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Shining a Light on the Muni Bond Portfolio


Most everyone I have ever met who is in a high tax bracket wants Municipal Bonds to be part of their portfolio. Unfortunately there are a number of misperceptions about Muni Bonds that cause people to make investments in them that are not necessarily in their best interest. This article explores how investors typically build Muni Bonds portfolios and the often-excessive fees they pay for such services. We also show how an ETF-based Muni Bond portfolio might be a superior approach when evaluated from the perspective of its impact on an entire diversified portfolio.

Bond Ladders

Most people are sold Muni Bond portfolios in what is known as a bond ladder. A ladder consists of a diversified portfolio of bonds that mature at a constant rate and has an average maturity that fits your particular needs. All bonds in a laddered portfolio are held until maturity no matter what happens to interest rates. For example 1/12th of your portfolio should mature every six months if you want a bond portfolio with an average maturity of three years. The higher the average duration of your portfolio the higher your sensitivity will be to interest rate changes. For example, a 1% change in interest rates will have a 10% impact on the value of a 10-year average-duration portfolio and only a 3% impact on the value of a three-year average-duration portfolio. In most cases the longer the average maturity, the higher the average yield. However if you’re worried interest rates will rise in the future then you will be better off with a short duration portfolio until you feel rates have leveled off. At that point in time you can extend the duration of your portfolio by buying more longer-term bonds.

The beauty of a laddered bond portfolio is what our advisor Meir Statman calls Mental Liquidity.  It feels great to know that current market losses on the bonds in your laddered portfolio will ultimately disappear when they mature. You never lose money if you hold all your bonds to maturity. Unfortunately that’s false economy because your laddered portfolio will lose buying power if interest rates rise.

Fees and markups, the true cost of a managed bond ladder

Most people think they pay a very low fee to have a portfolio of Muni Bonds managed for them, but looks may be deceiving.  To understand why we must first understand the difference in the way Stocks and Muni Bonds trade.

Brokers and financial advisors charge for the service of building a bond ladder in one of two ways, a wrap fee or a commission. A wrap fee is an annual fee based on your assets under management. In no case should you ever pay both.

Stocks are traded through perhaps the most automated market in the world.  When you place an order to buy a stock (or ETF), the order is immediately routed to every broker/dealer who makes a market in that stock so they can bid on fulfilling your order. This incredibly efficient market arbitrages out any excess profit one market maker (dealer) might try to charge for the same stock over another market maker.  The result is you can usually count on getting the best price possible when you buy a stock.

The Muni Bond market is not nearly as automated or efficient. Unlike Stocks, Muni Bond prices are not displayed in one central location. It requires significant work for a broker to find the best price and each transaction is a negotiation. As a result, two purchasers of the same bond may pay very different prices depending on from which dealer they were purchased. The difference in prices paid results from different dealer markups charged by different market makers. This is enabled by Munis’ significant bid/ask spread, which can be as high as 2% of the current market value of a bond. There is no way for a consumer to tell if she got the best price because the dealer markup is embedded in the price you pay.

Brokers and financial advisors charge for the service of building a bond ladder in one of two ways, a wrap fee or a commission. A wrap fee is an annual fee based on your assets under management. In no case should you ever pay both.

I have found that many people who benefit from selling a large chunk of stock for the first time want to start their investment portfolio with only Muni Bonds because they are perceived as a low-risk investment. If you are willing to commit at least $2 million to $5 million, private wealth managers will be happy to create a ladder for you in return for an annual wrap fee of 0.10% to 0.50% depending on the size and maturity of your portfolio. Brokers and financial advisors who charge a wrap fee are generally subject to the fiduciary standard, which means they are legally required to find you the best possible investment that meets your needs. In this case that translates to the bond with the lowest dealer markup.

Your annual wrap fee will often increase to something greater than or equal to 1% if you choose to have your wealth manager broaden her mandate to manage a diversified portfolio of stocks and bonds. The new higher fee is not only applied to your stock holdings, it will also be applied to your bonds. You should therefore think of the initial bond-only fee as the equivalent of a teaser fee, comparable to how a cable company gives you a special deal for the first six months of service.

Brokers who charge commissions rather than a wrap fee are held to the lower suitability standard. Unlike the fiduciary standard, the suitability standard only requires a broker to purchase what is suitable (i.e. not necessarily what is best for your needs).  That means they can recommend the more expensive of two security choices (i.e. the one that offers them a higher margin) as long as both of the choices are suitable investments. Commission-based brokers generally first look to sell you bonds out of their firm’s bond market making inventory which means you are highly likely to pay much larger dealer markups. And you will pay a commission as well!

Generally speaking the wrap fee is a better deal, which means you pay very high dealer markups when you choose what appears to be the lower-cost commission deal.  This should not surprise you when you consider your broker needs to make the same amount of money per unit of time on the two choices she offers you. Like most financial services, your true cost is not always apparent.

Muni Bond ETFs as an alternative

The alternative to buying a Muni Bond ladder is to buy a Muni Bond ETF.  The most popular Muni Bond ETF is the iShares National AMT-Free Muni Bond ETF (Ticker: MUB). It tracks the S&P National AMT-Free Municipal Bond Index®, which measures the performance of the investment-grade municipal bond segment and encompasses all maturities. Its popularity stems from its market leading annual management fee of 0.25% and its superior liquidity. The management fee on MUB is likely lower than what you will be charged by a broker or financial advisor unless you have at least $5 million to invest in Muni Bonds. You should also benefit from the lowest possible dealer markups because of the market power of the fund’s manager, iShares’, a subsidiary of BlackRock, the world’s largest asset manager. In other words, the managers of MUB have much more negotiating power over the dealers than your broker will have when placing trades for your $100,000 account. The dealer markups charged to an institutional money manager will likely be 1/10th to 1/100th that charged to individuals. As a result, the total cost should be vastly lower than what you would ultimately pay in terms of fees and dealer markups in a personal laddered bond portfolio.

The downside of owning MUB is that unlike a laddered Muni Bond portfolio, which consists of securities that are exempt from both federal and state income taxes, MUB is only exempt from federal taxes. You still need to pay state income taxes on the portion of the ETF’s returns that result from bonds issued by states other than the one in which you live.

You might be surprised to learn how small an impact the loss of the state tax deductibility has on your overall portfolio return.  Let me use an example to illustrate this point (see table below).  We’ll assume that our client lives in California and has a Risk Tolerance of 8 on a scale of 0 – 10 (our typical Wealthfront client).  A Risk Level of 8 results in a 13% allocation to Municipal bonds.  On a $100,000 portfolio that represents a $13,000 investment in MUB.  The current yield on MUB is 2.51%, which generates income of $326 per year.  The state taxes due at a 12.3% marginal state income tax rate is only $40 per year.

Here’s a chart to help illustrate this scenario:

Portfolio Size $100,000
Muni allocation % 13%
MUB allocation $13,000
MUB Yield 3%
Yield in Dollars $326
State Tax rate 12.3%
State Taxes owed $40
State Taxes as a % of Portfolio Value 0.040%

That extra state tax payment is only 0.04% of your portfolio, which I bet is a far smaller cost than you expected.  The difference is even smaller at a lower tax rate or if you live in a state that allows you to exclude that portion of your income attributable to Muni bonds held from your state (please see MUB’s overview page for the remainder of its portfolio composition).  Unfortunately California doesn’t allow you to exclude income attributable to California bonds unless California bonds comprise at least 50% of the portfolio, which is not the case with MUB.

A second downside to MUB is that it restricts its holdings to issues which were at least $100 million or larger at the time of original issue. It therefore does not give exposure to smaller municipal bond issues, which might have more attractive yields. And finally MUB’s average duration is 6.58 years. As a result MUB will tend to lose about 6% of its value if interest rates rise by 1%. This may be a longer duration than you would like, but you have no choice because it’s an ETF.

Benefits of using an ETF over a laddered portfolio

There are a couple of things you can do with Muni Bond ETFs to improve the tax efficiency of your overall portfolio that are not possible with laddered bond portfolios. For all practical purposes it’s only feasible to do daily tax-loss harvesting with ETFs or US stocks. It’s just not feasible to do daily asset class level tax loss harvesting on a laddered portfolio in software given the complexities of the Muni Bond market outlined above.

It’s also not feasible through software to use interest from a laddered Muni Bond portfolio to more tax efficiently rebalance your overall portfolio.

Ladders for the few, for most everyone else ETFs make more sense

A laddered Muni Bond can be a compelling investment. However we believe a Muni Bond ETF’s ability to facilitate daily tax-loss harvesting and dividend reinvestment-based rebalancing can make it a superior option even though an ETF is inflexible with regards to duration and offers limited state income tax deductibility.  We appreciate this is a very different perspective than what you might hear from a traditional advisor, but keep in mind they are highly unlikely to be able to perform daily tax-loss harvesting or dividend-based rebalancing. We welcome your questions and comments.

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Disclosure

Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.

This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.

Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.

The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.

A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at 844-995-8437. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.

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About the author(s)

Andy Rachleff is Wealthfront's co-founder and Chief Executive Officer. He serves as a member of the board of trustees and chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. View all posts by Andy Rachleff