Given that I wish to invest a portion of my portfolio in bond funds and I don't need the income for another five years, is there a better investment than California munis (without increasing my investment risk)? If so, what are some good funds? -- Ralph Mendoza P.S. I'm retired.
Without knowing your marginal tax rates, I can't say whether you belong in a municipal or taxable bond fund, but I can give you the information you need to figure it out.
First, by asking whether munis make sense for you, you are asking the first question of anyone interested in bond investing. For a certain class of investors -- those in the highest tax brackets -- it will almost never make sense to buy any kind of bond but municipals, because the after-tax yields on taxable bonds won't match what munis offer. Any potential bond investor's first step should be to determine whether he or she falls into that category. (This is with the exception of investors who don't want any credit risk at all. They'll need to stick with taxable Treasury bonds.)
To determine whether munis or taxables make sense for you, you need three pieces of information:
- The yield on the municipal investment you're considering.
The yield on the taxable investment you're considering.
Your marginal federal tax rate.
If you live in a state with a high income tax, you'll also need to know your marginal state tax rate. Because states with high income taxes typically have single-state muni bond funds that pay income exempt from state taxes.
Let's start with the yield on the municipal investment you're considering. There are hundreds of California muni bond funds, divided by fund tracker
into four categories: long-term, intermediate-term, short-intermediate term and insured. There are even a handful of high-yield California funds sprinkled among the long- and intermediate-term funds. (Please see the related stories below for guidance on which type is for you.)
Assuming you don't start out with a particular fund in mind, you need a general idea of how much funds in each category are yielding. Unfortunately, despite the wealth of mutual fund information now available on the Web, it's still not yet easy to get this kind of information yourself -- unless you work in a newsroom with a Lipper machine, like I do. According to Lipper, here are the median yields as of May 31 for retail funds in each California category:
- Long-term: 4.53%
Short-intermediate term: 3.69%
The highest-yielding California high-yield fund on May 31, the broker-sold
Franklin California High Yield Municipal, had a 12-month yield of 5.49%.
Now, you need a general idea of how much comparable taxable funds are yielding. Here, things start to get a little sticky. What's really comparable to a muni bond fund on the taxable side? Treasuries? They're considered risk-free. Corporates, on the other hand, are arguably riskier than comparably rated munis, since unlike corporations, municipalities don't generally ever close up shop. (Orange County, Calif., defaulted in December 1994, but bondholders ultimately got paid.)
So, recognizing that not everyone will agree that these categories of taxable funds can compare with the muni categories we're looking at, here are some median yields for retail funds as of May 31:
- Corporate BBB (at least 65% investment-grade, comparable to long-term): 5.95%
Intermediate-term investment grade: 5.53%
Short-intermediate investment grade: 5.40%
General U.S. government (comparable to insured): 5.54%
High yield: 9.21%
Now you need the equation that will tell you whether taxable yields are high enough for you, or whether munis will ultimately pay you more. There are a couple of different ways to look at it. You can either divide the tax-exempt yield by one minus your marginal tax rate (or your combined tax rate, if your state has an income tax and you're looking at a single-state bond fund) to calculate the taxable-equivalent yield:
- tax-exempt yield /(1 - marginal tax rate) = taxable-equivalent yield
If the taxable-equivalent yield is higher than what taxable investments are paying, you will prefer the muni. If not, you'll prefer the taxable.
Or you can multiply the taxable yield times one minus your marginal tax rate to get the after-tax yield:
- taxable yield * (1 - marginal tax rate) = after-tax yield
If the after-tax yield is lower than what the muni investments are paying, you'll prefer the muni. If it's higher, you'll prefer the taxable.
Say your marginal federal tax rate is 31% and your state tax rate is 9.3% for a combined rate of 40.3% (unless you deduct your state tax payment on your federal return, in which case your combined rate is 31% +
9.3% - (9.3% * 31%) = 37.4%).
High-yield taxable bonds would give you an after-tax yield of 5.50%, almost exactly comparable to what Franklin's fund is paying. But for investment-grade bonds, the choice would be clearer. The after-tax yield on the intermediate-term corporates would be 3.30%, making the munis more attractive
your combined tax rate is around 40%. If it's lower, that might not be the case. You need to do the math yourself.
Assuming you want a muni bond fund, pick one with a low expense ratio, since expenses have an enormous effect on the performance of relatively staid bond funds. Again, the information on what constitutes a reasonable expense ratio for a particular class of funds isn't easy for individual investors to get their hands on.
Here's a bit of guidance courtesy of Lipper. The median expense ratios for retail long-term California muni funds is 0.99%, but you can pay far less than that, and the lowest-cost funds have tended to be the best performers over time.
USAA California Bond charges 0.40% (and is also free of bonds subject to the alternative minimum tax -- our
Bonds Primer explains why you might care) and
Schwab California Long-Term Tax-Free Bond charges 0.49%. Sporting a relatively high minimum investment of $10,000,
Fidelity Spartan California Municipal Income charges 0.54%.
American Century California High-Yield Municipal also charges 0.54%. Those four funds are the best performing no-loads over the three-year period ended Dec. 31, 1998.
A couple of load funds are even cheaper. The Franklin high-yield fund's expense ratio is just 0.35%, and
Delaware-Voyageur Tax-Free California
fund charges only 0.22%.
Back-end-load and level-load muni funds generally have much higher expense ratios than no-load or front-load shares. I'd steer clear.
In the intermediate category, no-load
Vanguard California Insured Intermediate-Term Tax-Exempt is the best value by a long shot at just 0.19% (the category median is 0.73%). Don't want an insured intermediate fund? Might as well. The next cheapest intermediate fund has a 0.31% expense ratio and a lower yield. Vanguard also offers the lowest-cost insured fund,
Vanguard California Insured Long-Term Tax-Exempt, also charging 0.19% (the category median is a staggering 1.37%).
Among short-term California funds (median 0.87%), the lowest-cost offerings are
Schwab California Short/Intermediate Tax-Free Bond (0.49%) and
American Century California Limited-Term Tax-Free (0.52%).
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TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.