Ask The Expert with Larry Swedroe, December 2008 Issue

By Larry Swedroe, on December 3, 2008

This is the 11th issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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Question from Joyce K:

Larry, can you explain to me what “insured” means in regards to bond funds, in particular FRCIX. I’ve called my broker and at best get an ambiguous answer. I doubt anyone there knows. My husband and I are in our 60’s and have half of our savings invested in this fund. It gave a reasonable tax free return with minimum risk. Or so I thought. We are quite worried. The fund is currently at $11.21 and we bought in at $12.69. The math is ugly.

Joyce,

The following is a brief description of the fund. The investment seeks to provide as high a level of income exempt from federal income taxes and California personal income taxes. The fund invests at least 80% of net assets in insured municipal securities. Generally, it buys insured municipal securities only if they are covered by policies issued by AAA-rated municipal bond insurers. The fund may invest up to 20% of net assets in securities that pay taxable interest, including interest that may be subject to the federal alternative minimum tax.

There are some problems with a fund like this that you should be aware of. First, as stated above, funds like this will often buy bonds subject to the Alternative Minimum Tax (AMT). This is a problem for those investors that are subject to that tax as it results in lower after tax returns. Thus, if you are subject to this tax you probably should avoid any fund that allows such purchases. Some funds do not buy AMT bonds. The reason funds buy such bonds is to boost their reported yields (to offset some of the negative tax implications these bonds the markets require these bonds to provide a higher yield). Funds take advantage of naive (uninformed) investors in ways like this. Similarly, they often buy longer bonds, that take more interest rate risk, to boost the reported yield.

The second problem is that investors should not buy bonds based on the insured rating, which is what this fund, and probably most if not all funds do. My firm has a policy that we only purchase bonds based on the underlying credit rating of the issuer. The reason is that if a few municipal bonds default the insurers will have sufficient capital to pay off the debt. The problem is that if many default they will not. Thus, the insurance can be worthless just when it is needed most — during a financial crisis and all financial assets are getting hit.

One reason the fund has done poorly is that the market sees through the insured rating and looks to the underlying rating now that the insureds have all seen their credit ratings downgraded, a risk that was always there but most investors ignored. These risks are one reason we generally avoid owning municipal bonds inside of mutual funds. We only use mutual funds for those investors with a small amount to invest as we need the fund to provide sufficient diversification. For those investors with more than about $500,000 we buy individual bonds. That amount allows us to sufficiently diversify the credit risks. And we only buy bonds with credit ratings of AAA/AA and the rating without insurance cannot be more than one grade below the insured rating. And we will only buy A bonds if the maturity is very short as credit risk increases with maturity.

Also I believe that fixed income is not the place to take risks in search of higher returns.The place to do that is on the equity side where the returns can be earned in a more tax efficient manner and the risks can be more effectively diversified. Fixed income should serve as the safety net for the portfolio, lowering the overall risk of the portfolio to an acceptable level. Thus, we avoid all risky fixed income assets such as high-yield bonds, preferred stocks, convertible bonds, emerging market bonds and especially what are called the “structured note” products offered by Wall Street (such as Reverse Convertible and Super Track Notes). To learn more about alternative investments like these read The Only Guide to Alternative Investments You’ll Ever Need.

Unfortunately, there are problems for individual investors. The first is that they need funds to obtain sufficient diversification. Second, the secondary market (bonds traded after issuance) is expensive to trade in for most investors due to opaqueness of pricing. We typically see broker dealers adding spreads of as much as 2-6% on purchases and sales. Again, that makes funds attractive as they get wholesale prices when they buy and sell. But funds also have problems like the AMT issue and state specific funds lose the benefits of diversification across states (and the benefit of the local deduction should be weighed against the credit risks of having all your eggs in one state’s credit risk). Further, there is no way for investors to know the underlying credit rating of the bonds held in their fund, and that is extremely important as investors are now learning.

There are a few investment advisory firms like mine that buy individual bonds based on the underlying credit ratings and obtain wholesale-like pricing because we have scale. We buy over $2 billion in bonds a year for our clients. If you don’t work with such an advisor there is still a way to address the issue of the underlying credit and that is to buy individual bonds at issuance and diversify the risks across issuers. You have to establish a relationship with a broker dealer, but that should not be hard to do. But you also will have to be able to buy and hold to maturity the bonds because if you have to sell them prior to maturity the trading costs are likely to be quite high as indicated above.

The bottom line, unfortunately, for many individual investors is that they may not have a lot of great choices. Funds can have problems as stated above and unless they have sufficient assets to build a diversified portfolio themselves there are not great alternatives.

A few other thoughts. Municipal bonds have in general become more risky because of the state of the economy. Their budgets are getting hit on both sides due to reduced tax revenue and increased demand for social services. Thus, there will likely be an increase in defaults, especially in certain sectors that should be avoided–housing, health care and industrial development (significantly more risky). Having said that, even during the Great Depression AAA/AA rated municipal bonds performed quite well.

If you want to learn more about fixed income investing in general read The Only Guide to a Winning Bond Strategy You’ll Ever Need. It has a full chapter on municipal bonds.

Finally I offer these words of advice:

1. I know the benefits of the triple tax exemption for the State of California bonds are attractive due to the high tax rate, but you might want to consider diversifying that risk, giving up a bit of yield to reduce risk.
2. Given the problems with a fund (and its expenses-personally I would never buy this fund with its very high expense ratio of 0.61%) and the current very high yields on Treasury Inflation-Protected Securities (TIPS) (exempt from state and local taxes though not Federal) you may want to consider buying TIPS instead and they would protect you from the risks of inflation. I know you lose the Federal Tax exemption but it might be worth it. You can calculate the break even inflation rate based on your tax rate. But remember, TIPS have no credit risk whatsoever, your bond fund does.
3. If you are going to buy a fund, I don’t know why anyone would buy this fund with a 0.61% expense ratio and an upfront load — both absurdly high. You can buy Vanguard funds with much lower expenses (0.15% and no load). So whatever you do get rid of this fund.

I hope the above has been helpful.

Question from S.:

Larry, I took early retirement 2 yrs ago (age 56). I left all my 401K in equities in order to let it grow faster. Now I have lost about 25% and am wondering if I leave it where it is and wait it out or put it all in fixed or mix it up. If nothing major happens in my life (my husband is still working) I am not planning on using this until it is required. Thank you.

It is very hard to answer a question like this without more information. But let me make a few comments.

The first bit of advice is that if you don’t have a financial plan, get one done immediately. The overall plan should include an investment plan that has an asset allocation table in it that lays out the investment strategy — how much equities and how much bonds, and how the equities will be diversified by asset class (how much domestic and how much international and emerging markets and real estate, and large cap vs. small cap and value vs. growth).

Your plan should make sure it does not entail taking more risk than you have the ability, willingness or need to take. My book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, has tables in it to help you do just that, and it also shows you how to manage the portfolio over time (e.g., disciplined rebalancing). And make sure the financial plan integrates estate, tax and risk management (insurance issues like the need for long-term care insurance, disability insurance, etc) with the investment plan.

The plan should also be sure to build into it the fact that we will have financial crisis and bear markets like this one (we have one every few years on average) so that you don’t take more risk than you can handle and you can sleep well when the crises do occur and not be forced to sell in a panic because your stomach cannot take it any more.

I would also make sure that you only use low cost passively managed funds like index funds or ETFs. You should also make sure you have the location right. You want to hold as much of your fixed income assets in your tax advantaged accounts as possible and only then add equities to the tax advantaged accounts. When you have a choice, your preference should be bonds and other tax inefficient investments like REITs and commodities in tax advantaged accounts and equities in taxable accounts. That also means you want to hold the equities in the most tax efficient vehicles like tax managed funds and ETFs which can also be tax efficient due to their structure.

The key to successful investing is to have a well thought out plan that you can stick to. Investors are their own worst enemies because they allow their stomachs (out of fear and panic in bear markets) and their emotions (like greed and envy in bull markets) to make decisions. The head makes far better decisions than the stomach. In other words, temperament is more important than intellect when it comes to investing.

Finally, while I cannot guarantee that we will have a successful outcome from this crisis, I can tell you that we have successfully come out of every other crisis and investors that had the discipline to stay the course were rewarded (very hard if not impossible for most do it yourself investors to do — the evidence shows clearly they fail miserably at it, buying high in bull markets and selling low in bear markets).

Consider the following two bits of evidence. First, whenever consumer confidence fell below 55 (ten times prior to this episode) and thus everyone thinks conditions are really bad, the stock market returns 16% per annum over the next year (60% above the average long term return). Second, when the unemployment rate is very low (below 4.3%) and thus the economic outlook is rosy and investors are confident, stocks return just 2%. But when things are really bad with unemployment over 6%, stocks return 15% (50% above the long term average.

The bottom line for you is this. If you have a plan already and you did not take more risk than you should have, and you have the right type of investments (passively managed funds) and they are in the right location, stick with it. You are highly likely (but not certain; if you could be certain there would be no risk and you would earn Treasury bond returns) to be rewarded. But if those conditions are not met, I urge you to develop a plan immediately. And get professional advice from a fee-only planner if you need the help (and almost all investors need it whether they think so or not as they simply don’t have the educational training to do it themselves).

Finally, if you want to learn more about these issues I suggest you read Wise Investing Made Simple.

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Past Issues of Ask The Expert

• 11/2008 – Ask The Expert with Larry Swedroe, November 2008 Issue
• 09/2008 – Ask The Expert with Larry Swedroe, September 2008 Issue
• 08/2008 – Ask The Expert with Larry Swedroe, August 2008 Issue
• 06/2008 - Ask The Expert with Larry Swedroe, June 2008 Issue
• 05/2008 – Ask The Expert with Larry Swedroe, May 2008 Issue
• 04/2008 - Ask The Expert with Larry Swedroe, April 2008 Issue
• 03/2008 – Ask The Expert with Larry Swedroe, March 2008 Issue
• 02/2008 - Ask The Expert with Larry Swedroe, February 2008 Issue
• 01/2008 – Ask The Expert with Larry Swedroe, January 2008 Issue
• 12/2007 – Ask The Expert with Larry Swedroe, December 2007 Issue

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.

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Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services. Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You'll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You'll Ever Need (2008). Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!

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