Why Municipal Bonds Probably Don’t Belong In Your Portfolio

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.

1)  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.)

2)  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.

3)  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.

4) 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.

5) 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.


6) 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.

7) 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

Enter Your Mail Address

image_pdfimage_print


Comments

Why Municipal Bonds Probably Don’t Belong In Your Portfolio — 47 Comments

  1. Don’t ignore Closed End Funds as a way to get some great yield with Munis

    http://www.nuveen.com/CEF/DailyPricing.aspx

    A few more state options with these (although certainly not all or even half of the states) but i’ve been very satisfied with the leveraged return on my state’s fund over the years.

    you do have to understand closed end funds though.

  2. Great post. What I’d add is that I believe that under current law it is not possible for states to go bankrupt. Though that might really need to change.

    I would like to see you or someone else talk about muni risk in greater length.

  3. Z- I’m not sure I get why Munis in closed end funds are so different from munis in open funds, ETFs, or via individual securities. You could leverage any of those if you so desired. Please enlighten me.

    Larry- Good point about the munis subject to AMT. Gotta watch out for that.

    Anon- Which law are you talking about? It isn’t in the constitution, nor in the state laws of many states. California and Illinois are awfully close as it is.

    Munis have higher yields than treasuries currently (in our current wacky low yield environment), which makes them seem attractive even in retirement accounts. But what you have to keep in mind is that there is a reason the yields are higher. A pretty good rule of thumb in bonds is that the higher the yield, the higher the risk. Munis yield more (much more on an after-tax basis) because they’re riskier. What’s the risk? That they’ll default. If you really want to chase yield, why not go all the way? I’ve got some bonds paying 26% right now (peer to peer lending). Is the risk of default awfully high? You better believe it.

    State governments do have the ability to raise taxes (usually.) But they don’t have the ability, like the federal government, to print money. That’s worth a lot of yield apparently.

  4. I am not entirely clear about your rationale.
    What if we have maxed out our tax advantaged contributions and we still need to allocate to the bond portion of our portofoio ( in other words if the fully funded retirement portofoio cannot accomodate any more positions )?
    I have been very happy with Vanguard Muni Funds which have posted healthy returns for years.
    Anon

  5. If your fully funded retirement accounts (401Ks, defined benefit plans, backdoor Roth IRAs, HSAs etc) are all completely full of bonds, and you need more to meet your asset allocation, then yes, municipal bonds are for you. But that’s a rare doctor. I make more than the average doc, yet this year I’ll need to put away over 30% of my income before I need a taxable account at all. I’d have to save twice that much for years before I’d have to actually consider holding bonds in a taxable account.

    That said, if you need muni bonds, I very much like the Vanguard muni funds, especially if you’re in one of the states they have a state-specific fund for.

  6. How common is it for physicians to have defined benefit plans especially in a large practice
    with many employees?
    Have you addressed this on your web site in the past ?
    Thanks

  7. Whitecoat,

    The statement I made that “states cannot declare bankruptcy” comes from this NYT Article: http://www.nytimes.com/2011/01/21/business/economy/21bankruptcy.html?pagewanted=all. Here is paragraph 2:


    Unlike cities, the states are barred from seeking protection in federal bankruptcy court. Any effort to change that status would have to clear high constitutional hurdles because the states are considered sovereign.

    The person who has talked about the risk of muni bankruptcy, of course, is Meredith
    Whitney on 60 Minutes: http://www.cbsnews.com/2100-18560_162-7166220.html

    I believe that there is much more to say about muni bankruptcy and credit risk. I think that in the last year there have been a few high profile city or county filings:
    1. Jefferson County in Alabama, in November 2011 declared bankruptcy in the largest municipal bankruptcy in US History: http://www.reuters.com/article/2011/11/10/us-usa-alabama-jeffersoncounty-idUSTRE7A87WW20111110.
    2. Harrisburg, the capital of Pennsylvania, declared bankruptcy in October 2011: http://www.washingtonpost.com/business/economy/harrisburg-pennsylvanias-capital-files-for-bankruptcy/2011/10/12/gIQAeQ6HgL_story.html.

    Do you know of any reputable source that keeps a list of muni bankruptcies by year? I suspect that this is a trend that is increasing (both in terms of incidence of and size), but I don’t have hard evidence to back that up.

  8. I don’t know how common it is. I have one in my group. The larger the practice the easier it is to have one. I’ll be talking about it more in the future. It can be surprisingly flexible.

  9. Anon-

    Cities and counties certainly do go bankrupt all the time and muni bond funds are full of loans to those entities.

    It is news to me that states can’t go bankrupt. While that sounds like it is probably true (at least according to your source), that doesn’t mean they can’t default on their bonds. I suppose I should have been more specific.

    I agree the trend is increasing (although it certainly has occurred in the past, Orange County comes to mind), but am not aware of a good source listing bankrupt cities and counties. A quick google search brings up enough good stuff to do a follow-up post about this. Take a look at this one: http://theweek.com/article/index/211046/will-your-city-go-bankrupt-in-2011

  10. i actually think fewer physicians have defined benefit plans bc of the cost for employees. If you are a contractor or can find a way to not include non physicians then it works a lot better cost wise. Thus i think a lot of physicians have need for after tax investing. I too have a DB and a 401k PS but i dont have many friends who have both and 90% only have some sort of a Defined contribution/401k type plan and thus have lower contribution limits.

  11. @whitecoatinvestor

    1) With the bond ETFs there are not many state specific offerings (NY and Cali are the only ones to my knowledge) so if i dont’ get a state specific fund I can’t save on state taxes

    2) with a mutual fund bond fund I’m probably not going to have access to a no-load fund for my state…. those are probably only going to be for institutional customers.

    3) With any of those types of funds it’s going to be more expensive for me to leverage them myself than for a large fund to leverage them. A larger firm is going to get a much better margin rate.

    4) buying any one bond is risky… maybe you buy the one that goes bust. It would take an extremely large amount of money to get diversification… like 300-400K… now if you have that and you understand the bond market, mos def that’s the way to go.

    With closed end funds nuveen has 15 different states (mostly the bigger ones) and I can buy as little as one shares for like $15 or as many shares as i need, they will likely have better liquidity and lower transaction costs than a loaded mutual fund or the individual bonds themselves.

    In addition if you understand the nature of closed end funds and buy them at a discount to NAV or at least near par you can achieve some capital appreciation on your shares as well.

    Their expense ratios are a little high to reflect the leverage… but I have neither the money to buy a diversified portfolio of bonds, nor the expertise to buy them.

    But my state’s fund pays a nice 5.5% yield relative to NAV (where i bought) and if i were to sell my shares today i could do so at an 8% premium to nav where they are currently trading.

    It pays to look at this option

  12. @Rex-

    I think it is a shame if a physician can’t at least put $50K a year into some type of profit-sharing plan or 401K. If that is the case, that doc should be lobbying for a change in the plan. But I’m sure there are plenty of docs in that boat. Even fewer probably have access to a defined benefit plan.

    But even if you assume they have nothing but a 401K at $17K a year and two backdoor Roths at $5K each a year, then that’s still $27K a year into tax-protected accounts. Even if the doctor is saving that much into a taxable account each year, that still leaves little need for bonds in taxable. Will there be some docs that need to do it? Of course. But not most docs.

    @ Z – Yes, if there is not reasonable cost Bond ETF or no-load open mutual fund, I can see why you’d choose a closed mutual fund.

    I agree that buying a muni fund rather than individual munis is the right way to go.

    Buying a fund at a discount and selling it at a premium is obviously a bonus. Not always possible, but a good idea when it is.

    I’m not as sold on the idea of using a fund that routinely uses significant leverage. I’d have to look into it more before making a decision about that. While leverage isn’t always a bad idea, almost everyone who goes broke investing was using leverage in some form, so it is worth looking very carefully at any leveraged investment.

  13. There is some serious disinformation here. First, doesn’t everyone know that Meredith Whitney and her hysterical prediction on 60 Minutes in December 2010 has been thoroughly repudiated by Bloomberg and many experts in the municipal bond world? For clarity, read “2011: The Year 60 Minutes Misled Americans About Municipal Bonds” by bond expert Janet Tavakoli in Huffington Post. http://www.huffingtonpost.com/janet-tavakoli/2011-the-year-60-minutes_b_1175974.html

    Next, I thought everyone knew that municipal bonds provided the highest return of any investment category in 2011? As Bloomberg reported, ” In 2011 the $3.7 trillion municipal-bond market returned more than 10 percent, the best since 2009, and outperformed Treasuries, corporate debt, commodities and stocks.”

    Currently closed-end funds that invest in tax-free municipal bonds are returning tax free yields of 6% to 7%. If you’re in the top, 35% federal tax bracket, a tax-free yield of 6.5% is equivalent to 10% from a taxable security. For muni CEFs, 2011 was a rousing year. On average, the group gained 12.8% through October 7, according to Morningstar By comparison, the average national open-end muni fund earned 7.2% for 2011. Read more: http://www.kiplinger.com/columns/balance/archive/tax-free-income-from-closed-end-muni-bond-funds.html#ixzz1pO2M00f0
    Become a Fan of Kiplinger’s on Facebook

    On the subject of default and bankruptcy, specific bankruptcies, like Jefferson County and Harrisburg, are the final actions of a process that began several years previously. They were the result of poor decision making on the part of elected public officials. However, not every bad Muni deal ends in a bankruptcy. Many can be worked out. In those cases the political officials realize that avoidance of bankruptcy is “less worse” than choosing what appears politically to be an easy way out.

    While the past does not predict the future, it is noteworthy that the default rate of highly rated municipal bonds is exceedingly low. From 1970 to 2008, no municipal bond rated Aaa by Moody’s defaulted. The default rate of bonds rated investment grade by Moody’s was only 0.07 percent. I highly recommend that all of you read bond expert Cate Long’s article in Reuters she wrote two days ago entitled “Does default equal bankruptcy?” http://blogs.reuters.com/muniland/2012/03/15/does-default-equal-bankruptcy/

  14. @Rex- Some docs have a plan without a match that you can only put $17K into. That’s what I meant. Many employers, of course, either match you up to $50K or allow you to self-match up to $50K. ($55.5K if over 50.)

    @ Anon – The risk of default is the reason that munis, like corporate bonds, should be bought in funds.

  15. @ Frank-

    Good comment. Do you work for Kiplinger’s or something? That was just an odd comment about fanning them on Facebook.

    Your criticism about the fact that muni yields are particularly high is one that needs to be addressed because it is true. In our quite strange bond yield environment, muni yields are much higher than treasury yields (same duration) before tax, much less after tax. In the bond markets, yield is a pretty good indicator of risk, even if you can’t identify the risk. What the yield difference tells me is that munis have quite a bit higher risk right now. What risk? Default risk. It doesn’t mean it isn’t worth running that risk, I mean even the Vanguard tax-exempt MMF has a higher yield than the Prime MMF. But the risk is certainly there. I think this is a temporary situation, but it has already lasted longer than I expected it to last.

    As far as munis having some type of ridiculously high return last year, I disagree. Bonds had a great 2011. Let’s look at the respective Vanguard funds:

    VG High-Yield Tax-Exempt Fund: 10.70%
    Int Term Tax-Exempt Fund: 8.80%
    Long Term Tax-Exempt Fund: 10.70%

    Int Term Treasuries: 13.22%
    Long Term Treasuries: 29.93%
    TIPS 13.56%

    High Yield Corporates: 4.98%
    Inter Corporates: 8.21%
    Long Term Corporates: 18.42%

    As you can see, Munis certainly weren’t the highest returning bonds last year, but they did have a good year just like other bonds.

    The past doesn’t predict the future, of course, but I think we need to actually look at the facts about the past before believing what some reporter put in an article.

    As far as highly rated munis rarely defaulting, that is true. But most statements to that effect don’t take into account the fact that bonds are often down-rated multiple times before default, so that by the time they default they are no longer highly-rated bonds.

    All that said, could I understand someone choosing munis even in their retirement account because the yields are so high right now? Yes, I could. But that investor needs to understand the yields are higher for a reason and probably won’t remain that way indefinitely.

  16. No, I don’t work for Kiplinger. When I put the URL up so your readers could look for themselves, that sentence automatically got put up there too. I didn’t notice it during my review before I pushed the post button. Was that a “dig” suggesting I was in the investment biz just because I know about which I speak? I am in fact an investor who has been trading equities and bonds for 4 decades now. I also take an interest in articles, blogs which tend to deconstruct the facts about municipal bonds since it seems like such an easy target for some — like Meredith Whitney — these days

    You comment about yields being too high confuses me. I spoke to “return” for municipal bonds outperforming other investment categories in my earlier comment. Return is separate from yield. I did not say anything about the municipal bond yields being too high. Maybe you’re confusing the high numbers around 2011 “return” with the actual yields of municipal bonds and muni bond funds. Yields of municipal bond funds are currently about what they have been for a very long time. Yields on newly issued bonds are actually lower than they were 3-4 years ago and currently a 30-year municipal bond yields 3.48% according to Bloomberg. You’re saying that this yield is too high? Or are you saying it’s currently too high vis a vis a 30 year Treasury? In case you haven’t noticed that ratio has fallen this past week and all prognostications are that it will drop back to it’s usual relationship to Treasuries. Move along, nothing more to see here.

    And all this analysis of “risk” regarding these safe assets is tiresome to me anyway. No matter what is said by learned people about the low, low risk of munis (as well as Treasuries), there’s always someone out there who tries to make a story about the risk of those two investments. Except to unseasoned investors, this kind of pinhead analysis is indeed boring.

    Moody’s Investors Service put out a report last week underscoring the rarity of municipal bond defaults over the past four decades, saying there have been just 71 defaults from 1970-2011, including 11 in the past two years. Only five general obligation bond issuers – including cities, counties and other districts – defaulted on GO bonds in the 41-year study period, accounting for only 7% of all defaults, according to Moody’s. Only one GO issuer out of approximately 9,700 rated by Moody’s at the end of 2011 defaulted on GO bonds in the last three years. The majority of municipal defaults during the study period, 73%, occurred in the healthcare and housing sectors (dirt bonds). Moody’s said the number of defaults has risen since the recession, averaging 5.5 per year over the past two years versus 2.7 from 1970 to 2009. Moody’s also said historical recovery rates on defaulted U.S. municipal bonds are higher, on average, than those on senior unsecured bonds of corporate issuers. The average ultimate recovery for municipal bonds was 65% from 1970-2011, compared to 49% on corporate senior unsecured bonds over a period from 1987-2010. During 2011, America Airlines (AA) accounted for $3.4 billion of muni defaults while Tobacco bonds had $16.9bln of defaults. Combined, AA and the tobacco bonds comprised slightly more than 87% of municipal bond defaults. Corporate-backed muni debt makes up a small portion of the $3.7 trillion muni-bond market; bonds like the AA debt are typically issued through specially created local-government or airport authorities.

    And who said that municipal bond returns in 2011 were “ridiculous”? I didn’t. Maybe you did. Regardless, the data is in… maybe you missed it. Debt issued by municipalities returned 10.2% in 2011, according to Barclays Capital. Riskier high-yield corporate bonds returned 4.2%. According to Bloomberg, California state and local debt returned 14.8% in 2011. Their data was taken from a Bank of America Merrill Lynch index that measures price changes and interest payments. That’s more than the 11.2 percent earned by the overall municipal bond market, 9.8 percent for U.S. Treasuries and 7.5 percent for investment-grade company debt.

    And finally, are you disparaging the sources of my article referenced earlier when you say ” before believing what some reporter put in an article.” Would that include bond experts Cate Long and Janet Tavakoli? http://en.wikipedia.org/wiki/Janet_Tavakoli

  17. I don’t think yields are too high. Heck, in this low-yield environment I don’t think investors are being rewarded adequately for any bond holdings. But I do believe that the fact that the spread between the yields of treasuries and munis has not only narrowed, but become negative, indicates that the market believes there is significantly more risk associated with munis. Does that mean they’ve somehow become risky assets like stock, real estate, commodities etc? Of course not. They’re still bonds, and they’re certainly not the most risky bonds out there. They are, however, riskier than treasuries and at times, riskier than some corporate bonds.

    I’m not disparaging anyone. I’m simply saying that if someone believes munis returned more than treasuries (and long corporates) last year they’re wrong. .Everyone is entitled to their own opinion, but not their own facts. See the data above for details on 2011 bond returns. Are you suggesting those Vanguard funds are publishing false returns or that their portfolios aren’t what they claim they are?

    The premise of the post itself, that most doctors don’t need to hold munis, is based on two things- the usual relationship between muni and taxable bonds, and the fact that the bond portion of your portfolio should, as a general rule, be held within the tax-protected portion of one’s portfolio. Since most doctors ought to have a large percentage of their portfolio in tax-protected accounts, they don’t generally need munis. That isn’t to say munis are bad, or highly risky, or whatever. Just that most docs don’t need them in their portfolio.

  18. “Debt issued by municipalities returned 10.2% in 2011, 9.8 percent for U.S. Treasuries and 7.5 percent for investment-grade company debt.” Wow, nobody is making up that fact! [Edited for rude comment.]

    The financial advisor team I use has one specialist who does indeed buy municipal bonds for “docs” and also have been busy putting BABS into their tax-deferred accounts. Many people have a huge fear of this wacky equity market and the belief is that “docs” don’t have the time to watch investments in periods such this when there is virtually no visibility.

  19. It turns out that yesterday the NY Times ran an article about Stockton’s potential Bankruptcy filing, with an empasis on municipal pensions (CalPERS):

    http://www.nytimes.com/2012/03/17/business/untouchable-pensions-in-california-may-be-put-to-the-test.html?_r=1&pagewanted=all

    Apparently many municipal workers are allowed to fully retire at age 50 with a generous pension and fully paid health benefits for life. It is difficult to fathom how much money a private individual would have to stock away in order to do that themselves. For example, the famous Trinity Study (where the “4% rule”) comes from, was conducted for a 30 year retirement (e.g. age 65 to age 95). And of course, for private citizens healthcare costs must come out of that 4%.

    The interesting reporting in that article, however, is the intersection of california municipal bankruptcy and CalPERS, the state pension system. Apparently, when Vallejo declared bankruptcy they did not touch pensions. But with so many other California municipalities nearing bankruptcy, the article indicates that someone might have to touch (ie attempt to renegotiate) these benefits soon.

    On another note, I am not convinced that owning these bonds thru a mutual fund is necessarily safer. Yes, there is diversification, but there is also concern about a run on the bank. For example, Schwab once ran a YieldPlus Mutual Fund (SWYPX). Schwab advertised this fund as a safe alternative to a money market fund. It invested soley in high grade bonds of 90 day duration or less. But when the credit crisis occured so many people redeemed shares that they had to sell the bonds at a loss. The fund lost a ton of money, the NAV tanked, there was a class action lawsuit, etc. etc. Of course, in theory no one should have lost money at all: by waiting until all the underlying assets matured (only 90 days!) there could have been an orderly dissolution of the fund.

    It seems to me that if there are high profile municipal bankruptcies in CA (and Stockton and San Jose both seem close), then investors might flee these CA muni bond funds, which itself might cause a downward spiral in share price, which might lead to a similar situation as we saw with SWYPX.

    I am not stating whether I personally think that this is likely or not. I am simply saying that we have recently seen a precedent like this, and that it is the risk that investors take in funds like that.

  20. Great article on munis from the physician perspective. Thanks again for this blog. I did have an question of placing bonds in 401k vs. taxable accounts.

    What if the bonds in your 401k options are not that great?
    There is one with an exp ratio of 0.94% in my 401k and it’s corporate bonds.
    I opted for a cheaper S&P500 index fund in my 401k, then to get my asset allocation of bonds, bought a state specific Vanguard muni.

    What are your thoughts on this? Should I buy the VBMFX instead? I chose the Munis because I happened to be in a state where Vanguard had one. Thanks.

  21. It’s a pain to deal with crappy 401Ks. It’s quite possible that you could be better off with low-cost munis, especially given the relatively low (and sometimes negative) spread with treasuries right now. As a general rule, bonds belong in tax-protected accounts. But you seem to have a decent reason to have the muni fund. You could also put bonds into Roth IRAs. Are you doing a backdoor Roth?

  22. I plan on doing some backdoor IRAs after reading your article on it. I had plugged some numbers into this calculator that Vanguard has on the site to see if it was worth it. It was inconclusive :)

  23. 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.

  24. 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.

  25. 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.

  26. 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 ;-)

  27. 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.

  28. 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.

  29. “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.

  30. 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.

  31. 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.”

  32. 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.

  33. 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.

  34. Following up: Detroit just filed for bankruptcy. Apparently they are having trouble paying back $18.5 Billion that they owe.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>