Municipal Bonds or Municipal Bond Funds? Don’t Ask WWSOD? (What Would Suze Orman Do?)

Municipal Bonds or Municipal Bond Funds?

 We read an article about Suze Orman in Costco’s magazine a while back.  The Costco mag rag has a few articles and lots of Costco products. In a sidebar to the article, Orman advises investors to buy individual bonds rather than bond funds. Orman’s primary argument is that individual bonds can be held to maturity and that interest income of individual bonds is more stable. We disagree with Orman for the most part. We think she is making a quick punchy magazine bullet point that does a disservice to most readers who take her comments at face value.

A Bit of a Drag

In her article, Orman did not differentiate between taxable and tax-free bonds.  We will focus specifically on municipal bonds where we think Orman’s broad brushed advice is particularly doing readers a disservice.  The primary municipal bond mutual fund that we use in client portfolios is the Vanguard California Intermediate Municipal Bond Fund (VCADX). The internal management fee charged by Vanguard is 0.09 percent annually. One would naturally think that if one were to buy individual municipal bonds, after paying the transaction costs of the original bond purchase, one could at least save 0.09 percent a year avoiding the annual expense ratio drag embedded in the bond mutual fund. This does not turn out to be the case.

A Bit of a Spread

The municipal bond market is more fragmented and less efficient than the stock market. Individual bond investors routinely pay from 1 percent to 4 percent more than what a mutual fund manager would pay for the same bond. The mutual fund companies have a scale and a frequency of buying municipal bonds that allow brokers to lower bond prices and still make money. The difference between what one investor can sell a bond for and the price she would pay for that same bond is called the “spread.” The wider spread that smaller municipal bond investors pay is effectively a fee embedded in the price of the bond and not really fully disclosed. Studies indicating simultaneous prices paid by retail investors versus institutional investors confirm these wide spreads.

(Unlike the bond market, the equities markets are pretty much priced the same for smaller investors and large institutional investors. This is due to a combination of free market competition and regulation. As bond trading platforms improve, we do expect smaller investors to eventually have access to more competitive pricing. We expect this process to take several years.)

Assume you pay 2 percent more than what Vanguard paid for the same bond. Roughly speaking, you would have to hold onto that bond about 22 years (2%/0.09% = 22.3 years) before the 2 percent higher price you paid for the bond starts being more attractive than the additional 0.09 percent in annual fees you pay to Vanguard.

Particularly if you are in the asset building mode, individual municipal bond investing is even more expensive, because the individual investor continues to pay a premium every time she buys more bonds to reinvest municipal bond interest income. Municipal bond funds, however, allow savers automatic monthly reinvestment into the bond fund without a transaction fee. Also, depending on the size of coupon interest, the individual investor may not even be able to find a municipal bond issue small enough to buy in order to stay fully invested.

Stability, Income, and Diversification

We think a common investor opinion that the income from individual bonds is more stable than the income from bond funds is incorrect. Let’s say an investor builds a laddered bond strategy and attempts to keep a fairly stable average weighted maturity (or duration, which is a metric used by institutional investors and is a little more complex) by buying longer, such as by buying bonds of rolling maturities. If the investor keeps buying a replacement bond of the longest desired maturity every time a bond matures, she faces the risk that the reinvested coupon interest may be less than the coupon paid by the last maturing bond.

Another common investor sentiment goes something like, “Well, if I hold on to the bond until maturity, I will always get my principal back.” Bond prices fluctuate daily, just like bond mutual funds. Every investment should be evaluated on a total return basis, which incorporates both the change in price from one period to the next and the cash flow earned from the investment. Factoring changes in interest rates, the time value of money, and inflation, a known nominal fixed dollar payment ten to twenty years out really is not much of an assurance of the value of your bond today. More importantly, that fixed dollar amount that will be paid off that far out in the future is not much of an assurance of what your real economic return will be from that investment.

Digging through the actual mechanics and going over the details confirms what we really think: Any comfort that comes from knowing exactly when your individual bonds will mature relative to the constant maturity of a bond fund is really a false sense of security.

Finally two more points on why municipal bond funds may be better for you than individual municipal bonds. The first one is fairly simple. Unless the client has a large dollar amount to be dedicated to municipal bonds, the amount of diversification achievable through a bond fund such as VCADX is difficult to replicate.

The second point is a little more conceptually difficult. Broadly speaking, a portfolio of individual bonds becomes a little shorter in maturity every day. That may lead to your bond allocation moving from its original specified risk tolerance. This can be adjusted when new money is invested in bonds and when a bond matures. Developing strategies using municipal bond funds that target specific maturity ranges (i.e., short-term, intermediate, and long-term) is likely a better way to customize a municipal fixed income allocation tailored specifically for an individual’s interest rate sensitivity and risk tolerance.