Bond choices are plentiful: treasuries, municipals, corporates, junk. Bond durations vary: ultra-short, short, intermediate, long. Bond packages abound: mutual funds, ETFs, individual, ladders As a high income family we have specific needs from bonds, but what to do?
We’ve been wrestling with the decision to buy bonds for about 3 years. We had an all stock portfolio which was doing great thanks to the giant bear market. I had done my homework though, we needed some bonds for all the right reasons: diversification to equities, psychological ballast during market downturn, “dry powder” (William Bernstein) for buying stocks in a bear market or buying whatever.
But bond are just not sexy right now…. at all, right?
Bonds funds in our qualified accounts were yielding near negative returns thanks to expense ratios around 0.75-1% and low yields from the Federal Reserve Quantitative Easing program after the Great Recession. We struggled for a while to even pull the trigger on bonds. Once it was done, it was like taking off the band aid, it just hurt for a second. Our bonds are now yielding a modest but steady stream of income which is compounding. How we came to the decision of bond type is the subject of this post.
There are as many recommendations for bond types as there are authors commenting on the subject. I’m a huge fan of William Bernstein, the physician/scientist turned financial adviser. Dr. Bernstein advocates intermediate-term US treasuries for the bond portion of a portfolio. He argues that the “sweet spot” of the yield curve is in the intermediate range of maturation, ie around 5 years. Shorter duration give poor yield and longer is more prone to interest rate risk.
Ok fine, so I need some intermediate treasuries. Choices in our qualified accounts were poor plus I like the Roth IRAs to have REITs and needed all that space for the REITS. So the bonds were going in the brokerage.
Treasuries are taxed by the federal government as income at your marginal tax rate (state tax exempt). That means the higher tax brackets for a physician family. Not such a big deal considering the very low yields currently payed by intermediate treasuries. Here is the yield as of this post info on Vanguard Intermediate Treasuries Mutual Fund Admiral Shares (VFIUX). Note the SEC yield 1.78%. I love how the 10 year yield hints at the normal times; maybe this is the new normal??
Assuming this low yield for the foreseeable future, my tax implications wouldn’t be that bad. I would need a million in the fund to generate $20,000 in gains taxed at around 35% for a $7,000 tax bill per year if held in brokerage. I didn’t plan on being at a million for a least 10 years so taxes weren’t a deal breaker.
Municipal bonds at this time are yielding favorable (thats the treasury to muni spread) to compared with Treasuries of similar duration. Current SEC yield 1.86%, that’s higher than treasuries! As Munis are exempt from federal tax, buying Munis was a no-brainier for me in the higher tax brackets.
That of course, is not the end of the story. Why, do you ask, not just put the whole bond portion in Munis? Well, there are more functions of bonds in a portfolio than just yield. I touched on a few in the first paragraph and a full discussion is beyond the scope of this post. However, in summary, bonds provide diversification to equities, psychological ballast during market downturn, “dry powder” (William Bernstein) for buying stocks in a bear market or buying whatever, and others.
So I knew that I need bonds to not crash in a downturn. Once that requirement was known I could better make a decision as the the type of bond needed. This reason is why I don’t buy corporate or high-yield junk bonds. Those types tend to trend with equities in a market downturn. The very characteristic I need in bonds. This is why I avoid the Vanguard Total Bond Fund. It has corporates (and a healthy dollop of long-term bonds which I don’t particularly want.)
How we made the choice between Munis and Treasuries
First, I wanted to compare the returns of the 2 funds against each other and against the market. The graph below is Morningstar’s comparison rolling 12 month returns of my 2 bond funds of choice and the total stock market fund, all Vanguard. If using the link above, you might have to add the fund ticker symbols to the chart and select 12 month rolling average.
Take home points:
- Both bond funds provide diversification over stocks
- Treasures are less correlated with stocks over the entire time period (in the past)
- In a crisis, Treasuries are poorly correlated and Munis are well correlated with stocks. Crisis is one of the more valuable times to have bonds for a variety of reasons as mentioned above
- The 2 bond funds are not well correlated with each other, thus having both may add diversification (and a mild degree of increased portfolio complication)