April 16, 2018: Municipal Bonds As A Fixed Income Asset Class

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Municipal Bonds As A Fixed Income Asset Class

We have long argued that municipal bonds, the debts issued by state and local governments, are more than just tax-free substitutes. Because of their special nature, they should be considered as a standalone fixed income asset class that can be used even in a tax-deferred account such as 401k or IRA. In this newsletter, we will review the current municipal bond market and discuss their investment strategies.

Current municipal bond yields

Let’s first look at the current municipal bond yields, compared with Treasury bond yields.

Municipal Bonds	Muni Yield	Treasury Yield	Muni Taxable Equivalent (24%)	Muni Taxable Equivalent (37%)
One Year	1.67%	2.1%	2.2%	2.65%
Five Year	2.1%	2.68%	2.76%	3.33%
Ten Year	2.43%	2.83	3.2%	3.86%

So for a reasonably high federal tax bracket (24%) investor, the AAA rated municipal bonds are yielding higher than their Treasury bonds equivalent after tax. This is even before state tax consideration.

In fact, considering the absolute total return, an intermediate term Municipal bond fund has done better than an intermediate term taxable bond fund:

Taxable vs. Municipal Bond Performance Comparison (as of 4/13/2018):

Intermediate bond fund	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	10Yr Sharpe
VBMFX (Vanguard Total Bond Market Index Inv)	-2.0%	-0.5%	0.7%	1.3%	3.4%	0.81
VWIUX (Vanguard Interm-Term Tx-Ex Adm)	-1.1%	1.3%	1.9%	2.3%	3.8%	1.32

This is somewhat surprising! Municipal bond investors have gotten better total returns even in a tax-free or tax-deferred account for the past 1,3,5 and 10 years. Talk about market efficiency.

There are several possible reasons to explain this:

First, if one looks at the above chart more carefully, municipal bonds started to outperform taxable bonds in 2014, just around the time when the Federal Reserve began to raise interest rates in some meaningful way. In general, municipal bonds respond to rate change more slowly than Treasury bonds. A likely reason is that more municipal bonds are mostly (more than 75% by some estimate) held by wealthy individuals who are more likely to hold the debts till their maturity, thus making their prices less volatile.

Second, recent tax laws, especially the latest tax law have made it harder for local governments to issue debts. This creates a (less) supply and (more) demand situation, thus again pushing muni bonds’ prices higher.

Third, also because of the recent tax law that now limits state and local government tax deduction to $10,000, more investors are conscious of tax benefits and they flocked into muni bonds.

Municipal bond portfolios

Because of the properties stated above, one can see that muni bonds can have more stable trends. That’s reflected in our brokerage specific municipal bond portfolios listed on What We Do -> Brokerage Investors page:

Latest Tax Free Municipal Bond Fund Portfolios Performance Comparison

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR
Fidelity Muni Bond Funds	-0.8%	6.9%	4.1%	3.9%	6.4%
Schwab Muni Bond Funds	-0.8%	6.9%	4.1%	3.9%	6.4%
Merrill Edge Muni Bond Funds	-1.1%	3.4%	2.7%	2.8%	5.6%
Etrade Muni Bond Funds	-1.1%	3.4%	2.7%	2.8%	5.6%
Vanguard Muni Bond Funds	-1.0%	2.7%	2.1%	2.2%	4.5%
VWIUX (Vanguard Interm-Term Tx-Ex Adm)	-1.1%	1.3%	1.9%	2.3%	3.8%

Every quarter, these portfolios pick a municipal bond fund from a list of candidate funds that represent short, intermediate and long term municipal bonds as well as high yield municipal bond funds. They have done way better than intermediate bond funds such as VWIUX (Vanguard Interm-Term Tx-Ex Adm).

In fact, they are not that far behind the active taxable total return bond fund portfolios listed on the same page:

Latest Total Return Bond Fund Portfolios Performance Comparison

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR
Schwab Total Return Bond	-1.2%	2.9%	3.4%	3.5%	7.4%
Fidelity Total Return Bond	-1.2%	4.3%	2.6%	3.0%	6.9%
TDAmeritrade Total Return Bond	-1.2%	3.9%	2.7%	3.3%	7.4%
FolioInvesting Total Return Bond	-1.2%	2.9%	3.4%	3.5%	7.4%
Etrade Total Return Bond	-1.2%	2.9%	3.4%	3.5%	7.4%
Merrill Edge Total Return Bond	-1.2%	2.9%	2.5%	3.3%	8.3%
Vanguard Brokerage Total Return Bond	-1.2%	2.9%	3.4%	3.5%	7.5%
PTTRX (PIMCO Total Return Instl)	-1.3%	1.1%	1.5%	1.7%	4.7%
VBMFX (Vanguard Total Bond Market Index Inv)	-2.0%	-0.5%	0.7%	1.3%	3.4%

The municipal bond portfolios have done better for the past 1, 3 and 5 years. However, they still lagged behind in the 10 year time frame.

In general, a taxable total return bond fund has more opportunities to invest: in addition to the usual domestic taxable and even municipal bonds, a total return bond fund can venture into riskier (and higher-yielding) bonds such as international and emerging market bonds. They can also at times take advantage of high yield taxable bonds that can be more volatile (and thus more rewarding).

Regardless, municipal bonds, especially the active municipal bond portfolios discussed above, can be a viable alternative to taxable bonds. This is especially true at the early phase of a rising rate environment.

However, municipal bonds still carry similar risk as taxable bonds, as evident in the YTD (Year To Date) returns of these bonds and portfolios. Furthermore, in the late stage of a rising rate period, we expect these bonds will get less demand as their taxable equivalent ones will offer more compelling yields, thus diminishing their allure.

Market Overview

Now that the fear of geopolitical uncertainty (Syrian situation) and trade war with China lessened a bit, stocks finally started to respond to the positive earnings report. Up to last Friday, based on Factset, among 6% of companies in S&P 500 group had reported earnings. The blended (i.e. the mixed actual earnings and estimated earnings for those still to report) earnings growth is 17.3%, higher than the expected 17.1% on December 31, 2017. Investors have a high expectation for this earnings season. This is actually a negative as anything that’s less expected can derail the current over-extended stock market. To make the matter worse, this is in a highly overvalued stock valuation environment. As always, we urge investors to manage their risk exposure to a comfortable level while sticking to planned and sound investment strategies.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration has been in the office for more than a year, the economy and financial markets are in general still in a good shape. Whether the economy will continue to benefit from the supposedly trickle down of the tax cut, the deregulation, and the promised infrastructure spending remains to be seen. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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