Strategies

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.

2008-03-26_munivstreasury-w480.png

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:

http://www.diehards.org/forum/viewtopic.php?t=15385&mrr=1206592981

The Risk of Individual Stocks

There are two rather enlightening posts on the Bogleheads forum today. Both dealt with the risk of holding individual stocks but from different angles: one from the employee viewpoint, the other from the “mad” or “fun” money viewpoint.

(1) The danger of holding company stock – by Taylor Larimore

Last year investment bank Bear Stearns stock was valued at $170/share. I doubt if anyone anticipated that today the stock would be worth only $2/share. How does this affect its 14,153 employees?

According to the Wall Street Journal, “The pain could be most acute for Bear Stearns’s (14,153) employees, who are steeped in a culture of personal ownership, and hold about a third of the firm’s shares outstanding.”

Bogleheads often warn newbies about the danger of overloading their portfolios with company stock. What’s happened at Bear Stearns is a good example.

(2) Managing your “Gambling” Money Allocation – a reply by hollowcave2

I am going to come clean today just to cleanse my soul and perhaps someone else can learn from my experience.

I had a 5% allocation in a mad money account that had 5 individual stock holdings. Not a big amount of money to each holding, 1 to 2% each. I was doing pretty good. I was beating the market in this small account and getting some good gains. I was getting pretty confident. I wondered why I had 95% in my fund holdings.

Well, unfortunately, Bear Stearns was one of the holdings. I really hate to post this, but I guess I just need some therapy. I thought it offered a compelling buy last week when it traded around $50. So I actually got 100 shares.

Well, you know what happened. This evens out my gains from the rest of the year.

I have a very high risk tolerance, but this experience really rocks my emotions. It makes me rethink my entire investing life. I never experienced such a loss in a matter of 2 days. It is definitely the worst investing mistake of my life.

So I hope to learn from the experience, and one of the things to learn is single stock risk. I”ve always known the risk, in theory. But to really experience it is something else. Life is a good teacher.

Both posts carry a great lesson for all investors — the risk of individual stocks should be avoided whenever possible.

Tax harvesting from 529 plan?

If you started contributing to a 529 plan some time in 2007, the chances are that the plan is in the RED (with capital losses) due to the recent stock market conditions.

A thought came to my mind — since unqualified distributions from the 529 plan are taxable, is it possible to tax harvest from the 529 plan?

I asked this question on the Bogleheads forum, and here’s a reply from LH2004 (who had previously demonstrated to have very good knowledge on tax matters):

Yes. See “Losses on QTP Investments” in Publication 970. You’ll be subject to the 2% of AGI floor, though, so you’ll need to have really extreme losses, or a big account, or low AGI, or other miscellaneous itemized deductions to reach that floor.

Alternatively, under the IRS’s new theory regarding wash sales, you could take the position that a sale of an individual portfolio in the 529 plan at a loss, followed by a purchase of a substantially identical fund in your taxable account, is a wash sale, increasing your basis in the newly-purchased fund, which you could then immediately sell at a loss; that would be an aggressive position to take.

Taylor Larimore kindly found the link to the relevant section in Publication 970 — http://www.irs.gov/publications/p970/ch08.htm :

Losses on QTP Investments

If you have a loss on your investment in a QTP account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23, subject to the 2%-of-adjusted-gross-income limit.

If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts.

At this point, it doesn’t look like something I would do.