Municipal Bond Funds vs CDs

[Ready]

I have some 5 year CDs that will be maturing this year and I need to decide what to do with them. They are all currently paying just a bit above 3%. And I just moved some money over to PenFed and established some new 5 year CDs as well.

I'm trying to evaluate the best options for the fixed income portion of my portfolio, which is 40% of my total investment portfolio. I currently have about half of my FI portfolio in Vanguard CA Municipal Bonds (VCADX). The SEC yield on this fund is currently 2.3%. The distribution yield is a bit higher, at 3.35%, but my understanding is that this is not the figure to use when evaluating the actual performance of the fund, as it may factor in short term swings in the NAV, and not reflect the long term expected yield on the fund. I may be getting that wrong though. No matter how many times I read about the differences between SEC yield and distribution yield, I still don't really understand it.

In any case, if I take the 2.3% distribution yield, and divide it by .7 (I pay 30% in state and federal taxes), this gives me an equivalent taxable yield of 3.29%.

So in effect I can currently earn 3% in a CD, guaranteed by the federal government, or earn 3.29% in a bond fund. But the bond fund is subject to interest rate risk, where the CD is not. Of course if interest rates go down, I could earn more than 3.29%, but the likelihood of this happening seems pretty low. If interest rates rise, the NAV will drop, meaning I'm really earning less than 3.29%, at least if I end up selling before the higher yield offsets the drop in NAV.

So in effect I'm comparing a guarantee of 3% to a yield of 3.29% with interest rate risk. It seems like a very small premium for all the risk. Am I looking at this correctly? Is there anything I'm not considering regarding the potential performance of municipal bonds? Would I do any better buying individual bonds and holding them to maturity. It seems like I would have the same issues, since I would lose money if I sold them, or suffer a below market yield for many years if I hold them to maturity.

And of course, there is no guarantee that the 3% CD will be available once PenFed resets their rates tomorrow. But I still want to make sure I'm looking at this scenario correctly and evaluating all of the pros and cons of each before making a decision.

May I ask for some input into my analysis of this, and any other suggestions you may have for fixed income investing.

Thank you.

 

[pb4uski]

I think you're making the right comparison comparing your tax equivalent yield to the CD yield. I see from your profile that you retired in 2013. I think it would be important to use your projected 2014 marginal tax rate (rather than your 2013 tax rate when I presume you worked part of the year) in doing the tax-equivalent calculation.

I also agree that a 29 bps premium isn't adequate compensation for the interest rate and credit risk difference between the CD and the muni fund.

 

[brewer12345]

I also agree that a 29 bps premium isn't adequate compensation for the interest rate and credit risk difference between the CD and the muni fund.

+1. I would also be pretty uncomfortable to a 20% portfolio concentration in a single state muni fund. Bad things happen, so it is worth keeping concentrations down so you cannot be sunk.

 

[clifp]

+1. I would also be pretty uncomfortable to a 20% portfolio concentration in a single state muni fund. Bad things happen, so it is worth keeping concentrations down so you cannot be sunk.

+2 especially cause the state is CA. I can't even imagine where all the bodies are buried in the magic tricks they've used to balance the budget in the last 5 or 6 years. But fundamentally the citizen of CA can't afford the government they have.

Right now a thriving ag business, and Silicon Valley is keeping CA afloat. The drought really threatens the agricultural business, and every state in the union, and every country on the planet is trying to poach Silicon Valley business.

 

[obgyn65]

I am a big proponent of CDs. In your situation I would invest in CDs rather than muni bonds. The predictability of income of CDs with zero risk is paramount. The slight difference in interest rate is not worth it IMO.

 

[Ready]

Thanks for the feedback everyone.

pb4uski - 30% is my marginal tax rate in retirement because I'm still generating a small amount of earned income. CA taxes here are 9.3%, and that rate applies to both earned income and capital gains.

brewer, clifp - I gave a lot of thought to being heavily invested in CA municipal bonds rather than going nationwide. The Vanguard fund invests in 1,151 bonds across the state, so I have pretty good protection against any one municipality failing. If the entire state goes bankrupt and begins to default on bonds, then I guess I'm screwed. Switching to a nationwide municipal bond fund would mean paying an additional 9.3% in taxes, making the bonds even less appealing relative to a bank CD, so I guess I just have to keep thinking about this one a bit more. Ultimately, if I sold my CA Muni investments, I think I would just go with CDs at this point until yields improve.

 

[brewer12345]

brewer, clifp - I gave a lot of thought to being heavily invested in CA municipal bonds rather than going nationwide. The Vanguard fund invests in 1,151 bonds across the state, so I have pretty good protection against any one municipality failing. If the entire state goes bankrupt and begins to default on bonds, then I guess I'm screwed. Switching to a nationwide municipal bond fund would mean paying an additional 9.3% in taxes, making the bonds even less appealing relative to a bank CD, so I guess I just have to keep thinking about this one a bit more. Ultimately, if I sold my CA Muni investments, I think I would just go with CDs at this point until yields improve.

If something ugly happens to the state of CA, the correlation on all those bonds is going to 1 overnight. It won't matter what the actual bonds are, since the market will puke the whole thing over the side at once.

As someone who has made the mistake of letting the tax tail wag the investment dog on a concentrated position in the past, I would admonish you not to repeat the mistake which I have finally cured myself of. A 20% position in a related group of obligors would be considered outlandishly aggressive in an institutional asset management setting. Really, seriously reconsider making such a big bet for such a marginal return. I think the CDs would be a far better risk-adjusted return.

 

[jazz4cash]

One problem I see is you are using the 3% Penfed CDs for comparison, but they may not actually be available starting tommorrow. Do you have another option for CD's at similar rates? Navy Federal has started offering something similar but I don't know how long they will be available, either. Otherwise, the rates I see for 5yr CDs are in the 2-2.2 range.

 

[Ready]

Brewer - I hear you. I will plan to reduce my exposure to CA muni bonds in the near future. With the Pen Fed rates going away today, I will need to see what other options are out there as I don't want to go below 3% in a CD.

Jazz - you are correct, I'm evaluating an option that goes away tonight with no idea what may be offered later this year. My current CDs pay between 3.2-3.6% and have 9-18 months left to mature. The early term on them is only 60 days, and I did give a lot of thought to cashing them in and reinvesting them with Pen Fed. But ultimately I decided to roll the dice and avoid the early term fees and keep the slightly higher rate, hoping that when they mature I will be able to find a 3% rate again. I realize that very well may not happen this year though.

 

[Shawn]

I have a different opinion, partially based on assumptions that may not be fully accurate. Others may disagree with my opinion. Also, I originally had a much longer post describing my assumptions but decided to shorten it for simplicity.

A tax equivalent yield of 3.29% is calculated for VCADX using the SEC yield. This CA municipal bond fund yield is compared against the 3.00% yield for a "risk free" CD. The 0.29% difference seems quite small considering the interest rate risk with the bond fund.

However, a tax equivalent yield of 4.78% is calculated for VCADX if the distribution yield is used instead of the SEC yield. This 1.78% difference between the bond fund yield and the CD makes VCADX much more appealing.

Should the SEC yield or distribution yield be used?

For short-term investment horizons, the distribution yield should be used together with the interest rate risk. For long-term investment horizons (e.g., the 5 year duration of VCADX or the CD), the SEC yield should be used without significant consideration for the interest rate risk. This is because much of the interest rate risk is already built into the lower SEC yield for long-term investments. It should not be counted twice.

So the comparisons are ...

Short-term: 4.78% yield + interest rate risk for the fund vs 3.00% yield for the CD
Long-term: 3.29% yield for the fund vs 3.00% yield for the CD

Of course, other risks are important too, such as credit risk, but they are less significant for funds than for individual bonds. And keep in mind that CD's have interest rate risk too. If rates rise, either the money remains tied up in the lower yielding CD or the actual return for the CD will be less than 3.00% if the CD is prematurely redeemed with a penalty.

Personally, I believe California municipal bond funds are worth considering for state residents with relatively high incomes. California is a diversified state. The state and many local governments are loaded with bloat. Significant budget can be cut if and when push comes to shove.

For disclosure, I own VCAIX, the investor class equivalent of admiral class VCADX. I may increase my allocation and convert to the admiral version in the near future. I also own BCHYX, a high-yielding CA municipal bond fund from American Century. BCHYX has been one of my best performing investments over the last 15 years, providing me with a long-term tax equivalent return of 8-9% with "moderate" variability.

 

[FIREd]

I own both VCADX and CDs. I like the CDs for stability and principal protection in a rising interest rate environment. I like the munis because my marginal tax rate for state and federal is over 50% and VCADX's taxable equivalent SEC yield is nearly 5% for me.

 

[Newventurer]

I own both VCADX and CDs. I like the CDs for stability and principal protection in a rising interest rate environment. I like the munis because my marginal tax rate for state and federal is over 50% and VCADX's taxable equivalent SEC yield is nearly 5% for me.

I don't understand how CDs at a fixed interest rate protect you in a rising interest rate environment, wouldn't it be otherwise, if you buy a CD at say 3% and rates go to 4%, isn't this taking on risk?

Sorry if this is a dumb question.

 

[FIREd]

I don't understand how CDs at a fixed interest rate protect you in a rising interest rate environment, wouldn't it be otherwise, if you buy a CD at say 3% and rates go to 4%, isn't this taking on risk?

Sorry if this is a dumb question.

Here is a real life example. Early last year, I bought a 5-year CD that paid 2% interest. Interest rates started going up and, at the end of the year, I could find 5-year CDs paying 3%. My investment did not so good anymore. So I redeemed the CD paying 2%, I got back the principal plus some interests and reinvested the money at 3%.

Note: this only works with bank CDs, not brokered CDs. Keep an eye on early redemption conditions and penalties.

Anyways, I said that my principal was protected in a rising interest rate environment. Unlike with bonds, you can't lose money with CDs (on a nominal basis at least).

 

[34rlsa]

On the other hand, if you plan to keep the fund for a long period, say 5 years, it may be better to use the tax equivalent SEC yield of 3.29%. But again, note that the interest rate risk is already factored into this yield because any rate changes are eventually compensated in the long-term by changes in the bonds the fund owns.

So for a long time horizon, it may be better to consider the SEC yield and ignore interest rate risk (i.e., 3.29% for the fund vs 3.00% for the CD). For a short time horizon, it may be better to consider the distribution yield and factor in the interest rate risk (i.e., 4.78% + interest rate risk for the fund vs 3.00% for the CD). Of course, other risks are important too, such as credit risk, but they are less significant for funds than for individual bonds. And keep in mind that CD's have interest rate risk too. If rates rise, either the money remains tied up in the lower yielding CD or the effective return on the CD will be less than 3.00% if the CD is prematurely cashed with a penalty.

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?

We recently added PenFed CDs at 3% and have additional funds we need to reinvest to broaden our AA.

Thanks

 

[clifp]

Thanks for the feedback everyone.


brewer, clifp - I gave a lot of thought to being heavily invested in CA municipal bonds rather than going nationwide. The Vanguard fund invests in 1,151 bonds across the state, so I have pretty good protection against any one municipality failing. If the entire state goes bankrupt and begins to default on bonds, then I guess I'm screwed. Switching to a nationwide municipal bond fund would mean paying an additional 9.3% in taxes, making the bonds even less appealing relative to a bank CD, so I guess I just have to keep thinking about this one a bit more. Ultimately, if I sold my CA Muni investments, I think I would just go with CDs at this point until yields improve.

I understand I won't suggest going to national tax exempt fund because CA taxes are so high, that state taxes make a meaningful addition to the yield. I should add that IMO interest rate risk is significantly a bigger factor than credit risk. That said back when I was buying in munis in the late 90s and 2000, credit risk for muni was virtually zero. That is no longer true even though it is still small.

This is strictly a risk and reward calculation. Since we think the PenFed rates expired and the new rates are 2% for a five year. If you asked me would I keep a your intermediate fund with tax equivalent yield of 3.23% vs a 2% CD, I'd keep the bond fund today. The Penfed CD were a very good deal it, I moved my money from a Vanguard GNMA to the CD for the precisely the reason you discussed.

At 2% it is a different calculation. The average maturity of the fund is about 5 years, so a 1% interest will result in a 5% loss to principal the break even period is 4 years (3.23%-2%) so less than the 5 year length of time for the CD. Plus as I have learned the hard way, just because I and lots of expert think that interest rise it doesn't mean they will. Smart forum members like RunningMan make a strong case that we face a prolonged period of deflation despite the combined efforts of the world central banks to get us back to 2-3% inflation. In which case those interest rates on your muni bonds may look very appealing 5 years from now.

 

[sewang]

I understand I won't suggest going to national tax exempt fund because CA taxes are so high, that state taxes make a meaningful addition to the yield. I should add that IMO interest rate risk is significantly a bigger factor than credit risk. That said back when I was buying in munis in the late 90s and 2000, credit risk for muni was virtually zero. That is no longer true even though it is still small.

This is strictly a risk and reward calculation. Since we think the PenFed rates expired and the new rates are 2% for a five year. If you asked me would I keep a your intermediate fund with tax equivalent yield of 3.23% vs a 2% CD, I'd keep the bond fund today. The Penfed CD were a very good deal it, I moved my money from a Vanguard GNMA to the CD for the precisely the reason you discussed.

At 2% it is a different calculation. The average maturity of the fund is about 5 years, so a 1% interest will result in a 5% loss to principal the break even period is 4 years (3.23%-2%) so less than the 5 year length of time for the CD. Plus as I have learned the hard way, just because I and lots of expert think that interest rise it doesn't mean they will. Smart forum members like RunningMan make a strong case that we face a prolonged period of deflation despite the combined efforts of the world central banks to get us back to 2-3% inflation. In which case those interest rates on your muni bonds may look very appealing 5 years from now.

I think you need to have some BFZ or MUC, which gives you 6.5-7% tax free return if you are CA resident. Principle may go down, in which case you buy more, Principle may go up, you hold, or sell some. Over the long term, it's much better than these 2-3 percent bond or CD.

 

[clifp]

I think you need to have some BFZ or MUC, which gives you 6.5-7% tax free return if you are CA resident. Principle may go down, in which case you buy more, Principle may go up, you hold, or sell some. Over the long term, it's much better than these 2-3 percent bond or CD.

BZF why? A muni bond fund that lost 11% last year and staggering 34% in 2008. I think the purpose of the fixed income portion of your portfolio is to provide stability not a roller coaster ride.

The problem with leverage (which is what the fund uses to get its good long term returns) is it goes both ways it makes you more money on the way up and lose more on the way down.

 

[MooreBonds]

I don't understand how CDs at a fixed interest rate protect you in a rising interest rate environment, wouldn't it be otherwise, if you buy a CD at say 3% and rates go to 4%, isn't this taking on risk?

Sorry if this is a dumb question.

You are correct somewhat in general theory...but also remember that in this particular example, the much lauded PenFed 3% 5 year CD is a market anomaly: all other 5 year CDs are yielding (at best) maybe 2%, 2.2%. So it would take a while for the 'market' rate 5 year CD to even get up to 3%, much less considerably past 3%.

Plus, while there is some 'risk' of rising rates, you are guaranteed your return of principal plus the interest, and not subject to the gyrations of a bond fund with various maturities and coupons and buys/sells throughout the year that might end up hurting you more than the lost interest on a fixed rate CD.

 

[Ready]

Shawn - thanks for your detailed analysis of SEC yield vs distribution yield. I'm still trying to wrap my brain around what all that means. If I simply look at the dividend that I received yesterday for the month, and divide it into my total initial investment in the fund, it comes to 3.4%. Taxable equivalent yield for me would be 4.87%. So comparing this to a 3% CD (or now a 2% CD since PenFed no longer offers 3%), it looks much better.

34rlsa - regarding comparing a rise in interest rates with CD vs bond fund investments, let's look at a somewhat extreme example to illustrate the difference. Let's say both CDs and bond funds have a 3% yield today. I invest $100,000 into both the CD and the bond fund. I spend the interest and dividends to live on, rather than reinvesting them, for simplicity sake.

Now a year goes by and rates jump 2% (I know this is not typical, but I did say an "extreme" example). VCADX would see an immediate drop in NAV of about 12%, so now my $100,000 investment is only worth $88,000. My CD is still worth $100,000.

So now I cash in my CD and pay the one year penalty of $3,000. I now have $97,000 to reinvest into either a CD at 5%, or the bond fun at 5%. The reason the CD is so much higher is that your interest rate "risk" is capped at one year of returns, where as the bond fund has no cap on how low the principal can go as interest rates rise.

For this reason, I believe that a bond fund should pay more than a CD to reflect the added risk. In the case of VCADX, if you evaluate performance based on distribution yield, it is 3.4% tax free, 4.87% taxable equivalent yield. So the premium is enough there to warrant some risk, at least in my opinion.

The biggest problem for me with CDs is that they are taxed at the same rate as earned income. So I pay 28% tax on every dollar of interest on a CD. My equity funds are all index funds, so they are relatively efficient, and the small amount of dividends they pay are only taxed at 15%. And of course, municipal bonds are completely federal and state tax free, so they are a great choice for funds in your taxable investment accounts.

Now that PenFed has ended their 3% CD promotion, the comparison begins to favor the bond funds again. It was great while it lasted. We will have to see if anyone else follows their lead.

 

[sewang]

BZF why? A muni bond fund that lost 11% last year and staggering 34% in 2008. I think the purpose of the fixed income portion of your portfolio is to provide stability not a roller coaster ride.

The problem with leverage (which is what the fund uses to get its good long term returns) is it goes both ways it makes you more money on the way up and lose more on the way down.

Stability in income. Principle will go up and down. Dividend has not changed at all from day one. If you want growth, buy ETF. But if you want income for retirement, high yield, high quality bond is the way to go. That is why you have roughly half bond, half stock. CD is for
emergency fund, not investment.

 

[Ready]

Stability in income. Principle will go up and down. Dividend has not changed at all from day one. If you want growth, buy ETF. But if you want income for retirement, high yield, high quality bond is the way to go. That is why you have roughly half bond, half stock. CD is for
emergency fund, not investment.

I have never understood the purpose of choosing an investment that pays a high dividend but has potential for big drop in NAV. To me, the overall performance of the investment, including both the drop or rise in NAV, along with dividends, is the only thing to be measured.

Dividends may be good for people who don't have earned income and can avoid all capital gains taxes. But for me, I have to pay 25% (15% Fed and 10% CA) taxes on dividends, even if I don't need the income at the time the dividends are issued.

With investments that pay no dividends, all earnings come from capital gains. So if I need some money, I sell some shares and pay the taxes. But if I don't need to spend the money, I get to keep the funds invested, and not have to pay any taxes on them. Why wouldn't I want to have complete control over when the income is declared earned and taxable, rather than submitting to a fixed schedule that pays me whether I need the money or not?

 

[sewang]

I have never understood the purpose of choosing an investment that pays a high dividend but has potential for big drop in NAV. To me, the overall performance of the investment, including both the drop or rise in NAV, along with dividends, is the only thing to be measured.

Dividends may be good for people who don't have earned income and can avoid all capital gains taxes. But for me, I have to pay 25% (15% Fed and 10% CA) taxes on dividends, even if I don't need the income at the time the dividends are issued.

With investments that pay no dividends, all earnings come from capital gains. So if I need some money, I sell some shares and pay the taxes. But if I don't need to spend the money, I get to keep the funds invested, and not have to pay any taxes on them. Why wouldn't I want to have complete control over when the income is declared earned and taxable, rather than submitting to a fixed schedule that pays me whether I need the money or not?

If your tax bracket is not high, then muni may not be your cup of tea. Muni is a safe investment compared with many other investment. People hear Detroit, but Detroit is the only one. If you know how to pick stocks and always have capital gains. go for it.
For me I want to have some high yield muni and get the income for monthly expense. You can not do that with stock. My point is CD over the long term, like cash, is a loser.

 

[clifp]

If your tax bracket is not high, then muni may not be your cup of tea. Muni is a safe investment compared with many other investment. People hear Detroit, but Detroit is the only one. If you know how to pick stocks and always have capital gains. go for it.
For me I want to have some high yield muni and get the income for monthly expense. You can not do that with stock. My point is CD over the long term, like cash, is a loser.

It's not just Detroit. Vallejo, Stockton, San Bernardino and Mammoth Lakes all have recently filed for bankruptcy leaving their bond holder repayment to the mercy of the courts. A few decades ago Orange County did the same.

When I was buying CA muni bonds in the late 90s most had insurance, well almost all of the insurance company went broke in the 2008 crash, since they also issued insurance on mortgage backed securities and credit default swaps (oops).

Of bigger concern to me with your particular fund is it is use of leverage. Taking advantage of near 0% short term interest rates to buy long term muni bond is a great strategy when interest rates are falling. Leverages works both ways and it really sucks when interest rates are rising.

In general I agree CD are loser as investments, the PenFed was an anomaly. Fortunately PenFed rolls out these great deals every couple of years. 3-5 year 6% CD circa in 2007 (IIRC),something in 2009, 10 year 5% in 2011, and now this 5 year 3% in 2013. I am looking forward to the 2015 PenFed Xmas present.

 

[brewer12345]

Let's not forget that the 10 5% CD was a screw-up on PF's part (which we all took shameless advantage of). I am hoping for more above market rates at the end of the year from them, but I don't imagine they will make such a colossal screw up as that one.

 

[clifp]

Let's not forget that the 10 5% CD was a screw-up on PF's part (which we all took shameless advantage of). I am hoping for more above market rates at the end of the year from them, but I don't imagine they will make such a colossal screw up as that one.

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.