Municipal Bond Funds vs CDs

[Shawn]

I'm interested in learning more regarding yours and other folks take on bond funds. Are you saying if you plan to hold a fund for at least it's current average duration then the interest rate risk is mitigated by turnover to new bonds in the fund?

I have been considering adding a position in Vanguards Wellesely balanced fund. The current mix is ~60% bonds with 6 year average duration. I'm not an M* subscriber but their quick take on VWIAX states "Rising rates are this fund's arch nemesis". Is M* only considering short term returns?

That would be my take although I believe it depends on the specific questions asked and the comparisons made.

If I look at this from a short-term perspective, interest rate risk is very important. If I buy VCADX with its 5-year duration today and interest rates suddenly rise by 1% tomorrow, then I am immediately down 5%. This is a real and significant risk. I need to weigh this risk against the benefits of the fund, and then compare this information to the CD. The primary benefit of the fund is that it currently pays a higher yield than the CD. How much higher? In the short-term, it pays the distribution yield, which is about 2% higher than the 3% yield of the CD (based on the January PenFed offer, and using the tax equivalent yield for the tax-free fund). It is not paying the SEC yield in the short-term, so I believe it is inappropriate to use the SEC yield for these short-term comparisons. So the question is ... In the short term, say 1 year, do I want to risk a potential loss of 5% (if interest rates rise 1%) in the hopes of getting an extra 2% return? Maybe.

If I look at this from a long-term perspective, interest rate risk can be mostly ignored. Yes, the NAV will immediately drop if interest rates rise by 1% today, but I will get most if not all of this back in the long-term through the higher yielding bonds that the fund will eventually own. Because of this, many people such as John Bogle argue that the expected long-term return of a fund will be similar to its present day yield regardless of interest rate changes. In this case, I think they are referring to the SEC yield and are defining long-term as being comparable to the duration of the fund (could be wrong about this). So for long-term comparisons, I believe it is appropriate to use the current SEC yield as the baseline for the fund and essentially ignore the interest rate risk.

As with everything, real life is more complicated and variable.

I cannot speak for M*, but rising interest rates are a nemesis for almost all bond funds. If rates suddenly rise, you lose money - at least in the short term. It is better to purchase a fund immediately after a sudden rate spike, rather than before, but no one can predict if and how rates will change. Personally, I would not try to over think the issue. If you are a long-term investor and believe Wellesely is appropriate for your AA, and it very well may be, I would be inclined to buy it. Yes, anything can happen and there is a real possibility that you will lose money in the short term, but waiting for the "perfect" time to buy carries a risk all of its own.

 

[brewer12345]

That we did. If PenFed dependent on ER forum members they'd be broke. I've had 6% CD, while borrowing money on fixed 3.99% Home Equity loan.

Right now I have a 45K Car loan at 1.75% while my CD ladder is paying 3%, 3.5%, 3%, and 5% with gaps in few year. I guess they make it up in volume.

Good thing for both PF and us that there are all those suckers paying 14% on credit card balances.

I waffle about paying off a car loan at 1.79%. I don't care for the monthly obligation, but we are talking about 15k and the liquidity costs very little.

 

[brewer12345]

If I look at this from a short-term perspective, interest rate risk is very important. If I buy VCADX with its 5-year duration today and interest rates suddenly rise by 1% tomorrow, then I am immediately down 5%. This is a real and significant risk.

I disagree, actually. The instantaneous 1% shock is a ripple in the return line over the long term. What I'm a lot more worried about is this: We are in an environment where the rate cycle of ever lower yields since the early 80s appears to be over. At the very least, the rally simply cannot mathematically go much further. On the flip side, there is asymmetric risk in the bond market as the possibility that we go on a multiyear (or even decade) rate increase cycle is as high as it has been in my adult lifetime. To make things even more challenging, I think it is harder than ever to figure out what the chances of this outcome happening might be. I have absolutely no interest in being the 1966 retiree. I think this is a big enough risk that I keep my bond maturities short, I have a big hunk of my fixed income portfolio in things other than high grade USD bonds (CDs, Cash, stable value type thing, I bonds, foreign bonds of short maturity, etc.). I also deliberately went into ESR with a 30 year fixed mortgage.

 

[34rlsa]

I disagree, actually. The instantaneous 1% shock is a ripple in the return line over the long term. What I'm a lot more worried about is this: We are in an environment where the rate cycle of ever lower yields since the early 80s appears to be over. At the very least, the rally simply cannot mathematically go much further. On the flip side, there is asymmetric risk in the bond market as the possibility that we go on a multiyear (or even decade) rate increase cycle is as high as it has been in my adult lifetime. To make things even more challenging, I think it is harder than ever to figure out what the chances of this outcome happening might be. I have absolutely no interest in being the 1966 retiree. I think this is a big enough risk that I keep my bond maturities short, I have a big hunk of my fixed income portfolio in things other than high grade USD bonds (CDs, Cash, stable value type thing, I bonds, foreign bonds of short maturity, etc.). I also deliberately went into ESR with a 30 year fixed mortgage.

That is a very discouraging scenario for bond funds.

 

[Ready]

T In the short-term, it pays the distribution yield, which is about 2% higher than the 3% yield of the CD (based on the January PenFed offer, and using the tax equivalent yield for the tax-free fund). It is not paying the SEC yield in the short-term, so I believe it is inappropriate to use the SEC yield for these short-term comparisons.

I believe the SEC yield is appropriate to use if you have not put money into the fund and you want to know the anticipated yield should you invest today.

I put money in a year ago so I've already lost 5% NAV, but I am currently earning the higher distribution yield. So for me, the loss on NAV is a sunk cost at this point and not relevant to consider in deciding whether or not to stay in the fund. However, in putting new money into the fund, I think the SEC yield is the appropriate rate to use when comparing it to alternate investments.

A PenFed 3% CD in an IRA is still a much better investment than VCADX. For money outside an IRA, VCADX looks more attractive. And of course, if you didn't put the money in Pen Fed at this point, the new rate is 2%, which also looks less attractive to me than VCADX.

 

[Shawn]

However, in putting new money into the fund, I think the SEC yield is the appropriate rate to use when comparing it to alternate investments.

When comparing the CD held 5 years to maturity vs VCADX held for a similar period of time, then I agree that the SEC yield is the appropriate comparison metric for new money. But in this case, I believe that interest rate risk should be mostly ignored. This is because the long-term return of the fund should approximate the current SEC yield regardless of the direction of interest rates.

At least that is how I look at it (and I believe others such as John Bogle look at it this way too). I am with you in that I have never completely understood the nuances and full ramifications of SEC yield.

Your initial comparison was 3.00% for the CD vs 3.29% for VCADX (using the SEC yield). Yes, in this case I would have gone with the CD for an IRA investment. It was a much closer call in the case of a non-IRA investment. And now that the CD rate has significantly dropped, VCADX has a lot more appeal.

Personally, I was on the fence about whether or not to invest in the PenFed CD at the high December/January rates (3 years at 2%, 5 years at 3%). The tax equivalent yield of VCADX is about 4% for my tax situation (using SEC yield), and I decided not to go with the CD. Admittedly, though, I have not yet used new money to increase my VCADX allocation either. These funds are still sitting in shorter term investments.