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Intermediate vs Long Term Municipal Bond Funds
Old 03-08-2014, 10:19 AM   #1
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Intermediate vs Long Term Municipal Bond Funds

May I ask for some guidance from the bond gurus on the forum please. I'm evaluating whether to move a portion of my municipal bond funds from intermediate term to long term. The Vanguard funds I am comparing are VWIUX and VWLUX.

Here are the basics:

Intermediate has an SEC yield of 2.13%, duration of 5.2 years, maturity 5.4 years.

Long term has an SEC yield of 3.19%, duration of 7.2 years, maturity 7.1 years.

So an extra 2 years of duration yields an additional 106 basis points, which equates to 53 basis points per additional year of duration. On the surface, it would appear that the slightly longer maturity is more than justified by the extra basis points. But it appears to good to be true. I feel like I'm missing something here. I found one article on the subject suggesting that the 7.2 year duration on the long term fund may not be accurate because a larger portion of the holdings may be callable before the 7.2 years take place, but I'm still not sure how that impacts the fund.

Vanguard shows a risk potential of 2 for intermediate term, and 3 for long term. Am I missing something, or should I consider moving a portion of my holdings to long term to get the extra 106 basis points?
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Old 03-08-2014, 03:03 PM   #2
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The longer the term of the bonds in the portfolio the harder the hammer will fall when interest rates go up. Every two percent increase in interest rates will reduce the value of an intermediate bond fund by about fifteen percent. Many here don't agree with me, but I'm completely out of bonds. But if you do insist on investing in munis, don't go long, stay intermediate or short term.
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Old 03-08-2014, 05:08 PM   #3
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The longer the term of the bonds in the portfolio the harder the hammer will fall when interest rates go up. Every two percent increase in interest rates will reduce the value of an intermediate bond fund by about fifteen percent. Many here don't agree with me, but I'm completely out of bonds. But if you do insist on investing in munis, don't go long, stay intermediate or short term.
Understood, but what I was really trying to understand is why such a small increase in duration would provide a full percentage of additional yield. I understand some folks don't want to be in bond funds due to interest rate risk. For me, I'm only trying to understand the delta between the two on this thread.
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Old 03-08-2014, 05:13 PM   #4
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It depends on your time horizon. If you don't think you will need to sell the bond fund for seven years, then go long. The funds will lose value when rates rise (longer more loss than shorter), but after a time maturing bonds will be replaced by new issues and in the long run you will be fine, and earn a higher income in the meantime. If you need the money sooner, you should think about putting some in each, and maybe add a short-term fund. A ladder would be another option, but I don't like this because you are exposed to individual issue risk and bonds have high transaction costs for individuals.

Personally, the vast majority of my fixed income portfolio is in VWALX. I don't envision ever needing to sell at a loss because overall portfolio income well covers my expenses.
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Old 03-08-2014, 05:55 PM   #5
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Perhaps I'm not asking the question correctly, so let me try again.

There is a general formula for evaluating additional yield versus additional duration. I am not sure what the exact number is, but I'm sure it is less than 53 basis points per additional year of duration. Based on the typical formulas comparing yield to duration, I believe there is something abnormal about the Vanguard long term fund. I'm hoping someone can look at the holdings in the portfolio and identify why such a small addition in duration yields such a significant increase in yield.
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Old 03-08-2014, 08:28 PM   #6
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Ballpark rule of thumb I've read is a 1% rise in interest rates produces a % decline in bond fund asset value roughly equal to its duration. This assumes no change in bond rating/quality over time. So, all else being equal, a 1% rise in rates would mean approx declines in NAV of your 2 prospective bond funds of 5+% and 7+%. So it would take a bit over 2 yrs' worth of interest payments to match this NAV loss in either fund. Of course potential loss could be much higher should rates rise >>1%. Personally I do not find the yield vs duration of VWLUX "too good to be true".

While no one can predict the future, we are in a historically low interest rate environment. Many say artificially low due to easy $$ policies of US & most other nations. Almost all expect rates to rise as gov't policies shift &/or economic growth picks up. IMHO- given current economic conditions holding bonds or funds with >2-3yr maturity/duration is not worth the risk of rapidly rising long rates UNLESS one intends to hold bonds to maturity (ultimate redemption at face value) or bond funds for a period approaching their duration (so fund's purchases of newer higher-yielding bonds over time would increase the total interest payments).

While I agree with 45th Birthday's logic that you'll likely do fine holding either of OP's investment grade bond funds 7+yrs, I'm not a fan of any hi-yield muni fund right now. Risk of more stories like Detroit & Puerto Rico make that market far too unsettled for a small bump in yield (e.g. 0.3% SEC yield VWALX vs VWLUX).
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Old 03-08-2014, 10:00 PM   #7
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Quote:
Originally Posted by Ready View Post
Perhaps I'm not asking the question correctly, so let me try again.

There is a general formula for evaluating additional yield versus additional duration. I am not sure what the exact number is, but I'm sure it is less than 53 basis points per additional year of duration. Based on the typical formulas comparing yield to duration, I believe there is something abnormal about the Vanguard long term fund. I'm hoping someone can look at the holdings in the portfolio and identify why such a small addition in duration yields such a significant increase in yield.
I checked the credit quality of both funds and the average is A. Morningstar has similar things to say about both funds, higher than average credit, much lower than average expenses leads to slightly higher than average performance.. The normal Vanguard stuff.

So if your question is I am crazy, or aren't I lot better of investing in VMLUX than VMUIX, I think the answer is you maybe crazy, but hell yes. The risk to return ratio is very favorable.

My only plausible explanation as to why this is happening is because of labels intermediate vs long-term. With everybody and DogBert, (including me) saying avoid long term bonds, prices of intermediates have gone up and long term gone down. (i.e steep yield). Those smart guys at Vanguard have found the sweet spot.. short long-terms bonds..
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Old 03-08-2014, 11:25 PM   #8
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My only plausible explanation as to why this is happening is because of labels intermediate vs long-term. With everybody and DogBert, (including me) saying avoid long term bonds, prices of intermediates have gone up and long term gone down. (i.e steep yield). Those smart guys at Vanguard have found the sweet spot.. short long-terms bonds..
Clifp,

It could just be that simple. I've searched the Bogleheads forum and seen numerous threads similar to mine, each with a variety of theories but never anything conclusive. The main theme that comes up has to do with the callability of the bonds in the long term fund. Their theory is that the fund may have a number of bonds that are much longer term...say 20 years, but they may have a call feature in 5 years, so Vanguard considers them to have 5 year duration. However, if interest rates go up, the bond holders may elect to hold on to the bonds for much longer, which then increases the duration of the bonds and therefore increases the risk of NAV loss more than one might anticipate.

It's an interesting theory, yet I have not been able to find any bond gurus who understand this stuff well enough to state whether this is a legitimate concern or just some guessing on what might be going on.

I will be calling Vanguard next week to poke around and see what I can find out.
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