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!
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.