Chapter 15
Moving Beyond Basics into Municipal and Foreign Bonds
IN THIS CHAPTER
Finding tax-free interest in your bond portfolio
Exploring bonds beyond U.S. borders
Understanding how currency hedging works
Choosing ETFs that resemble individual bonds
Every investor needs bonds. Not every investor needs municipal bonds or foreign bonds. But for higher-income investors who find themselves in the northern tax zones, municipal bonds, which pay interest exempt from federal income tax (and possibly state and local income tax as well), can make enormous sense. For those with larger bond portfolios, the added diversification of foreign bonds is something to consider very seriously.
Municipals for Mostly Tax-free Income
Historically, municipal bonds have yielded about 80 percent of what Treasury bonds of similar maturity yield. As I write these words, the two kinds of bonds have yielded about the same recently — mostly due to Treasuries paying less and less. But that’s on a before-tax basis. After taxes, you will likely do better with munis, even if you’re not in the highest tax bracket. If you are in the highest tax bracket, you will likely do much better with munis…assuming the munis you buy don’t default.
In fact, munis rarely do default. And the broad diversification offered by certain municipal ETFs makes any serious loss of principal due to defaults even less likely (but not impossible, by any means). Still, muni ETFs are riskier than Treasuries, and riskier than agency bonds. You don’t want your entire portfolio in munis.
To figure out the tax-equivalent yield on a muni or muni fund, you may want to visit one of the gazillion tax-equivalent yield calculators on the Internet. One of my faves is on www.dinkytown.net. Click Investment Calculators in the column on the far left of your screen. Then click Municipal Bond Tax Equivalent Yield. You’ll figure it out from there.
You can also figure out the tax-equivalent yield with pencil and paper. You start with the reciprocal of your tax rate, which is nothing more than your tax rate subtracted from 100. If you pay 30 percent in taxes, then the reciprocal of your tax rate is 70 (100 – 30). Next, you multiply the interest rate that the muni bond (or ETF) is offering, and you divide it by the reciprocal. Thus, if you had a muni bond paying 2.5 percent, you would divide 2.5 percent by 70. This would give you 3.57. That’s what you’d have to earn on a taxable bond to get the same after-tax return as you would with the 2.5 percent muni.
Take a tour of 50 states
In this section, I highlight a few national muni ETFs — that is, funds that offer munis from across the land. You’ll find national muni ETFs issued by iShares, Invesco, Vanguard, SPDRs, PIMCO, VanEck, First Trust, and others.
If you live in a state with high income taxes, such as New York or California, and you’re in a high tax bracket, you may want to investigate state-specific muni funds. When you buy muni funds that are specific to your home state, you exempt yourself from having to pay not only federal income tax on the interest, but often state income tax, and potentially local income tax, as well.
At present, you’ll only find a handful of state-specific muni ETFs, all designed for wealthier-than-average New Yorkers or Californians. (Both these states have high taxes, and they offer the largest potential number of investors.) I expect that over time, more state-specific munis will hit the stage, but for now, if you live in a state such as Pennsylvania, New Jersey, Colorado, Georgia, or Connecticut, you may have to go with a mutual fund if you want these tax-free darlings. (See Chapter 25 for more information.)
Vanguard Tax-Exempt Bond ETF (VTEB)
Indexed to: The S&P National AMT-Free Municipal Bond Index, featuring 5,900 individual bonds issued by municipalities across the nation. (California and New York bonds make up 35 percent of the total.)
Expense ratio: 0.06 percent
Current yield: 0.82 percent
Average credit quality: AA
Average duration: 4.6 years
Russell’s review: If you are going to own one national muni fund, this is a darned good choice. The intermediate-term duration is where you want your muni portfolio to be. High-credit quality, which this fund delivers, is a must. With interest rates so low these days, the top performers moving forward are going to be those with the lowest cost, and Vanguard, as is typical, offers the lowest-cost option in the land. Importantly, all of the bonds in this portfolio are AMT-free. AMT stands for alternative minimum tax, and if you are rich enough to know what that is, you are likely aware that the AMT can cost you.
iShares National Muni Bond ETF (MUB)
Indexed to: The ICE AMT-Free U.S. National Municipal Index, which includes investment-grade municipal bonds from almost all 50 states (California and New York bonds make up 42 percent of the total), as well as allowing for investments in U.S. territories. There are 6,850 constituent bonds in the index.
Expense ratio: 0.07 percent
Current yield: 0.77 percent
Average credit quality: AA
Average duration: 6.2 years
Russell’s review: This fund was the first muni ETF on the U.S. market, and it still remains extremely popular. It is free of the AMT (alternative minimum tax), which is a decidedly good thing if you derive a lot of income from tax-free sources. Its long-term return is lower than that of the Vanguard ETF (a five-year return of MUB is 2.85 percent versus VTEB’s 3.08 percent), but that’s most likely because the iShares fund was significantly more expensive in previous years. Now that iShares has dropped the expense ratio to within an angel hair of Vanguard’s, I expect that the returns moving forward will be very close. (By the way, “ICE” in the fund’s name does not stand for Immigration and Customs Enforcement or In Case of Emergency! It stands for Intercontinental Exchange, Inc., a relative newcomer to the indexing business.)
Foreign Bonds for Fixed-Income Diversification
Over the long haul, U.S. and foreign bonds of similar default risk and maturity will likely yield about the same returns. But in the short run, substantial differences can exist in the yields and total returns of U.S. versus foreign bonds.
Note that as is the case with U.S. bonds, international bonds can be of the conventional type or inflation-adjusted. Whereas I believe strongly that U.S. inflation-protected bonds deserve an allotment in most portfolios, foreign inflation-protected bonds just don’t make as much sense (unless you plan to retire abroad or take a lot of senior world cruises). Nevertheless, for the sake of added diversification, if you want to add a small dose of inflation-adjusted foreign bonds to your portfolio, I won’t object.
Foreign bonds, just like U.S. bonds, can also be issued by governments or corporations. Unless you choose to have an exceptionally large allocation to foreign bonds, I feel the best foreign-bond funds for most American investors would include a mix: corporation bonds for higher yield, and government bonds (provided the government is solid, like that of Germany or Sweden versus, say, Venezuela) for security.
And finally, foreign bonds, unlike U.S. bonds, can come either currency hedged or currency unhedged. I prefer hedged, and I explain why in the sidebar, “Currency hedged or unhedged?”
Vanguard Total International Bond (BNDX)
Indexed to: The Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD hedged), government and corporate bonds — about 6,300 of them — from all corners of the globe, although 95 percent of the bonds are from developed nations
Expense ratio: 0.08 percent
Current yield: 0.44 percent
Average credit quality: AA
Average duration: 8.4 years
Top five countries: Japan, France, Germany, Italy, United Kingdom
Russell’s review: This is the complete package, offering high-quality bonds, great diversification, dollar hedging, and a very reasonable expense ratio. You’ll note that the current yield is only 0.44, much lower than the Vanguard Total (U.S.) Bond Market ETF (BND), which has a current yield of 1.34 percent. But current yields can be like tropical storms, changing dramatically from moment to moment. The five-year returns of BND and BNDX are almost identical.
iShares International Treasury Bond ETF (IGOV)
Indexed to: FTSE World Government Bond Index — Developed Markets Capped
Expense ratio: 0.35 percent
Current yield: 0.05 percent
Average credit quality: AA
Average duration: 9.22 years
Top five countries: Japan, France, Italy, Germany, Spain
Russell’s review: Yes, this foreign government bond fund has a similar credit quality to Vanguard’s (foreign government and corporate) BNDX. But I would say that this fund’s average credit quality is more at the high end of the AA spectrum, and BNDX may be at the lower end. Both are unlikely to lose your principal; however, both will be fairly volatile (by bond standards) because of the interest-rate risk that factors into all longer term–duration bonds. The five-year return on this fund is 1.22, quite a bit less than BNDX’s 2.83.
SPDR FTSE International Government Inflation-Protected Bond ETF (WIP)
Indexed to: The FTSE International Inflation-Linked Securities Select Index — inflation-linked bonds of both developed and emerging-market nations, similar in nature to U.S. TIPS
Expense ratio: 0.50 percent
Current yield: 0.30 percent + inflation bump
Average credit quality: From A to Aa
Average weighted maturity: 11.7 years
Top five countries: United Kingdom, France, Brazil, Italy, Mexico
Russell’s review: Not for everyone. In fact, unless you are planning to retire outside of the United States, or you drink a heck of a lot of coffee, you really don’t need to be very concerned with the inflation rate in Central or South America. If you are planning to retire abroad, then okay, you might consider this fund. But do be aware that the expense ratio is pretty high. And the credit quality is lower than either of the other two foreign-bond funds (BNDX and IGOV) introduced earlier. This is because the fund does invest in countries in South America, where the governments are not as stable as those of, say, Scandinavia.
Invesco International Corporate Bond ETF (PICB)
Indexed to: The S&P International Corporate Bond Index, which tracks the ups and downs of 685 corporate bonds issued by non-U.S. investment-grade issuers
Expense ratio: 0.50 percent
Current yield: 0.45 percent
Average credit quality: From A to BBB
Average duration: 7.0 years
Top five countries: United Kingdom, France, Canada, Germany, Spain
Russell’s review: Yes, these are “investment-grade” (versus junk) bonds, but a good number of them barely make the grade. You’re taking considerably more credit risk with this fund than you are with any of the other funds I introduce in this section, so you’d expect a high return. In the past five years, this fund has returned an average 3.82 percent a year. That’s higher than most other international bond funds, but is it worth the added risk? I’d be more tempted to say yes if this fund had a lower expense ratio. But even then, my belief is that bonds are for ballast, for safety, and that high returns should come from the stock side of your portfolio. Nonetheless, if you really want a sliced and diced portfolio with many moving parts, you might consider foreign corporate bonds.
Emerging-Market Bonds: High Risk, High Return
I don’t like U.S. high-yield (“junk”) bonds. They tend to be highly volatile, and they tend to move up and down with the stock market. In other words, they don’t provide much of the diversification power or soft cushion that bonds are famous for. Foreign junk bonds are a little different. These bonds, issued by the governments of countries that may not be entirely stable, may be just as volatile as bonds issued by unstable U.S. corporations, but they do not necessarily go up and down with the U.S. stock market (although they certainly may at times — and did so in 2008).
For reasons of diversification, investors with fairly good-sized portfolios may want to consider allocating a modest part of their portfolios to emerging-market debt. In my personal portfolio, I have allocated 4 percent of the total to this asset class. Note that I’m not referring to “my bond portfolio” but to my “portfolio.” I actually think of my holdings in emerging-market debt as more of a stock-like investment than a true bond investment. After all, you’re likely to see stock-like volatility and long-term stock-like returns with these investments.
The first emerging-market ETF, the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), came into existence in December of 2007, and has seen a total return since inception of almost 6 percent. The T. Rowe Price Emerging Markets Bond (mutual) Fund (PREMX) has been around since December of 1994, and has a return since inception of 9.3 percent. But there has been volatility, for sure: In 2008, while stocks were tanking (nearly 50 percent over the course of the year) and sedate U.S. Treasuries were more than holding their own, emerging-market bonds were foundering — at one point, losing about 30 percent of their value.
Vanguard Emerging Markets Government Bond (VWOB)
Indexed to: The Bloomberg Barclays USD Emerging Markets Government RIC Capped Index. Vanguard includes a representative sampling of 730 of the Index’s 959 bonds.
Expense ratio: 0.25 percent
Current yield: 3.7 percent
Average credit quality: About half of the bonds are below Baa and half are above Baa on the Moody’s scale. In other words, half are junk bonds.
Average duration: 8.4 years
Top five countries: Mexico, Saudi Arabia, Indonesia, Turkey, United Arab Emirates
Russell’s review: This is yet another Vanguard “best in class” with a low expense ratio and excellent diversification. If you come to Vanguard for exposure to emerging-market bonds, you won’t be disappointed (unless emerging-market bonds, as a whole, take a nosedive).
SPDR Bloomberg Barclays Emerging Markets USD Bond ETF (EMHC)
Indexed to: The Bloomberg Barclays USD Emerging Markets Government RIC Capped Index. State Street Global Advisors includes a representative sampling of 386 of the Index’s 959 bonds.
Expense ratio: 0.23 percent
Current yield: 3.7 percent
Average credit quality: About half of the bonds are below Baa, and half are above Baa, on the Moody’s scale. Yes, you are taking some credit risk.
Average duration: 8.4 years
Top five countries: Mexico, Saudi Arabia, Indonesia, Turkey, United Arab Emirates
Russell’s review: This fund is very similar to Vanguard’s VWOB. It has a slightly lower expense ratio, but you get less diversification with a far smaller representative sampling of the same index. I’d go with Vanguard, but choosing EMHC would be perfectly reasonable.
iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB)
Indexed to: The JPMorgan EMBI Global Core Index. EMB uses 547 bonds in the index, all U.S. dollar–denominated, from more than 30 emerging-market nations.
Expense ratio: 0.39 percent
Current yield: 3.7 percent
Average credit quality: From BB to BBB, right on the cusp of “investment-grade” and “junk”
Average duration: 8.6 years
Top five countries: Mexico, Indonesia, Saudi Arabia, Qatar, United Arab Emirates
Russell’s review: The expense ratio is a bit high for my liking, but certainly not ridiculous. The iShares fund, the first ETF to tap this asset class, is okay but not the best way to tap into emerging-market bonds. That would be either with Vanguard or State Street SPDRs.