Optimizing Investment Portfolio With Municipal Bonds

Today I will continue my long-running series of posts (see this, this, this, this, and this among others) on how to squeeze a bit more out of today's fixed income choices. These have gone from fair or good value two years ago to meager at best now. Unfortunately, we have to invest in what's available, not in what we'd like to see available. So I've been trying to suggest the best ways to make lemonade out of today's fixed income lemons.

As before, if you are perfectly content to hold a simple three-bond type portfolio (e.g. VTSMX, VGTSX, VBMFX or equivalents such as LifeStrategy or Target Retirement funds) for as long as you live, then you should stop reading right now (and by the way, sometimes I wish I could tune out like that). Everyone else, especially those with limited tax-sheltered space and/or in higher tax brackets, please read on.

Today's idea is simple: the way things stand, it makes quite a bit of sense to invest in "long-term" (I will explain the double-quotes in a bit) municipal bonds in taxable accounts and to use the limited tax-sheltered account space for equities, rather than the "conventional" approach of keeping equities in taxable and using tax-sheltered space for bonds. Note that this discussion is complementary to my recent cheerleading for I- and EE-Bonds. Those -- especially the I-Bonds -- remain very good deals. But for many investors the relatively low purchase limits on I/EE-Bonds mean that decisions must be made on what other fixed income investments to hold. Hopefully what follows will help...

This chart attempts to visually capture the yield to maturity (YTM) and relative creditworthiness available from four Vanguard bond mutual funds (one column per fund) as of today. From left to right the four funds shown are:

1. Total Bond Market (all nominal, taxable bonds). Mutual funds: VBMFX, VBTLX (Admiral)
2. Investment-Grade Intermediate-Term Corporate. Mutual funds: VFICX, VFIDX (Admiral)
3. Long-Term Tax-Exempt Municipal. Mutual funds: VWLTX, VWLUX  (Admiral)
4. High-Yield Long-Term Tax-Exempt Municipal. Mutual funds: VWAHX, VWALX  (Admiral)

The first three rows of the chart capture SEC yield available from the Admiral version of each of the four bond funds. SEC yield is the best available tool we have for comparing expected yield to maturity from different bond funds -- note that actual yield will be different depending on the unknowable future yield curve movements. From top down, the first three rows represent:

1. Pre-tax YTM, such as would be captured in a tax-sheltered account.
2. Post-tax YTM in a taxable account at 25% federal tax bracket.
3. Post-tax YTM in a taxable account at the new 39.6% federal tax bracket.

The font size used for the YTM number is proportional to the YTM itself for a bit of extra visual effect (you are correct -- I am not exactly artistically gifted). For simplicity I ignore state taxes and the extra taxes imposed on highest earners by the recent health care legislation -- they would not change the conclusions I will draw from this post.

In the bottom four rows of the chart I tried to capture the relative creditworthiness of each fund's holdings, using credit quality data published by Vanguard. Here too I scaled the font size of credit ratings (from highest Aaa to lowest investment-grade Baa) in proportion to the percentage held in each fund. For example, at a glance you can hopefully tell that, for example, long-term tax-exempt fund (column 3) primarily holds Aa- and A-rated securities, while intermediate-grade corporate fund (column 2) primarily holds A- and Baa-rated securities.

You may note that I haven't mentioned anything about either maturity or duration of any of these bond funds and you would be right to wonder about that. It makes little sense to do an apples-to-apples comparison like the above on bond funds without taking into account their different average maturities/durations. After all, price fluctuations in bond funds will very much depend on their duration and a bond fund expected to fluctuate by, say, 2% annually is a very different animal from one expected to fluctuate by 10%. Fortunately for us, all four bond funds in question have essentially identical average maturities/durations of 6-7 years, which makes for an easy comparison. This is despite the "long-term" in the name of the two municipal bond funds. Vanguard's use of "long-term" in the fund name refers to different and much shorter time period for municipal bonds than for treasuries or corporates.

Getting to the point, it should be immediately obvious that holding either the Total Bond Market or Intermediate-Term Corporate funds in taxable accounts is simply a bad idea. The higher your tax bracket, the worse it gets. What might be interesting, however, is that the tax-exempt municipal bond alternatives, both higher-quality and high-yield, exceed or match corporates both in quality and in yield, even before taxes are taken into account! After taxes, it's not even close. Even at the middle-class 25% tax bracket, you can expect to get 25-50% more yield out of munis relative to corporates in taxable accounts. The deal gets even better in higher tax brackets.

Now, granted, credit ratings agencies are not perfect. You may recall their infamous AAA ratings on tranches of "subprime" mortgages that ended up paying pennies on the dollar during the housing collapse. So it is conceivable that these credit ratings for municipal bonds are way too optimistic. But all in all, credit ratings agencies have had a pretty good multi-decade history of accurately gauging credit worthiness of various issuers. And municipal bonds have had an even longer history of very few defaults, even compared to similarly-rated corporates. During the depths of the recent crisis munis (blue line) were less volatile than corporates (orange line):

I'd feel pretty good about the safety of Vanguard's VWLUX, both in absolute sense and relative to the corporates. For that matter, I think Vanguard's high-yield munis VWALX has more than enough cushion in its ~0.4% higher annual yield to overcome its slightly lower credit quality relative to VWLUX (although it will be more volatile in a crisis). 

We already knew that I-Bonds, EE-Bonds, and various FDIC-insured CDs and savings accounts are clearly preferable --  both in yield and in safety from rising interest rates -- to treasuries that form the bulk of Total Bond Market. Today we also learned that municipal bonds are almost as clearly preferable to corporates -- again, both in yield and in safety from defaults. The course of action for somebody who doesn't mind spending a bit of time to optimize his or her portfolio becomes clear:

• Phase out treasuries in favor of I-Bonds, EE-Bonds, FDIC-insured CDs and savings accounts.
• Phase out corporates in favor of munis.
• Since both treasuries and corporates have been (hopefully) kept in tax-sheltered space and since I/EE-Bonds and munis belong in taxable space, equities should now be re-allocated to tax-sheltered and fixed income be re-allocated to taxable accounts.

The only caveat here is if you happened to have a lot of capital gains in your existing taxable equities holdings. In order to re-allocate them into tax-sheltered space you would of course have to sell them in taxable which will trigger capital gains taxes which may well ruin the entire deal. 

So what you'd need to do is check whether some of your taxable equities holdings may have capital losses or at least only the most minimal of gains. Good candidates to check for that are international equities, especially international developed which have had the roughest time of all equities in the past five years or so. Moreover, their high dividend payouts have meant that their capital appreciation is limited, making them even more likely candidates for the transfer to tax-sheltered. 

By moving international equities to tax-sheltered accounts you will lose the foreign tax credit on dividend taxes withheld overseas, but that is a very small price to pay relative to keeping those dividends out of the Uncle Sam's hands entirely. And on top of that you will be getting same or higher yield at same or better safety out of the I/EE-Bonds and municipal bonds held in taxable compared to treasuries or corporates held in tax-sheltered.

If you happen to be sitting on large capital gains across all of your taxable equities, then unfortunately this re-allocation of existing investments will not be viable for you. But you can still use the same idea going forward. Until the interest rate situation changes significantly, you can keep keep your new fixed-income investments in taxable accounts via I/EE-Bonds and munis and use new tax-sheltered space exclusively for equities (and maybe FDIC-insured CDs).

And if down the road the interest rates revert to their higher historical norms which include muni yield slightly lower than treasuries yield which in turn is slightly lower than corporates yield (of same maturity, of course), you should be able to undo this optimization with no losses to taxes. You will be able to swap your tax-sheltered equities back into taxable (no capital gains issues there) and sell your taxable munis at likely no capital gains (and quite possibly small capital losses) and buy a mix of treasuries and/or corporates (such as Total Bond Market) in tax-sheltered.

Very roughly speaking -- exact numbers will vary widely depending on your tax bracket, amount of tax-sheltered space, and exact mix of investments -- I would guesstimate that doing this sort of portfolio optimization will yield you around 0.5% per year more on the entirety of your portfolio, across both equities and fixed income.