do not think most docs would be happy with 2.2 tax free yield today
the cost of owning a bond over 30yrs is not an issue
you are doing your readers a disservice by telling them to avoid individual munis
I am starting my daughters portfolio shortly with CT munis
Are you selling those munis when they get to 20 years maturity? Probably not. So the average maturity of your personal muni fund is probably pretty similar to Vanguards. If so, then the reason your yields are higher is that you’re picking up riskier muni bonds, i.e. more likelihood of default. Vanguard’s bonds are almost all AAA, AA, or A (average AA). How about yours? Or perhaps the bonds you hold were purchased when rates were higher and you’re just fooling yourself that the yield is still 4% (in reality the yield is lower, but your principal is higher than you might think due to falling interest rates.) You don’t get away from interest rate risk just by buying individual bonds.
Nobody is happy about 2.2% yields today (the Vanguard fund actually has an SEC yield of 2.32% and a YTM of 2.4%), but that’s what the market offers. Nothing you can do about it other than choose riskier bonds or longer term bonds. I agree that the high transaction costs you’re paying (looks like about 2%, or nearly the entire yield for the first year- or perhaps the first 6 months if you’re still buying 4% bonds) don’t matter as much over 30 years, especially if you only pay them on one end.
However, I fail to see why you think I’m doing readers a disservice. A bond fund offers greater diversification, lower costs, and more convenience. That far outweighs any benefits (primarily control of when securities are bought and sold) of trying to be your own bond fund manager, which is precisely what you are doing. Now, do I think buying individual bonds is stupid or somehow going to make it impossible to retire? Of course not. It’s really a rather minor thing. But I do think a bond fund is a little bit better for the vast majority of muni bond investors, including doctors.
I have owned individual muni’s for the last 12 years! I have a diversified portfolio of 35 bonds all AAA, AA or A only. I earn 4.8% YTD. I will Never own a bond fund again! Why, you may ask. During the financial crisis of 2008/2009 the one bond fund I did have lost a HUGE amount of principal. 25% to be exact had I stayed in the fund. Thank god I got out before it took that huge hit. You fail to tell your readers it can happen and even if it isn’t that dramatic they still only get paid the interest on the Principal amount. I retired at 55 and have been living on the coupons for the last 9 years. Just my thoughts from a real life person who got screwed when the so called financial advsior told me to sell my individual munis and buy bond funds! They got their 5% commission and I learned the most valuable lessons of my life. I manage my own money period.
You bought a bond fund with a 5% commission and then were surprised that was a bad move? I’m not sure you and I are talking about the same kind of bond fund here. By comparison, the Vanguard tax-exempt bond funds had the following returns in 2008 and 2009:
Short Term 2008: 3.74%, 2009: 3.07%
Intermediate Term 2008: -0.14%, 2009: 10.22%
Long Term 2008: -4.87%, 2009: 14.08%
So, if that’s what the overall investment-grade municipal bond market did in 2008 and 2009, and your bond fund lost 25% over those two years, I’ve got to wonder what kind of bond fund you were investing in? Some high-expense, loaded junk muni bond fund or something? You’ve got to look under the hood and see what is actually in these funds before buying them.
Do you see any large scale risks in the muni-bond market based on the magnitude of the unfunded liabilities (pensions and healthcare costs for retired state and local government employees). Ignoring the politics of the issues, it strikes me that bond payments are not necessarily “first in line” for payment and, despite guaranteed sources of revenue to service bonds (such as sales taxes) these bonds can receive haircuts in a municipal bankruptcy.
Given the relatively low yields of muni-bonds, it seems to me that you are not being fully compensated for the risk you are taking (I agree the overall risk of default for a portfolio would be low, but individual bonds could be blown up). Would CDs or treasuries be a safer place to stash your “safe money,” and you just forget about the state/local tax benefits?
Two questions 1) When should you add muni to your portfolios? (I dont have any munis, wondering if I need to add or not) 2) What percentage of portfolio should be munis 3) From the article it appears its ok to keep them in taxable accounts or are like bonds they are better in tax sheltered?
Munis are useful if you are in a high bracket and have a need to hold bonds in taxable. I’m in a high bracket, but essentially my entire portfolio is in tax protected accounts. Thus, no need for munis. No need to put munis in tax sheltered since they’re at least federal tax free, and possibly even state tax free. Be aware that some are subject to AMT though. So I wouldn’t feel like you need a muni allocation. That said, for many people, munis in your taxable account and stocks in your tax-protected accounts is a better move than stocks in your taxable account and taxable bonds in your tax-protected.
If you were to buy some muni ETFs from Vanguard and state tax exemption was zero, which would you choose?
Not sure what you’re asking. What do you mean by state tax exemption is zero? You mean you don’t pay state taxes? Or your state doesn’t issue muni bonds? Or what? If there is no state-specific muni bond fund for your state, then you’re left with choosing between the short, intermediate, and long term funds. As a general rule with bonds, long bonds may not compensate you enough for the additional interest rate risk. Swedroe likes to use a 0.15% per year of maturity (I think it’s maturity, not duration) figure. So at Vanguard, these stats apply:
Short Term Yield 0.31% Duration 1 year Maturity 1.4 years
Intermediate Term Yield 1.63% Duration 4.7 years Maturity 8.8 years
Long Term Yield 2.32% Duration 6.1 years Maturity 16.6 years
If you use duration, given the current yield curve, and using Swedroe’s rule of thumb, it looks like investors are currently being compensated to go long. But looking around the internet, I think Swedroe’s rule of thumb is supposed to use maturity, not duration. So 7.4* 0.15= 1.11, so you’re being compensated to go intermediate. 7.8*0.15 = 1.17 so you’re not being compensated to go to long term. I think that’s how the yield curve generally looks.
In my opinion though, duration, not maturity is what matters. 69 basis points for an extra 1.4 years of duration seems like a heck of a deal to me. Too bad my crystal ball is cloudy with regard to future interest rates. It would make decisions like these much easier. Remember that the lower the yield, the higher the duration for any given maturity.
Hopefully most doctors will have TAXABLE ACCOUNTS. If not there is something very wrong. That taxable portion should have an allocation to muni bonds LONG TERM, as they have steady high income and no need to liquidate at any time. As long as you buy A rated or better(GO bonds are better than revenue) and create a portfolio of 30-40-50 bonds, you will be fine
The default rates are quite low; almost insignificant
While I agree many doctors have taxable accounts, it doesn’t necessarily mean something is very wrong if they don’t. For instance, I am able to put about $150K into tax-protected accounts (two 401(k)s, a DBP, HSA, two backdoor Roths etc) every year. Most docs save less than that.
Default rates are lower than corporates, but I’m not sure they’re quite low enough to be insignificant.
http://www.bnymellonwealthmanagement.com/our-views/perspectives/muni-bond-defaults.html
Most are in the 1-5% range, but housing and healthcare bonds are as high as 30-40% (as noted in the original post.)
and doctors should own Stock Index funds, like vanguards, in their taxable accounts as well
Doctors should have plenty of c ash to invest after maxing out ret plan contributions, hopefully!!
LAST 45yrs
AAA munis-ZERO DEFAULTS
AA- 1 in 10,000 have defaulted
Seems pretty safe to create your own portfolio of munis
Keep in mind many of them are downgraded prior to default. So although they might be B just prior to default, they may have been AA a year before.
MUNI BOND FUND has an expense ration of .2% and of course you pay that yearly
Owning bonds individually-no expenses after initial commission
so 40yrs of .2% yearly does ADD UP
with individual bonds you know exactly your yield
A fund fluctuates in its yield and many times management changes
.2% on a million is costing you 2 grand yearly as the expense ratio
Do bond funds hold CASH as well for investors cashing out
Researching online seems to indicate a mix of funds and individual is appropriate for most
I am sticking with my million dollar portolio as it has done me well over 40yrs
I am curious Ken, what is your portfolio made up of? Plus also curious, how it has changed in last 10 years.
You know your coupon yield, but not your current true yield. Bond values fluctuate with interest rate changes, whether they’re held in a bond fund at Vanguard or in your own personal bond fund. There is a slight cash drag in any mutual fund. Even at 0.2% I think the overall costs (including spreads, commissions, your time etc) are still far lower for the fund. But hey, we don’t have to agree on everything. Sounds like you’re doing just fine doing what you’re doing. There are many roads to Dublin.
I always bought LONG TERM 25yrs plus INVESTMENT GRADE A or better(most are AA). If they matured or were called I would reinvest
Best to buy GO bonds if available
As stated the default rates are miniscule
You do pay a commission but over 25-30yrs its not significant
THIS IS long term so if you think you need the money, go elsewhere or use funds
THE TAX FREE INCOME IS A LIFE CHANGER-allows you to WORK LESS AND PLAY MORE
This post is about individual muni bonds vs muni bond funds. The income is just as tax-free for both of them.
Default rates are lower than corporates, but higher than treasuries.
As mentioned previously, commissions are lower with a buy and hold strategy, but they’re no more insignificant than a 10-20 basis fund ER.
What do you see as the big benefit of having individual bonds? Your argument seems to be “diversification doesn’t matter, I can get my costs as low or lower than a fund can, having bonds called when rates drop forcing you to reinvest at lower rates isn’t a big deal, and there is no interest rate risk with individual bonds.” I disagree with all of that. All you’re doing is being your own muni bond fund manager, but without the benefits of scale.
Ken, could you give a little background on yourself to help me understand your point of view please? What is your medical specialty, age, net worth, and stock v. bond mix? Thx!
The only thing that has changed is that yields are lower on all bonds
But getting 3.5% is equivalent to 6 plus taxable
Yes, yields are lower on all bonds when rates fall, whether you own them in a muni bond fund or in your own muni bond fund.
And 3.5% is equivalent to 6% taxable in a fund or in your own fund. That’s not an argument for individual bonds.
Biggest benefit owning individual munis-SIGNIFICANT INCREASE IN YIELD
Having a portfolio of 50-60-70 bonds is diversified enough and as I said the default rates for A rated or better are insignificant
Of course if you buy these bonds you should know you will be holding till maturity
BUY AT PAR or lower in general
GO bonds over Revenue bonds
Why do you believe you can buy munis with higher yields than a mutual fund manager can? If you want high yield muni bonds, buy a high yield muni bond fund. For example, Vanguard’s High Yield fund with a duration of 6 years has a yield of 2.8% instead of the 2.3% you can get from the non-high yield fund with similar duration (long-term.) The average quality of the regular fund is AA, the average of the high yield is A. Vanguard’s high yield philosophy seems to be the same with their tax exempt as their non-tax exempt- i.e. really high quality for junk. If your yields are higher than 2.8% (you had mentioned 4%) it means you’re either taking more term risk, or more credit risk. There’s no free lunch here just because you’re selecting bonds yourself. However, if you can’t find a good, low-cost muni bond fund that invests in the bonds you want to invest in (apparently long-term, junk muni bonds) then perhaps it’s worth the effort and cost to try to do that yourself. But before doing so, it might be worth considering why a company like Vanguard doesn’t offer that option.
This analysis is correct, but not complete. Like the patient who tells the doctor what medication to prescribe, because the patient has seem a late night commercial, there may be more to know before making a conclusion.
Buying low-cost equity funds usually make sense, but bonds are another story. Most bonds are not exchange traded and that makes a difference. The bond market is more like craigslist, with each seller listing their bonds for sale and buyers looking for bargains. A good investment advisor buying individual bonds can find more bargains and add a lot of value. Here’s how.
First, the chart of transaction costs refer to the bid-ask spread. It is true, larger lots have tighter spreads than smaller lots. But spreads are irrelevant, you’re not buying a spread you are buying a bond.
Counter-intuitively, smaller bond lots have lower selling prices and that is more important. This is because the bond market is dominated by very large players. The large buyers aren’t interested in buying small odd-lots. It would be like trying to fill a bathtub with a teaspoon.
So these small lots are harder to sell and go for lower prices, often times a lot lower. The bond market is one of the rare markets where small buyers have an advantage. Premium bonds and zero-coupon bonds also tend to go at discounts, because many institutional buyers can’t buy them within their guidelines.
Second, the everything else equal individual bonds and bond funds have the same general interest rate risk. But, everything isn’t equal. Some individual bonds have more individual risk than others. E.g., high-coupon premium bonds have less interest rate risk than low-coupon bonds.
So your advisor can design a portfolio that is less interest sensitive. This is difficult to do with a large bond fund. You can learn more about that here: http://seekingalpha.com/article/1358261-protect-your-portfolio-with-cushion-bonds.
Third, you can save on taxes by doing swaps with individual portfolio. If interest rates do go the wrong direction and you have book value loses you can sell one AA muni and buy another AA with the same coupon, rating, and maturity and take the tax loss now. You can’t do this with a fund.
Fourth, bond funds are riskier. Bond funds don’t mature. With an individual bond the buyer gets their money back at maturity. With a bond fund the buyer must sell back their shares at market. A bond fund is like buying a perpetual bond, and perpetual bonds have more market risk than maturity bonds.
Psychologically it is much easier sitting out a bear market knowing you will eventually get your money back. Learn more here: http://seekingalpha.com/article/2481375-managing-market-risk-with-a-3-d-portfolio.
Fifth, diversification is less important in the bond market, because muni bonds seldom default. So, you don’t need many bonds to get decent diversification.
Sixth, an individual advisor can tailor portfolios. Some clients want more income and will tolerate less interest rate risk, some will tolerate less. It is much easier to control the behavior of a portfolio with individual bonds.
Seventh, it is the macros, not the fees that will get you. It will be being in the wrong bond funds for a given interest rate environment. Don’t forget 2008. A good macro manager can help avoid this.
Last, because of the above variables, a clever investment advisor should easily outperform a giant bond fund.
The low-fee bond fund argument is put forth mostly by companies that are making millions of dollars selling low-fee funds. Bond funds are riskier, more expensive, less flexible, and less tax-efficient, but they won’t tell you that, because that’s not what they are selling.
So, be careful about prescribing a solution from what you learned in a commercial.
1) Spreads are not irrelevant. Why would they be irrelevant? It’s a cost. It comes out of your pocket to pay someone else. Every dollar that comes out of your pocket is a dollar that isn’t working toward your retirement.
2) Sure, the higher the coupon the less interest rate risk. I’m pretty sure bond fund managers are also aware of that fact, no?
3) Tax loss harvesting is a well-known, and useful technique. It can be done within a fund, reducing future capital gains distributions, and a good manager will do so. Do you have more control over it if you’re the muni fund manager? Sure. Is it worth the additional costs to have that control? Not in my opinion. If you disagree, you’re welcome to hire your own personal bond fund manager.
4) You say bond funds are riskier. What risk are you talking about? You seem to be implying that bond funds are running interest rate risk that can be avoided by buying individual munis. That isn’t true. The risk is the same whether you hire a manager or function as your own manager. Same bonds in there. You do get your money back if you hold individual securities to the end (and they don’t default), but if your holding period is longer than the fund’s duration, you’ll actually come out ahead with the fund if interest rates rise.
5) Sounds like a Peter Lynch argument. Diversifiable risk is uncompensated risk. Why run a risk you’re not being compensated for? Default rates might be low, but they’re not zero.
6) Sure. You can be your own bond fund manager and run your own personal bond fund any way you like. But there are costs and hassle factors that you can avoid with a fund.
7) Are you suggesting a good advisor can predict the future? The evidence suggests that isn’t so. If they could, they wouldn’t be doing what they’re doing, much less doing it for someone else.
8) I guess most of them aren’t clever, or certainly aren’t clever enough to overcome their costs.
9) The low-fee bond fund argument is well-documented by academics, authors, and other without a dog in the fight. Costs matter even more with bonds than they do with stocks. Bonds funds are no riskier, much less expensive, and much more convenient when run by a professional with economies of scale than when run by “a clever investment advisor” with an office on the corner. You can pay Vanguard 12 basis points a year and pay tiny spreads, or you can pay your local guy 0.5-1% a year to pay huge spreads. The decision belongs to the investor really. I don’t expect advisors who make their money by selling their ability to buy and sell individual muni bonds better to agree with me, however. But if they were really good at what they’re doing, you would think they’d be working for someone like Vanguard or Fidelity managing their bond funds rather than investing a couple hundred thousand for 20 docs in small town USA.
I’m just saying there are pros and cons to individual bonds vs. owning an index. It is not as clear cut as you are making it. Don’t confuse the advantages of buying a stock index with the advantages of buying a bond index. It is apples and oranges.
Most municipal bond investors need some individual advice and individual management. There is research that says computers are cheaper and better at diagnosing some illnesses than doctors in the aggregate, but that doesn’t mean you should trade your doctor for a computer. I think you are short selling the advantages a good advisor can offer.
As for your questions.
1) Well it really isn’t really a spread; it is a mark up. If you are in a investment advisor account you aren’t charge a mark-up, you get the bond for cost, the RIA is compensated with an annual fee. If you buy it from a broker-dealer they will buy the bond and then mark it up to a higher price, like a store. When the transactions occur through a B-D the spreads are smaller for a big order than a small order. But there is no spread in an investment advisor account. So that’s a savings your not counting.
2) Yes, most bond managers understand that higher coupon bonds are less risky in a rising rate environment, but they are restricted in buying these. High-quality, high-coupon bonds sell at a premium and they are usually bought and sold on the secondary market – although there are some new issue premium bonds. Most big bond funds buy their bonds in the primary market. In a sense, bond funds buy new cars, individuals buy used cars. Often times you can get more for your money with a used car. It’s the same with bonds.
There is in a sense a free lunch, if you know what you are doing.
3) A bond index isn’t concern about one individuals tax situation. Trust me it is much easier to harvest from a personal portfolio than a bond fund.
4) Bond funds are riskier not because of the interest rate risk, but because they have no stated maturity. Bond funds are not bonds.
The upside of a bond is you get your money back plus interest. With a fund you only get interest. There is no bond between you and the seller that you will have your principal returned by a stated date. Therefore, bond funds are not bonds, they are speculative securities. Bond funds are legally stock in a company that owns bonds. That makes for a stranger structure, than a stock fund which is stock a company that owns other stocks. One is equity in equity, the other is equity in fixed-income, but they are both equity, not bonds. Equity is always riskier. This is subtle, but important to understand.
Let’s say you have a college bill due for a child in 15 years, if you have a high-grade individual bond you will know you will have your money returned in 15 years, but with a bond fund you don’t know what it will be worth. It will be worth whatever the fund is worth 15 years from now.
Or look another way. Nobody in the history of the US has every lost money on a US Government bond held to maturity. But, lots of people have lost money on Goverment bond funds, because they have no maturity.
So, having a non-maturing asset is always riskier than not having one.
5) Bond investors are compensated for risk. Riskier bonds pay high interest rates. Equity buyers are not always compensated for risk, because equities don’t mature. You can buy a risky equity and lose money. If you buy a riskier bond you will be paid a higher coupon. Bonds are different.
6) Or you can pay a Investment advisor to manage your bonds, and he or she may be able to better meet you individual goals at the same cost or less of owning a bond fund or index. I can design a portfolio around an individual’s needs.
If you’re worried about rising interest rates I can tailor a portfolio to minimize the volitility, the portfolio will behave better when rates rise. If you are worried about rates going lower, I can design that to. If you want income no matter what, that can also be achieved. No solution will be perfect, and without risk. Vanguard will not do that. Vanguard will not tailor their indexes to your individual needs.
7) No, I can’t predict the future anymore than the school janitor. But, I avoided 2008 not because I brilliant, but because junk bonds were six percent and government-guarenteed mortgage bonds were paying also at six. Given they had the same coupon, which would you prefer to own. Almost everyone said the government-guarenteed bonds. But if you’re weren’t looking at the macro picture, you would miss that macro anomoly. I think, at least in that instance, I overcame my 70 bps per year expense over an index.
9) The low-fee argument is well-documented in active vs. passive stock managers. There is little research on whether a bond index can beat a portfolio of individual bonds, simply because it is hard to find a control group of individual bond investments.
As a point of clarification, you don’t pay both the .5%-1% a year and the spread. That’s illegal. You either pay the annual fee and no mark-up or no annual fee and a mark-up, depending on if you are using an investment advisor or a broker-dealer.
So the question is, is the extra 50 bps per yearcost worth it for the individual bond selection, cheaper odd-lot purchases, portfolio design, tax-swaps, and having someone remind you that government-guaranteed bonds are yielding the same as junks.
Some people don’t like advisors, or have had bad ones and will favor indexes. And there are bad advisors just like there are bad doctors.
But, compared to stocks, bond advice comes pretty cheap and can be helpful.
There is a market for both of these products and I use bond indexes for certain senarios, like equity hedging, but they are not bonds and they are riskier.
1) How are you suggesting the broker is paid if there is no mark-up/spread/fee/transaction cost/whatever you wish to call it? You think they just do the advisor a favor and let him collect the fee?
2) Why are they restricted from buying them? Who’s doing the restricting if this is such a “free lunch” why aren’t institutions interested? Your theory isn’t passing the sniff test.
3) Sure, and there is a little bit of benefit there in deferring some tax. But unless you die with them, that tax is paid eventually. I don’t doubt there is a tiny benefit there, but it’s not worth paying 1% a year for.
4) You get your principal back when you sell your shares of the fund. It’s not just interest. Might it be less principal than you put in? Sure, just like it might be if you sell a bond prior to its maturity. You’ve got the same risk with individual bonds if you cannot hold them until maturity. This theoretical risk of losing tons of your principal in a well-managed bond fund with a reasonable maturity and credit profile is rather silly, especially if your investment horizon is at least as long as the duration of the fund.
5) Were you not aware that some bonds default? Just because the risk is lower than equities doesn’t mean it doesn’t exist.
6) It seems unlikely that without the benefits of scale that you can manage my own personal $100k muni bond fund at 12 basis points per year. Sure you want to do that for $120?
7) Were you lucky, or skilled or are you lying? Unfortunately, there’s no way to tell. 70 basis points per year on an asset class that’s yielding 2.3-4%. So your investors are paying you up to 1/3 of their return, 6 times as much as Vanguard is charging. No wonder you have to try so hard to convince investors of the merits of hiring you. Seems a big hurdle to overcome to me.
If you, and your investors, wish to use individual muni bonds, knock yourself out. I don’t have a dog in the fight. I don’t even own a muni bond fund. I think it’s a waste of time and money, but there are many roads to Dublin. Certainly there are dumber ways to invest than buying individual muni bonds. If I had a big taxable account though, I certainly wouldn’t be out looking for someone to buy individual bonds for me.
When you own individual munis, there is no annual fee, but guess you will get whacked if sold prior to maturity
That’s why these should be long term investments held to maturity or call date
So what’s the best choice long term
A portfolio of individual bonds A rated and better held till maturity over 500k or
A long term muni bond fund from vanguard
If you value control more than convenience, and you can make the costs similar enough (might be tough given the transaction costs), then buy your own bonds. But if you have to pay somebody 70 basis points a year to do this for you….seems like you’d be better off with the fund to me.
Ken: If you have 5k you’re better with an index, but with 500k you’d benefit with individual bonds. Individual bonds mature so they have principal protection. Indexes don’t have principle protection. You’ll also have a lot more flexibility. You can do it yourself or pay an advisor. If you’re just buying bonds, you should be able to find someone that will do it for 50bps- one half percent per year or less.
I agree, if you’re going to do individual muni bonds, your best return would be to hold them until maturity. I would try to avoid bonds that can be called all together if possible.
Jim, I’m not trying to convince people to hire me, I’m just telling investors the risk of the medicine before they take it. That doesn’t mean you shouldn’t take it. And, you don’t even need an advisor to implement this advice.
I’m trying to make an explanation, not an argument. My main point is bond funds are not bonds, and investors need to know that. Stock funds have pretty much the same risks as stocks, bond funds do not. In my experience, bond funds are riskier and often more expensive than bonds. Thanks all.
Answers to your questions:
1) Mark-ups and fees. Most bonds on the are not exchange traded like stocks. They are traded on a list, like Craigslist. Buyers list what the have to sell – something like 100,000 – 4% 2024 Podunk Sewerage BBB @95 min 25.
That is 100000 $1000 par value 4% bonds rated Baa that mature in 2014 with a min order of 25 selling for 95 or $950 each. Below that might be 8 – 4% 2024 Podunk Sewerage Baa @ 90. You can buy eight of the bonds at 90 or $900, but if you want more you need to buy them from the other guy and you must buy at least 25.
The guy with eight bonds knows he has a weird number and he wants to sell fast so he has lowered his price. The local pension fund doesn’t want to mess with eight bonds so they buy the lot of 100000 through a broker(Series 7) and the broker marks them up and sells them at say 95.20($952.00 per bond) a mark-up of two dollars a bond. The brokerage makes a 2000 dollars on a million dollar order. The broker works for the brokerage house. Maybe they pay less, maybe more. If it is dealer owned inventory they won’t know what the mark-up is.
Now if you have a Registered Investment Advisor (Series 63,65,66) he or she legally works for you not the brokerage house. He charges between .25% and 1.5% per annum depending on account size and asset type to manage your portfolio. He or she is paid whether they buy or not. Legally, by SEC regs, he can’t take commissions or mark ups. They can’t double-dip. They generally use discount brokers that charge about a dollar a bond mark-up.
Because you’re small potatoes, you only need a few bonds so he or she picks up the eight bonds at 90 ($900)you get the bonds at $901 per bond including an one dollar fee to the discount broker. That’s how the little guy gets his free lunch. Yes there is a small mark-up but the purchase price is less.
2) Restrictions. PIMCO doesn’t want a portfolio with 100,000,000 lots of 100 bonds. They want big lots of 100 bonds. So they pass on the small stuff. They will usually buy new issues in big lots, not secondary bonds. But the better deals are in the secondary market.
Next, to run a bond index you don’t need just large lots, you need huge lots that are widely traded, sell daily, and are very liquid on the secondary market, this is another restriction. So Vanguard can only put very large issues into the index.
They can’t put Podunk Sewerage in the index because it doesn’t trade very often, they need to buy NYC Sewerage. So they also pass. That’s the restriction. Because of this lack of big buyers, the good deals are on smaller less traded issues.
Also, they usually don’t buy zeros and premium bonds ( bonds that trade over par), so that’s one more opportunity for the individual investor.
3) Write-offs. You may want the tax write off this year. Maybe you had a big year and it’s bumping you into the top tax bracket. So it’s an advantage that may be worth the extra fee.
4) Maturity risk. You’re right, you do have the same risk fund if you don’t hold your bonds to maturity. But, fortunately, you can hold your bonds to maturity, and, unfortunately, you can’t hold a fund to maturity, it is asymmetric, so there’s less risk.
The there is also the asymmetric psychological responses to losing vs. gaining. You’re are more likely to hold on if you know you will get your money back at maturity.
Losing money in a bond fund is not a theoretical risk, people can and do lose money in bond funds. Some closed-end Muni funds lost 50 percent in the crash. Muni ETFs have had three five percent plus drawdowns in the last 10 years, that’s a lot of movement for many conservative investors. If you panic and sell during the draw downs, you get burned. And some investors do panic.
You will seldom lose money money holding investment-grade muni bonds to maturity.
5) Investment Grade Muni’s default about 0.01% over ten year periods, less if you avoid Housing and Hospitals, which are about 60% of the defaults. It’s not zero, but it is not the stock market either. So you pick up some default protection from an index, but not a lot. It’s not like diversifying stocks.
6) No most independent advisors won’t manage it for $120 per year. But for a muni only fund you’ll probably pay less than .5% maybe a little more on a small account. And most advisors can make up the extra $380 or so per year pretty easily. Because the bond market isn’t exchange-traded it is not as efficient as the stock market. There are lots of places to pick up $100 bills, to make up for the extra cost.
7) Choosing between a government-guaranteed bond or a similarly yielding junk bond is neither luck nor skill. It’s just an educated guess.
You’re right if an advisor were running a low-yield bond portfolios, that would be too much to pay, and most wouldn’t charge that much on a muni only portfolio.
http://marccortez.com/wp-content/uploads/2012/09/beating-a-dead-horse.jpeg
I think we’ve exhausted what can be said on this subject. I’m very skeptical that an advisor can find enough inefficiencies in this asset class to make up his fee, especially when considering the increased spreads there are on average and the additional risk from having less diversification. I also see the big risk advisors use to sell this service (if you hold to maturity you won’t lose money) as a very minor risk in the context of all the investment risks I’m running. Sure, there were lots of funds that cratered, but look at the super-cheap, broadly diversified funds at Vanguard. No losses in the last 15 years in the short term muni fund. Worst loss in the last 15 years in the intermediate fund was -1.05%. The stock market has losses like that a dozen times a month. Even in the long term fund, there were 3 down years in the last 15 years, all in the 2-2.5% range. I don’t think investors need to go looking for a solution to this “problem,” and certainly not one that costs 5-15 times as much as simply buying a fund.
One other huge advantage of funds that we haven’t talked about as much is the advantage of having liquidity. You can get out of your entire muni bond investment on any day the markets are open at the fund NAV. How many basis points should that be worth per year to investors? It’s worth something, and thus increases the high hurdle the individual bond selector is already facing.
spoke to a big bond broker and he says individual munis is the way to go as I do
I will be looking to buy in the future from states other than mine, NJ
With an individual bond, your 5k is guaranteed at maturity: With afund no one knows
There’s an unbiased source for you. I spoke to a mutual fund manager and he assured me a fund is the way to go. 🙂
Seriously, if you and David Cretcher and Larry Swedroe want to be your own fund managers, don’t let me stop you. This is a rather minor issue in investing.
I emailed Larry swedroe
INDIVIDUAL bonds are the CHOICE
Emailed Burton Malkiel
If you can d iversify, INDIVIDUAL BONDS ARE BEST
So both swedroe and malkiel agree with me
Obviously you need a 100k or more to get started
Interesting that both Swedroe and Malkiel would change their minds in response to your email. I would suggest their positions on the subject are far more nuanced than your comment would suggest. First, Swedroe:
At the end of the article, the disclosure talks about what he actually holds:
Looks like he holds both individual bonds and a fund.
http://seekingalpha.com/article/1912191-larry-swedroe-positions-for-2014-risky-equities-always-trump-chasing-yield?page=2
Then Malkiel:
http://www.wsj.com/articles/SB10001424052702303345104579284603227774012
Frankly, even if they disagreed with me, (which it appears they do not based on these recent articles,) it wouldn’t be the first time. My position is mirrored by Vanguards:
By the way, as long as we’re citing “investment authorities” this is what Jack Bogle invests in:
http://news.morningstar.com/articlenet/article.aspx?id=160557
But, it’s your money, your portfolio, your retirement etc. You state buying $5K of individual muni bonds at a time has worked well for you for 40 years and presumably you have reached your financial goals by doing so. No reason to change what’s working. It especially seems foolhardy to sell all your individual bonds now (paying large transaction costs) and move the money into a fund. But what YOU should do at this point, and what someone else who has no money invested in individual bonds but wishes to now buy munis in the best way possible moving forward, are two different matters.
If anyone wants the responses from malkiel and swedroe, send me an email
[email protected]
Ken, could you give a little background on yourself to help me understand your point of view please? What is your medical specialty, age, net worth, and stock v. bond mix? (You didn’t respond above so I wasn’t sure if you saw my comment or preferred not to respond.)
Semi retired dentist. 5 million liquid assets
80% ret plan very diversified
20% individual munis
Almost 65
20% stocks! the rest fixed
Bulletproof to not touch principal hopefully with 4% withdrawal rate
So did you accumulate your wealth with only 20% stocks when you were younger or have you moved to a more conservative asset allocation as you became semi-retired? You have obviously been very successful financially. It would be educational to hear more of your story if you are so inclined…
I agree.
Email sent.
Edit: Looks like you already forwarded Swedroes to my business manager. It’s important to point out when discussing Larry’s response what your question was:
Q.
A.
So a few comments on this brief interchange. First, you gave the caveat “never need to sell.” One of the upsides of a muni bond fund is you can sell it any time you like for the NAV. Of course, how many people can truly accurately predict they will never need to sell any of those bonds. I submit the number is very small. Even if you don’t need to sell them, your heirs might. If your question had instead asked “might need to sell them prior to maturation” what would Larry have said? I submit he might have recommended a fund.
Second, Larry has a firm that gets paid to buy individual muni bonds. Descartes said, “Man is incapable of understanding any argument that interferes with his revenue.” Upton Sinclair said, ” It is difficult to get a man to understand something when his salary depends on him not understanding it.” Larry has an obvious conflict here. Now, I know Larry and I think he’s a great author, advisor, and thinker. He has a very successful firm and I’m sure he’s very well off. So I doubt he has much need for one more client, BUT, there is a conflict of interest there. I’m sure if the question were addressed to Konstantin Litovsky or any other advisor who performed the service of picking individual munis, you’d get a similar response.
Third, Larry qualified his answer with “for anyone with sufficient assets.” I would propose that if you asked him if buying individual muni bonds $5K at a time was a good idea, that you would have gotten a different answer. As seen above, and I’m sure Larry would agree, the smaller the amount, the greater the transaction costs as a percentage of the amount invested. Costs matter in investing.
Last I don’t dispute there are advantages to buying individual bonds, which Larry lays out nicely in his response. However, I do not feel that for the vast majority of investors (who don’t have $1 Million in muni bonds, BTW), that those advantages outweigh the disadvantages noted elsewhere in this thread.
But, as mentioned many times already- If you feel like the advantages for you outweigh the disadvantages, then buy individual bonds yourself or hire somebody to do it for you. For as much writing as has gone into this comments section, this is a very small issue in the grand scheme of investing.
Looking forward to Malkiel’s response.
Here’s Malkiel’s response to similar question:
Q.
A.
Again, both these guys are smart enough to qualify their statements. Malkiel is saying if you buy insured, very high quality munis and can buy enough of them that you are diversified, then buy individual bonds. My contention is that in order to do that at a reasonable price, you need a muni bond allocation in the hundreds of thousands. If your muni bond allocation is 20% of your portfolio, we’re talking about at least a $2M portfolio.
This is a good time to pull out one of Taylor Larimore’s statements- When experts disagree, it probably doesn’t matter much.
To beat a dead horse.
The transaction cost on bonds is minimal. i think you are over weighting the transaction costs. The transaction cost through a discount broker is $1 per $1000 bond.
On a multi-year investment that just isn’t a significant transaction cost. If you buy $100000 of bonds (100 bonds) that is $100 over say a ten year investment period or $10 per year.
The IMBG 2018 Term Maturity ETF yields .94% with a rating of AA. I just pulled up six AA bonds that mature in 2018 that pay between 2.2 and 3.5%, in 5 to 15k lots that’s double to triple the yield, and the market is closed. Given a couple weeks there will be more. That’s the advantage of individual bonds. The bond market isn’t as efficient as the stock market. And you don’t need a large amount to diversify.
As for diversification AA munis default at .01% over a ten year span. There’s not a lot of concentration risk. http://www.bnymellonwealthmanagement.com/our-views/perspectives/muni-bond-defaults.html
Bonds can be traded intra maturity pretty easily. It might take a hour or a day or two to get an odd-lot sold but they’re very liquid.
I’m having a hard time reconciling your statement that there are no transaction costs with the graph posted above suggesting up to a 2% cost for very small lots.
Here’s another article discussing this: http://investorsolutions.com/knowledge-center/investment-vehicle/buyer-beware-the-hidden-costs-of-municipal-bonds-2/
I can’t for the life of me figure out why you think you are (or are) immune to these costs.
To reconcile it you need to know how the primary and secondary bond market works. It’s much more complicated than the stock market. You are buying the bonds for the the yield, quality and duration. If you don’t like the terms you don’t by the bond. The transaction cost they are refering to is an embedded cost, not a tack on cost like a stock. If you buy a sweater from a clothing store, the sales tax is a transaction cost, but is the merchant’s mark up a transaction cost? See this article it explains it in more detail: http://www.municipalbonds.com/education/read/150/how-bonds-are-sold-your-transaction-costs
I think your in your quote they are talking about a dealer mark-up. If you buy through an advisor (Series 63,65,66) you get the bond at cost with no mark-up.
If you buy through a stockbroker(Series 7) they can mark the bond up. For instance, they have a bond in their inventory that yields 4.5 percent the broker says “I’ve got this 20 year AA bond that pays 4 percent” You say ” sure that sounds good, I’ll take it”. But, a half a percent for 20 years is a 10% mark up which is pretty high. These transaction cost can sometimes be high, and that’s what they are talking about. Of course, you could also say “no thanks, what else do you have?”
It’s a little like the used car market, dealers find cars for cheap and sell them to retail buyers for a profit. But the buyer is free to shop around.
But either way the buyer is buying a yield, quality and duration. Only the unsuspecting overpay – just like used cars. This is where it can help to have an advisor that understands the markets.
Whether it is embedded or not, you still pay it. Sure, you get to see the price of the bond with that cost included, and only buy it if that price is acceptable. But it’s not like you get away without paying it.
If you are starting from ground zero as I did, you gotta start somewhere and I probably bought my first muni at 5k and built up a portfolio over the yrs to a million dollars. I was only concerned about hi quality and the yield I desired. Basically went out very long term, 25-30yrs, knowing with steady income I would never need to sell them. If so its pretty easy to sell them. I’d bet Buffett owns individual munis.
Ken you did it right. Small lots are a great way to start. If you don’t need the income, you can also buy zero coupons and pick up higher yield. However, they’re more volatile intra maturity.
I can understand your investment decisions back when bonds were yielding much more than they are presently. I can also understand with your current net worth being satisfied with your current low yield. But, if you were starting now would you proceed the same? How in the world did you not increase stock exposure in the 1990’s? I appreciate your response as it is great and fascinating hearing varying views.
Owned plenty of stock index funds in the 90’s in my ret plans
Some yrs earning 400k on a 40% yr-IT WAS INSANITY
I did not want to pay any more in taxes so all my taxable was in munis-in retrospect a mistake-would not advise the same today, BUT
you might not remember that yields on tax free munis were double or more than those of today. There was a time of double digit returns on munis when 30yr treasuries were around 17%
So getting 7% tax free was as good as the historical return on equities and I SLEEP BETTER
Today in your taxable account own MUNIS and STOCK INDEX FUNDS in a mix that suits you. The income from stock index funds is small on a yearly basis.
AND LASTLY, anyone who can do a ROTH, DO IT
AND do it for your teenage kids(GIVE THEM A JOB)
Thanks for your insight. Always enjoy your comments!
Just for accuracy’s sake, the yield on 30 year treasuries peaked in September 1981 at ~ 14.68%. At the time the 10 year was 15.32%. The Federal Funds Rate that summer was over 19%, so you had to be smart enough to give up 4% in a money market fund in order to lock in a lower rate for 3 decades.
https://research.stlouisfed.org/fred2/data/GS30.txt
I think your bet would be wrong. I don’t think Buffett owns bonds at all.
Never bought zero coupon muni-thanks for the new idea
Did buy MANY yrs ago-It funded my kids education as rates were double digits
THOSE WERE CARZY CRAZY TIMES
Every Tom Dick and Harry was buying and talking stocks
REMEMBER TO REBALANCE IN JANUARY DO IT YEARLY!!!
It was a great time for bonds. Turns out the best performing investment one could make 30 years ago wasn’t stock it was a 30-year government bond. Bought in 1983 Paid out at 13% annual till 2013, uncallable. And fully guaranteed by the issuer of the currency.
Allan Roth had an interesting article recently.
http://blog.aarp.org/2014/12/04/your-bond-income-could-be-an-illusion/
That’s a good article showing the dangers of paying a premium for a higher yielding bond- some of the yield that seems so high is actually return of premium.
You want to get the Yield-to-Worst value,from the broker or advisor, that will give your worst case scenario. The yields I quote above are YTW.
However, if you actually had to invest a sum every year from 1983 to 2013 (like most people) you were better off investing in stocks.
While I wasn’t old enough to be paying attention, when interest rates were at their highest, in 1981 and 1982, I disagree that everybody was buying stocks. In fact, there was a famous article run in 1979 entitled “The Death of Equities.” http://www.businessinsider.com/death-of-equities-revisited-2012-8
They should have been buying stocks, as stock returns bested 18% in 5 out of 7 years from 1979 to 1985, but I’m not entirely sure they were.
Last, while I agree that rebalancing is an important portfolio risk control concept, there is nothing special about doing it in January or even doing it yearly. The data suggests it should be done no more frequently than yearly, and perhaps only every 2-3 years.
Risk aside they should have bought stocks. Time and volatility matters. For the math geeks see links:
file:///C:/Users/David/Downloads/TW-NA-The-Irreversibility-of-Time%20(4).pdf
https://www.youtube.com/watch?v=f1vXAHGIpfc
You mean due to the reinvestment risk?
Ken, am I missing something, there are no capital gains here
Vanguard has posted “Year-End Capital-Gain Estimates” for the three funds in the Three Fund Portfolio:
Total U.S. Stock Market Index Fund: “None”
Total International Stock Index Fund: “None”
Total Bond Market Index Fund: “0.28%” *
* Total Bond Market Index Fund should normally be in tax-advantaged accounts.
The recent round of distributions argues that if investors want to help protect against unwanted distributions, their best defense will be broad-market equity exchange-traded funds or index funds, which tend to distribute few, if any capital gains. — Morningstar Article
Bonds should not necessarily be held in tax-advantaged accounts. You have to consider both the tax-efficiency of the asset class, AND the expected rate of return of the asset class. At current yields and expected returns, many investors will be better off holding bonds in their taxable and putting stocks in their tax-protected accounts. You have to run the numbers with your assumptions to know for sure.
The taxable bonds (such as TBM) vs munis decision is almost completely separate, and should be made once the previous decision as to asset location is made. More details here:
https://www.whitecoatinvestor.com/asset-location-bonds-go-in-taxable/
Ken’s investment strategy (buying individual munis and never selling them before maturity) doesn’t generate capital gains. They’re sold (actually redeemed) at precisely the same price that they were bought at. In fact, when you consider inflation, they’re sold cheaper than they’re bought at, but the government doesn’t allow you to index capital gains to inflation. Although if he had a default, he could deduct that as a loss.
So if I have two funds, VTSAX an index fund w yield of : 1.78% and a bond fund: VBTLX with a yield of 2.07%, which of two should be placed in Tax deferred and which one in taxable?
The bond index should be in your taxable account, because you pay ordinary income tax on the interest.
The stock index should be placed in your taxable account because it is subject to the lower capital gains and dividend tax rate.
It is also more volatile and risky and if you lose money on it you can write it off your taxes as a loss. Because it is volatile if there are losses you can harvest them by swapping it for a similar stock index.
Unfortunately, you cannot write off losses in your retirement account.
I think you meant to put a “not” in your first sentence.
Your reasons for asset location don’t take into account the benefit of having a larger tax-protected account. You must consider not only the tax-efficiency of an asset class, but also the expected rate of return of an asset. Here’s a simplified example to help you understand.
Asset Class A- Makes no distributions until you sell, at which time you pay 15% capital gains taxes. Gains 10% a year
Asset Class B- Makes annual distributions of its entire return, taxed at 50%. Gains 2% a year
You have a $10K Roth and a $10K taxable account. Which asset class should you put where? By your guidelines, you should put asset class A into the taxable account and asset class B into the Roth, no?
However, if you actually run the numbers over 30 years, that set-up will allow you to finish with $168K.
However, if you put the higher returning asset into the tax protected account, you’ll end up with $188K (plus the future tax and asset protection benefits to you and your heirs of having a larger Roth.)
Run the numbers and you’ll see. For this reason, at certain interest rates and with certain expected returns and for certain people, it can make sense to put the least tax-efficient asset class into taxable, because it has a much lower expected return than the other asset class. Hope that helps. Also realize this doesn’t mean that bonds always go in taxable for everyone. But these days, that’s the way to go for many/most people.
No bonds in the tax account. Yes, if you torture the data enough it will confess.
If you have a Roth it might be better the other way. But, it is unlikely you will get a 15% return over 20 years, given the current PE and inflation rate.
http://en.wikipedia.org/wiki/Price%E2%80%93earnings_ratio#mediaviewer/File:Price-Earnings_Ratios_as_a_Predictor_of_Twenty-Year_Returns_(Shiller_Data).png
It is also likely you can do much better on your bond portfolio.
So given the much higher volatility and higher risk of loss. I would put the bonds in the qualified account and the stocks in the taxable account. The odds are in your favor, but I could be wrong.
I think you are wrong on this point (although as I said, it can vary for different individuals.) I’m not sure where you got the 15% return as I thought I used 10%. At any rate, it was a simplified example to show you that bonds in taxable CAN be the right answer.
Whether or not it’s a Roth or a tax-deferred account, however, has NOTHING to do with it so long as you make an appropriate tax adjustment for the account FIRST. Most investors fail to do this, so their numbers end up showing stocks in taxable coming out ahead. The fact is you only own part of your tax-deferred account. The government owns a percentage of it. So when determining your asset allocation, you have to acknowledge that fact, then make the appropriate calculations. So you can’t compare a $10K taxable account to a $10K 401(k). If your expected tax rate on the 401(k) withdrawals is 25%, then you need to use a $10K taxable account and a $13,333 401(k). Easier to run the numbers with a Roth, of course.
I don’t see it as torturing the data. You can make the example more complicated, (say an 8% equity return, a 3% bond return, part of the equity return paid out each year at favorable tax rates etc) and the magnitude of the advantage of stocks in Roth will decrease, but the direction probably won’t until interest rates go up (or until your expected stock return goes down.)
The point is it isn’t all about tax-efficiency. The rate of return must be part of the equation for you to arrive at the right answer.
Unfortunately, you haven’t provided anywhere near enough data to answer that question. For instance, what do you plan to do with the stock fund? Will you hold it until death? Will you give it to a charity? Will you sell it in less than a year? Will you sell it in more than a year? And that’s just one factor that goes into a very complicated calculation.
I am sorry, here is more information, I plan to hold the stock and bond index atleast for next 20 years (if not 30). So WCI, does it make sense to put the stock index with lower yield in taxable and bond index with higher yield in tax deferred?
I plan to start using it for my retirement in 30 years or so.
Not even close to enough information. Have you read this post?
https://www.whitecoatinvestor.com/asset-location-bonds-go-in-taxable/
Chances are good you should put muni bonds in taxable and stocks in the tax protected account, but there are lots of adjustments to make to individualize it. Donating shares to charity or leaving them to heirs or getting a lot of benefit out of TLHing can also change the equation. Your expected returns out of your stock portfolio and bond portfolio also matter as does your capital gains rate and marginal tax rate. And your AMT rate. And your state rate. And whether you’ll move to a tax-free state before selling the shares. Etc etc etc. It’s complicated. I wish I could give you a straight answer. The straight answer is that bonds probably go in taxable. But it’s possible that isn’t right for you.