I recently received a request from a reader that I write a bit about municipal bonds. I'm not a huge fan of municipal bonds for several reasons I'll list out below, but first, a brief description for those who have no idea what I'm talking about.
A municipal bond is a loan to a local or state government. The government might use it for schools, a stadium or some other purpose. It is guaranteed by the state or local government, which has the ability to raise taxes to pay the bond, so it is generally considered safer than loaning money to a company. But it is much riskier than loaning to the federal government, which not only has the ability to raise taxes, but also to print money in order to pay the interest and principal on the bond.
In order to encourage investors to buy munis, the federal government makes the interest on (most of) them federal-tax-free. If it is a bond in your state, it is also usually state-tax-free. This can be a pretty good deal for those in a high tax bracket (especially in a high-tax state such as California or New York.)
Now, the reasons why you probably shouldn't put these in your portfolio.
Bonds Should Generally be Placed Into Tax-Protected Accounts
Most investors, and in fact most doctors, can and should be investing almost entirely inside tax-protected accounts such as 401Ks, IRAs, and Roth IRAs. I make more than the average physician, save more than most doctors, and still find little need for a taxable investing account. It usually makes no sense to hold munis inside retirement accounts, so I have no need for munis. Even if you do have a sizable taxable account, you still probably have room to have your entire bond allocation in your retirement accounts, and don't have a need for munis.
The reasoning for this comes down to the fact that stocks receive preferential tax treatment compared to bonds. The dividends and long-term capital gains are only taxed at a maximum of 15% whereas bond income is taxed at your regular marginal tax rate (same as your regular pay.)
Munis Can and do Default.
Defaults aren't nearly as common as with corporate bonds (especially junk bonds), but they do occur. Counties and cities go bankrupt from time to time and many political commentators are even speculating that large states such as California or Illinois could go bankrupt in the future. That isn't necessarily a huge problem, and can usually be overcome (at least at the local level) for many people by using a mutual fund. But if your entire bond portfolio is invested in California state muni bonds and California defaults on them…..you're just out of luck.
Most of the Time You Have to Pay State Taxes Anyway
Most states don't have a low-cost muni bond fund available. Vanguard, for instance, only offers tax-exempt bond funds for California, Florida, Ohio, Massachusetts, New York, New Jersey, and Pennsylvania. No dice if you're in another state with a state income tax; You can get a generic muni-bond fund (federal tax-free, but not state tax-free), but you'll have to pay state taxes on it. There's a fund available in my state, but it has a 4% load and an ER of 0.83%. Considering the current yield is only 3.94%, it'll probably take me a year and a half just to break even on my investment, and that's before inflation. No thank you.
Your Mutual Fund Options are Limited
As discussed above, there aren't very many options for muni bond funds. Even if you can find a low-cost state-specific muni bond fund, you probably can't get one with the duration you want. It's rare to see a long-term, medium-term, and short-term bond fund for your state. There's also a good chance you won't be able to find an index mutual fund. You'll likely be stuck with a high-cost, actively-managed fund.
Buying Individual Muni Bonds is a Poor Option.
While it is now cheap and easy to buy stocks with minimal commissions and spreads, it is still quite difficult to do that with individual muni bonds. These bonds aren't very liquid, so commissions and spreads are high, and that's if you can find a buyer at all. I assure you the baby in the eTrade commercials isn't trading muni bonds with a click or two of the mouse. You also need to buy a lot of them to get proper diversification. Not only does that increase your costs, but it also increases the hassle factor of implementing and maintaining a portfolio.
You Double-Down on Local Economy Risk
Most informed investors are aware that their portfolio shouldn't hold much, if any, of the stock of the company they work for. It's also a bad idea to have a portfolio entirely made up of the stocks and bonds of local firms. Muni bonds have similar issues. If you want the best tax treatment, you have to buy bonds from your own state. If your state economy tanks, not only is your regular income threatened, but now the value of your portfolio is hurt at the same time. Investing in muni bonds violates an important rule of investing: Don't put all your eggs in one basket.
Muni Bonds Can Be a Poor Choice If You're in a Low Tax Bracket
In order to decide whether to buy a muni bond or a non-muni bond with similar risk, you have to divide the yield on the non-muni bond by your marginal tax rate. For example, if the muni bond yields 4.5%, the non-muni bond yields 6%, and your marginal tax rate is 35%, you multiply 6% by 1-0.35= 3.9%. You'd be better off with the muni bond. But if your marginal tax rate is just 15%, then the non-muni bond has an after-tax yield of 5.1%, far better than the muni bond. Yields change and tax brackets change, so you need to periodically do this calculation to make sure your muni portfolio still makes sense for you.
Image credit: Bspangenberg, CC-BY, Wikimedia
I’m not sure what calculator you’re talking about. If it is a Roth conversion calculator or a Roth vs traditional calculator I think you’re missing the point. The backdoor Roth is in addition to anything else you’re already doing.
The higher yields on muni bonds are only partly due to the higher risk of default compared to t-bonds. Note that the risk is higher than US bonds (which have no risk of default), but still not very high. The larger part of the the yield differential is the call feature of muni bonds. If interest rates go down, muni bonds can be paid off at par or slightly above after the call date. So now most previously issued muni bonds will be paid off prior to maturity. However, US bonds do not have a call feature. No matter how low interest rates go, the US is stuck paying the former high interest rate until maturity. That is obviously a good thing for people who want to buy bonds as a speculation on lower future interest rates.
Good point about the call risk.
Whitney’s concern was valid…for a while.
Municipalities have borrowed more than their tax base can safely cover. This risk of default is usually covered by municipal insurance. However, Municipal Insurance providers (companies like Assured Guarantee) looked like they were facing bankruptcy. In which case, bond failure would get messy for bond holders.
A Billion dollar lawsuit against Bank of America, a cash infusion by Ross Wilbur, and an improvement in credit-worthiness in states like California has held improved the situation of muni bonds.
I’d be a buyer of short duration California munies in taxable accounts. In fact, I’m thinking of using this exclusively for my bond holdings.
While some bankruptcies have occurred the default rate on Muni Bonds are very very low. I bought muni bonds and now I am getting about 4.75% tax free return. My 10 year average on my equity income mutual fund are about the same.
As for state declaring bankruptcy or defaulting only one state in the 20th century ever defaulted on their bond obligation, Arkansas. Most tax rates in state are lower then they were 15, 20, 25 or 30 years ago. Most state have a fair degree of room to raise taxes to cover bonds.
But if folks want to spread fear in the Muni Market, go ahead. With every rumor spread by a chicken little the muni interest rates go up. And that is when I buy. Wait until October when the NYCEDC defaults on some $250 million of bonds for Yankee Stadium parking. Rates will spike and I will be there waiting to buy 😉
They spent $250 million on a parking garage? Moneyball indeed.
David, you seem very knowledgable about muni bonds and their risk, which is great – I’ve been looking to connect with people who are more knowledgable than me. You mention that in the 20th century only one state defaulted. Can you provide a reference to that? Also, other municipalities besides states issue bonds: do you know of any organizations that compile a history of defaults for non-state munis?
In other news, the municipality of Mammoth Lakes, California just announced that they are beginning the process of entering bankruptcy: http://www.sfgate.com/cgi-bin/article.cgi?f=/n/a/2012/04/05/state/n141820D54.DTL.
This is the most ridiculous assessment of municipal bonds I have ever read, and wrong on many, many counts. I can’t believe someone would give out this misinformation. First of all, if you buy double or triple-A rated municipal bonds, there is virtually NO CHANCE OF DEFAULT. Whether in California (I own a number of California bonds, and there are some very wealthy communities there) or in any other state. I’ve owned a huge portfolio of municipal bonds for years, and when the stock market tanked I didn’t lose a single dime. And you should buy individual bonds, not bond funds — bond funds charge administrative fees. Not so, individual bonds. If you buy highly rated municipal bonds, you can get returns in excess of 7% with virutally NO RISK. Why do the TV financial pundits never even mention this? Suze Orman has most of her money invested in — you got it, bonds, baby.
“Virtually” no chance of default and “virtually” no risk are not the same as no chance of default and no risk. Anytime you’re investing in something that yields significantly more than the no risk alternative (say an FDIC insured savings account) there is risk there, whether you can identify it or not. It’s not a free lunch. Consider Orange County in 1995:
http://www.nytimes.com/1995/07/11/business/orange-county-seen-by-sp-in-bond-default.html
There are also plenty of good reasons to use a fund, instead of individual securities, especially if you’re investing a relatively small amount, don’t want the hassle, and can find a fund being managed for just a few basis points, such as at Vanguard.
All that said, munis are not a horrible investment by any means, especially given their current spread over treasuries and for someone without any space for bonds in tax-protected accounts. You’ll notice even the title of the post uses the word “probably” quite prominently.
Perhaps you’d like to submit a guest post discussing your experiences investing in muni bonds and the steps you’ve taken to increase yields and decrease risk? I’m sure the readers would enjoy it. I’ve actually gotten a fair amount of negative feedback about this particular post. It seems many docs aren’t as fortunate as I am with regards to their access to tax-protected accounts.
Ron,
The track record of TV pundits is abysmal. Why would you even mention them?
It amazes me how passionately holders of municipal debt feel about it. I know of no other investment where people feel so strongly that they are getting risk-free return. I think that that alone says something.
Here’s a recent article from Forbes about the state of California’s finances:
http://www.forbes.com/sites/joelkotkin/2012/06/11/is-perestroika-coming-in-california/
I do not know of any authoritative list of municipal bond defaults, so I can’t make a statement such as “the rate of muni defaults, or the size of money defaulted on, is rising”. But the defaults that are currently going on Jefferson County, AL, Harrisburg, PA, Stockton, CA and Mammoth Lakes, CA seems to be more than what went on in, say, the the prior 5 years. But maybe that’s just me paying more attention now than in the past.
Of greater interest to me than how creditors are faring is whether or not there is a structural problem in US Muni finances due to pension obligations. I think that the answer to that is yes. On Sunday Rham Emanuel, the mayor of Chicago, was interviewed by Fareed Zakaria and he essentially said that he (and other municipalities) would have to – and I am paraphrasing here – unilaterally change the terms of written contracts to state employees and retirees. That sounds like a default to me, except the financial obligations that the muni is failing to meet are to pensioners and not bond holders. I think that this is the interview here: http://macromon.wordpress.com/2012/06/10/fareed-zakaria-rahm-emanuel-on-pensions/.
I think that there were votes on this issue in San Diego, San Jose and a recall election in Wisconsin about this last week. But I haven’t studied that.
I am not an expert on muni finances – I think that it would take a full time job over several years to do it justice. But I think that this is a very interesting time in the history of muni finance, and that it will probably be written about in history books and studied for a lont time to come. But from simply reading articles in reputable publications occasionally you can see that there are structural problems (ie pensions), recent defaults (jefferson county, harrisburg, vallejo, stockton), predictions of future larger defaults by political leadership in those municipalities (los angeles, san jose) and attempts by governemnts to unilaterally change their pension obligations, which pensioners probably consider to be a default.
I think that reasonable people can probably look at the facts and draw different conclusions about whether they want to borrow american municipalities money right now. But it’s hard for me to feel that this is risk-free return.
Stockton, CA filed for Chapter 9 protection yesterday. Bondholders can get in line with everyone else in hopes of getting some of their principal back.
http://www.sltrib.com/sltrib/world/54382982-68/bankruptcy-stockton-chapter-creditors.html.csp?page=1
Today Mammoth Lakes, CA joined Stockton in declaring bankruptcy: http://blogs.wsj.com/bankruptcy/2012/07/05/the-daily-docket-mammoth-lakes-enters-bankruptcy/
Add San Bernardino to the list.
The article included this quote:
“In the six decades since Congress created bankruptcy protection for cities, fewer than 500 municipal bankruptcy petitions have been filed, according to the United States Courts website.”
I think I would have phrased that differently- instead of “fewer than” I would have written “nearly 500 have been filed, or more than 8 per year.”
Thanks for posting that white coat. I saw that article this am and was debating whether to add a link myself. 2 things:
1. While Scranton, PA has not declared bankrtupcy (the state refuses to let it), it apparently only has $5k left in the bank and has unilaterally cut all city employees wages to minimum wage:
http://www.npr.org/blogs/thetwo-way/2012/07/11/156599026/in-scranton-pa-city-workers-sue-over-having-wages-slashed.
2. Regarding the quote you cite: While the absolute number of muni bankruptcies is interesting, it would be more valuable to see the data in a chart so we can see how the current number compares to historical norms. Furthermore, it would be useful to see a chart showing the amount of money (inflation adjusted) defaulted on per year. Presumably the size of recent defaults (Stockton, PA being the largest city to ever declare bankruptcy and Jefferson County, AL being the largest country to ever declare bankrtupcy) dwarfs previous muni bankrtupcies, but I don’t have a sense of scale. I know of no place to see this data in this way, but would love it if someone posted a link.
Compton, CA might be next:
http://www.huffingtonpost.com/2012/07/18/compton-bankruptcy-ca-cit_n_1682866.html
“I have $3 million in the bank and $5 million in warrants due in the next 10 to 12 days,” said city treasurer Doug Sanders during the live-streamed city council meeting. “By then, the council will have a decision to make: don’t pay the bonds, default on them, or have a serious talk about bankruptcy.”
Kind of like a game of dominoes, isn’t it. It would be huge if this happened to the state of California itself. It’s the 7th largest economy in the world and would make a default in Greece pale in comparison.
Today the Washington Post ran an interesting article on regulation and transparency in the muni market titled “SEC asks Congress for more authority over municipal bonds”:
http://www.washingtonpost.com/business/economy/sec-asks-congress-for-more-authority-over-municipal-bonds/2012/07/31/gJQAfgfqNX_story.html
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Detroit just defaulted on $2.5B debt: http://www.foxnews.com/us/2013/06/15/emergency-manager-detroit-wont-pay-25b-it-owes/
Following up: Detroit just filed for bankruptcy. Apparently they are having trouble paying back $18.5 Billion that they owe.
Oh, the link: http://www.chicagotribune.com/news/chi-detroit-bankruptcy-20130718,0,6170774.story
I know you’re not a big fan of munis, but I was thinking of a long term strategy to minimize both taxes and expenses…and I stumbled upon the concept of muni bonds. I have a bond allocation of 20%, which is currently held in a tax protected 401k. It gives me access to only one bond fund (PIMCO) and ER is insanely high at 0.85%. In addition to high cost, when the retirement day eventually comes, I will still have to pay taxes on any gains I have realized over the years.
I was thinking that by moving my bond allocation to a taxable account and choosing a federal tax-exempt vanguard muni bond fund (I live in FL and we have no state tax) I could make the income and growth of that money tax free forever. Advantage would be low/no tax, low cost, and more space in my 401k for my stock allocation (VTSAX with low ER).
Apart from the issues with munis you have raised here, can you poke some holes in this strategy? I guess another strategy would be use the Roth space and choose total bond market fund?
Your strategy is fine. I’ve softened my tone on munis since I wrote this post:
https://www.whitecoatinvestor.com/asset-location-bonds-go-in-taxable/
The main reason I cite in this post for not using munis is that I was under the impression that you always want bonds in a tax-protected place. Once you realize that probably isn’t true, then munis don’t look nearly as bad.
Hi Brenden,
The biggest benefit from a diversified portfolio is rebalancing.
Rebalancing your portfolio once a year means you sell some of your winners and buy some of your losers. For the most part, your monthly contributions into your 401k will make this easy to accomplish.
However, in times like 2008 when stocks fell more than 30%, you will want to sell some of your bonds to buy stocks. This is not easily accomplished when your bonds are in a separate account.
And if you have international stocks, emerging market stocks, and REITs, then calculating how much to buy and sell manually can be quite cumbersome. It’s easier to leave everything in the same account and not worry about the taxes. Your biggest wins will come from the amount you save and how much you allocate to investments.
I didn’t know that you wanted proper diversification when you’re buying municipal bonds. I guess it makes sense because then you can cover all your bases. You want to make sure that you actually have enough to get a return on your investment.