Muni’s as safety anchor in portfolio

After the abnormal behavior of muni funds near the end of Feb 2008, I had reservations about the recommendation of using muni funds as the safety anchor of a portfolio. It appears that because muni bonds are relatively illiquid, their prices (NAV) could be quite volatile, as evidenced by the price drops when hedge funds were allegedly dumping them last month.

Usually you would hope that bond prices would hold up when equity prices were dropping; and this was indeed the case for treasury bonds. But not for muni bonds: their prices were dropping along side with the equity markets last month. The divergence of muni bonds from treasury bonds can be observed from the figure below.


The figure above shows that from the middle to the end of Feb 2008, the Vanguard Intermediate Tax Exempt fund (duration 5.5yr, average quality AA+) and Vanguard Intermediate Treasury fund (duration 4.9yr, average Aaa) were on a diverging path as equity markets were falling.

If an investor had held treasury bonds in the portfolio as a safety anchor, the portfolio would have held up much better than another investor using muni bonds, even though the muni bonds were also of very high credit quality. Fortunately, the prices of muni bonds have recovered somewhat (but not fully) in March.

The above occurence could be just an one time event or it could happen again with a longer duration. Nobody knows for sure. But if muni funds are intended to be the safety anchor of a portfolio, I think it is prudent for the investor to remember that the relative illiquidity of muni bonds could magnify their price fluctuations from any major trading activity, and thereby possibly resulting in undesirable price movements.

Related information:

I also posted the above view on the Bogleheads forum in a post/poll. This is reproduced below:

Time to re-think muni’s as safety anchor?

For many people, the fixed income or bond portion of the portfolio is designated as the safety anchor of the portfolio during market turbulence (basically Larry’s viewpoint, not Rick’s).

The recommendation has been to use very high grade and short term debt instruments like treasury bond funds or even VG’s invest-grade bond funds. And for investors in high tax brackets, it has been generally recommended to use municipal bond funds.

However, the recent municipal bond turmoil shows that muni’s are not working as they should. Just as you hope municipal bonds can help soften the losses on the equity side, it does exactly the opposite, tanking along with equities.

Is it time to re-think the usage of municipal bond funds as part of the safety anchor?

It seems that the fact that the municipal bond market is rather illiquid and often subject to hedge fund’s trading activities might make municipal bonds unpredictable during market turmoil.

What do you think?

The poll result shows that most (currently 32 out of 34 votes) people do not think that there is need to rethink about whether muni bonds are good options as a portfolio’s safety anchor. It appears that my view belongs to the minority only.

PS. For an investor looking for income in bonds (as opposed to a safety anchor), then NAV drops might not of major concern.

For my own reference:

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