Municipal bonds question

[DoingHomework]

Partly because of what I've read here about the whole "buckets" idea, I've decided that with retirement about 4 years out, I need to start filling our buckets for the first few years by moving money into bonds. The trouble is, since we'll both be under 59.5 for the first few years we'll need to pay for that period from taxable accounts (or 72t?). And during the next few years we are in the 28% tax bracket for any bond income.

I'm considering building these bond holdings in municipal bond funds. I know this is not the best time to be moving into bonds because interest rates are low. But I plan to be careful with duration so I'm not that worried about price decline.

My question is this: I have always avoided muni bonds because I believed that they "should" return the same as equivalent corporate bonds after accounting for taxes in the higher brackets (say ~35%). In other words, an investor in the 35% bracket would earn the same return after taxes in either munis or corporates. That seems to be the prevailing theory.

But when I start comparing actual returns over the last 10-20 years it doesn't seem to have played out that way. It seems like the "yield penalty" for the munis has made the break-even happen for an investor in a 20% tax bracket. I derived this by looking at similar funds in a couple of different families.

Does this seem right? The numbers speak for themselves but am I maybe missing something? For example, I'm wondering if the recent runup in muni prices is distorting things. What has been the actual experience over the last couple of decades of those of you that own munis? Has the return really been better than expected (after taxes) compared to corporates?

My conclusion from this, given that I do think I want to move into bonds because of our "lifestage" (not market timing), is that muni funds might be a good place to do it since we'd avoid taxes on the income and would not pay as big a penalty on yield as theory would predict.

We already have substantial bond holdings in tax deferred accounts as well as a "phantom bond portfolio" in the form of a government pension. But we'll be supplementing the pension with taxable money for the first few years.

Comments?

 

[pb4uski]

Typically one's bond allocation would go into their tax-deferred, tax-free and taxable accounts in that order. If you end up with bonds in your taxable account and are in a high marginal tax rate, then you would consider munis if the current muni yield exceeds the current taxable yield *(1-t).

Historical relationships are interesting but less relevant to current yields since that is what you would be investing in.

Do you have equities? Are they in your taxable accounts?

In my case, my tax-deferred accounts absorb all my 40% overall fixed income allocation, so my Roths and taxable accounts are all equities.

 

[DoingHomework]

Typically one's bond allocation would go into their tax-deferred, tax-free and taxable accounts in that order. If you end up with bonds in your taxable account and are in a high marginal tax rate, then you would consider munis if the current muni yield exceeds the current taxable yield *(1-t).

Historical relationships are interesting but less relevant to current yields since that is what you would be investing in.

Why use current yield? I understand that past yield is essentially meaningless but wouldn't you want to use expected future yield rather than current? And while no one know the future, if I had to choose between two funds in the same family with similar expenses, wouldn't I expect the one with the higher past yield to do better in the future? (What I said is not very clear. What I mean is that, as an asset class, if munis have done better after taxes than expected in the past, wouldn't I expect this relationship to continue, if it has an underlying economic cause?)

Do you have equities? Are they in your taxable accounts?

Yes, we have mostly equities in fact. Taxable accounts are all equities except for a small (~5%) bond allocation due to beginning this allocation shift last year. Tax deferred accounts are about 70% equities. Plus there is a government pension that has a value about equal to the rest of our portfolio based on a conservative estimate of the present value of the payments.

So, overall, if I count the pension as bond/fixed income we are over 50% bonds already. We're young but also near planned retirement so I'm comfortable with that. But excluding the pension we're probably close to 75-80% equities. I think that is high given our plans.

I understand the basic recommendation to keep the bonds in tax deferred accounts and that's probably the advice I'd give to others. But given our need to withdraw from taxable accounts in about 4 years and also not wanting to be too risky with that money now, what would you suggest?

I guess what I am really struggling with is that I look at the allocation between bonds and cash as being driven by when the money is needed. Since we will need money from our taxable accounts in 4-9 years or so and tax deferred money not for at least 10 years, it seems like we should have bonds in taxable accounts. But that creates tax problems on unneeded income now that munis would seem to avoid.

 

[MooreBonds]

My question is this: I have always avoided muni bonds because I believed that they "should" return the same as equivalent corporate bonds after accounting for taxes in the higher brackets (say ~35%). In other words, an investor in the 35% bracket would earn the same return after taxes in either munis or corporates. That seems to be the prevailing theory.

But when I start comparing actual returns over the last 10-20 years it doesn't seem to have played out that way. It seems like the "yield penalty" for the munis has made the break-even happen for an investor in a 20% tax bracket. I derived this by looking at similar funds in a couple of different families.

Does this seem right?

I had also noticed that similar comparison over the past decade or so.

I guess I wrote it off to munis being a relatively 'botique' area of the market that only the higher-end income folks deal with, versus EVERYONE clamoring for various taxable bond funds (lower/middle/upper class alike). Perhaps the combined demand from everyone for bonds has made the relatively yield on them lower compared to after-tax munis?

Also, perhaps part of it is that many people aren't truly number crunchers (as evidenced by many economic studies), where people will take what appears to be better on the surface (ex. a 6% corporate bond yield vs a 4% muni yield), even though the after tax net result (3.5% corporate bond vs 4% muni) is worse.

And maybe there's also the part of that psychological transparency issue? A lot easier to see what the board/management of XYZ company is doing versus the political whims of some small municipality/city/state halfway across the country that may be very difficult to get info on. Might be more relative level of accountability on the part of corporate management versus many elected politicians?

 

[LOL!]

with a tiny bit of cleverness, if you have assets in taxable, there is no need to put bonds there if you have room for bonds in tax-advantaged. Here's how to get access to your fixed income investments in tax-advantaged without withdrawing from tax-advantaged:
Placing Cash Needs in a Tax-Advantaged Account - Bogleheads

Read it twice and if you still don't get it, read it twice more.

 

[pb4uski]

Why use current yield? I understand that past yield is essentially meaningless but wouldn't you want to use expected future yield rather than current? And while no one know the future, if I had to choose between two funds in the same family with similar expenses, wouldn't I expect the one with the higher past yield to do better in the future? (What I said is not very clear. What I mean is that, as an asset class, if munis have done better after taxes than expected in the past, wouldn't I expect this relationship to continue, if it has an underlying economic cause?)



Yes, we have mostly equities in fact. Taxable accounts are all equities except for a small (~5%) bond allocation due to beginning this allocation shift last year. Tax deferred accounts are about 70% equities. Plus there is a government pension that has a value about equal to the rest of our portfolio based on a conservative estimate of the present value of the payments.

So, overall, if I count the pension as bond/fixed income we are over 50% bonds already. We're young but also near planned retirement so I'm comfortable with that. But excluding the pension we're probably close to 75-80% equities. I think that is high given our plans.

I understand the basic recommendation to keep the bonds in tax deferred accounts and that's probably the advice I'd give to others. But given our need to withdraw from taxable accounts in about 4 years and also not wanting to be too risky with that money now, what would you suggest?

I guess what I am really struggling with is that I look at the allocation between bonds and cash as being driven by when the money is needed. Since we will need money from our taxable accounts in 4-9 years or so and tax deferred money not for at least 10 years, it seems like we should have bonds in taxable accounts. But that creates tax problems on unneeded income now that munis would seem to avoid.

I say current yield because that is the best information available on what your yield will be and I would suggest current yield is more indicative of future performance then past performance.

I don't worry about where the liquidity is but look at my AA across all of my accounts. I just recently ER'd and will likely be selling equities in my taxable accounts to fund living expenses. If those sales adversely affect my AA then I can respond by selling bonds in my tax-deferred account and buying equities. At the end of the day it is the same as if I held bonds in my taxable account, except without the taxable income.