4 Reasons to Avoid Individual Municipal Bonds

Some investors and advisors advocate using individual municipal bonds rather than a good municipal bond mutual fund. Here are 4 reasons that might not be a good idea.

Municipal bonds are attractive to many physicians and other high-income investors because their dividends are usually federal income tax-free and sometimes even state income tax-free. After-tax, these bonds often have a higher yield than a more typical treasury or corporate bonds. I occasionally run into investors and advisors who advocate using individual municipal bonds rather than a good municipal bond mutual fund. In this column, I will discuss 4 reasons why this may not be a good idea for you.

Bond Funds Are Cheaper

The first reason to use a good municipal bond fund is that it is far less expensive. Vanguard, the low-cost leader among mutual fund companies, runs its municipal bond mutual funds at expense ratios of just 12-20 basis points (0.12-0.20% per year). That’s a cost of $12-20 per $10,000 invested. That is a bargain for the professional management, diversification, and economies of scale that these large funds provide, and far less than it would cost you to assemble an inferior portfolio.

If your financial advisor is choosing individual bonds to buy and sell, not only does he expect to be paid a reasonable fee for his services (often 100 basis points a year or more), but he is not going to be able to benefit from the lower commissions and lower bid-ask spreads that a large fund at Vanguard will receive. In investing, you get what you do not pay for, and a bond fund costs an order of magnitude less than hiring an individual to manage a few individual bonds just for you. Even if he has 5 or 10 other clients he is doing this for, your advisor simply cannot keep costs as low as a $39 billion non-profit mutual fund can. In his writings, Jack Bogle has clearly demonstrated that costs matter to your long-term returns, and that they matter even more in fixed income (bond) investing than in equity (stock) investing.

Same Interest-Rate Risk

The main reason individual bond pickers use to sell their services to individual investors is a faulty argument. They argue that by buying individual bonds, and holding them to maturity, there is no interest-rate risk. This is the risk that comes from rising interest rates. When interest rates rise, bond prices fall, just as when interest rates fall, bond prices rise. If you just hold the bond for 5-30 years until it matures, the bond picker argues, then you get exactly what you were guaranteed — a dividend every quarter and all your money back at the end. On the other hand, the Net Asset Value (NAV, or price per share) of the bond fund fluctuates every day in the bond market. The bond picker incorrectly believes there is no interest rate risk with individual bonds.

The price of a bond fluctuates every day, whether it is held by an individual or by a mutual fund. If interest rates rise from 5% to 6%, a bond with a duration of 5 years will fall in value by 5%. If the bond was previously worth $1000, it would now be worth $950, whether held by an individual or a fund. The individual bond picker would argue that 5 years from now, that bond will be worth $1000 again, which is true, but you still have interest-rate risk. A simplified example will demonstrate why. Imagine you bought a 1 year bond paying 5%. The next day interest rates rise to 6% and you buy a second $1,000 bond. At maturity, the second bond will be worth $10 more than the first bond ($1,060 vs $1,050.) In order for the first bond to be equal to the second bond, you must now invest an additional $9.43. That’s interest-rate risk. Buying the bonds individually instead of inside a bond fund didn’t eliminate that risk.

One risk you can avoid by not using a mutual fund is the risk that all the other investors in a fund bail out and force the remaining investors to sell the assets at fire sale prices to meet redemptions. However, this risk is seriously overblown. For example, when Bill Gross left PIMCO recently, their funds saw huge outflows of $74 billion, and probably didn’t get a very good deal on the bonds they had to sell to pay for that. However, since the funds held around $2 trillion in assets, that still represented only about a 7% outflow, and these funds often hold up to 2-10% cash, minimizing this issue. The lower costs of a bond fund more than make up for this issue.

Lack of Diversification

Individual municipal bonds generally sell at a minimum face value of $5,000, but in reality, if you want a good deal on the transaction (low commissions and spreads), you need to realize that anything under $100,000 is considered a “small order.” That means that even an investor with a million-dollar portfolio that is 40% bonds could only purchase 4 individual bonds at a reasonable price. Compare that to the holdings of Vanguard’s Intermediate Term Tax-exempt bond fund, which holds 4,268 bonds, providing more than 1,000 times as much diversification.

While there is little benefit to diversifying among US Treasury bonds (since they are all backed by the same issuer), municipal bonds are backed by various state and municipal governments across the country. These entities, while generally less likely to default than corporations, still do go bankrupt or become downgraded from time to time. The last several years have seen bankruptcies in Jefferson County, AL, Central Falls, RI, Vallejo, CA, Stockton, CA, Harrisburg, PA, Mammoth Lakes, CA, and San Bernardino, CA. While default rates are lower than what is seen with corporate bonds, it is not zero. By dollar value, about 1% of municipal bonds defaulted in 2012. BNY Mellon reported that from 1970 to 2012, counties defaulted 2.7% of the time and cities defaulted 4.1% of the time. In some sectors, such as housing and healthcare, municipal bond defaults were as high as 30-40%. Certainly there is a role for diversification when purchasing municipal bonds, and that is difficult to do well unless you have a portfolio far larger than that of most physicians.

Likely to Underperform

If you (or your local financial advisor who is planning to buy and sell municipal bonds for you) were really talented, you would be working for an institution, such as an endowment, hedge fund, or mutual fund. Due to higher costs, active management works poorly in equity investing, and it is even worse in bond investing. Your local advisor has even higher relative costs than the large funds that, on average, underperform the market due to their costs. The terrible truth of active management is that you pay more for lower returns, and this fact is just as true for municipal bonds as for large cap stocks.

While you get a little more control with individual bonds since you and your advisor get to decide when to buy and sell them, that control is not worth the additional cost, risk, and underperformance you are likely to see in the long run, especially when that control may be just as likely to harm you as help you. Do your portfolio a favor and stick with a low-cost bond fund for your municipal bond holdings.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.