Hold Munis Simply for Diversification?

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GoneOnTilt
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Hold Munis Simply for Diversification?

Post by GoneOnTilt »

I understand the tax-equivalent yield considerations for holding municipal bonds vs. taxable bonds. But since munis aren't included in a total bond fund, should they simply be held as part of any well-diversified portfolio? Why are tax considerations generally the only reasons addressed when thinking about holding municipal bonds?

Does holding municipal bonds help to spread risk, regardless of tax considerations?
Call_Me_Op
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Re: Hold Munis Simply for Diversification?

Post by Call_Me_Op »

bck63 wrote: Sun Jun 13, 2021 7:22 am I understand the tax-equivalent yield considerations for holding municipal bonds vs. taxable bonds. But since munis aren't included in a total bond fund, should they simply be held as part of any well-diversified portfolio? Why are tax considerations generally the only reasons addressed when thinking about holding municipal bonds?

Does holding municipal bonds help to spread risk, regardless of tax considerations?
Yes and no. If you were holding only treasuries, then adding munis would increase risk. If holding total bond, which consists of treasuries, agencies, corporates, etc, it's hard to say because you are adding a new source of risk (which is diversifying) but also diluting your treasuries (which adds risk).
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dbr
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Re: Hold Munis Simply for Diversification?

Post by dbr »

If you don't have a highly diversified muni fund you add both the risk of concentrating in certain munis and also, as pointed out above, more default risk if you were in Treasurys* before. A problem with munis is that tax advantage tends to be state specific but people may not want to concentrate in the munis of only one state if things are not going well with local governments and agencies there.

*Anyone see what I am doing there?
UpperNwGuy
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Re: Hold Munis Simply for Diversification?

Post by UpperNwGuy »

Why do you think bonds need to be highly diversified? Many here just hold treasury bond funds. Some just hold municipal bond funds.
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GoneOnTilt
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Re: Hold Munis Simply for Diversification?

Post by GoneOnTilt »

dbr wrote: Sun Jun 13, 2021 9:36 am If you don't have a highly diversified muni fund you add both the risk of concentrating in certain munis and also, as pointed out above, more default risk if you were in Treasurys* before. A problem with munis is that tax advantage tends to be state specific but people may not want to concentrate in the munis of only one state if things are not going well with local governments and agencies there.

*Anyone see what I am doing there?
I was referring to a highly diversified national muni fund.
Last edited by GoneOnTilt on Sun Jun 13, 2021 10:00 am, edited 1 time in total.
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GoneOnTilt
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Re: Hold Munis Simply for Diversification?

Post by GoneOnTilt »

UpperNwGuy wrote: Sun Jun 13, 2021 9:39 am Why do you think bonds need to be highly diversified? Many here just hold treasury bond funds. Some just hold municipal bond funds.
Why would I exempt bonds from the concept of diversification (an honest question; I definitely see the point you make above)?
dbr
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Re: Hold Munis Simply for Diversification?

Post by dbr »

In my 50/50 stock bond asset allocation I could hold all TIPS for bonds but instead hold half in intermediate TIPS and half in intermediate Treasurys because it just seems like a bad idea to hold half of all one's wealth in one narrow corner of the bond market. If someone can help me out there I'm listening.
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anon_investor
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Re: Hold Munis Simply for Diversification?

Post by anon_investor »

bck63 wrote: Sun Jun 13, 2021 9:57 am
UpperNwGuy wrote: Sun Jun 13, 2021 9:39 am Why do you think bonds need to be highly diversified? Many here just hold treasury bond funds. Some just hold municipal bond funds.
Why would I exempt bonds from the concept of diversification (an honest question; I definitely see the point you make above)?
Because US treasuries have no credit (default) risk. All other bond types have some level of credit risk. Many feel that it is better to take the risk on the equity side if bonds are for safety especially in today's low interest rate environment where bonds likely will have real yields below inflation.
dbr
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Re: Hold Munis Simply for Diversification?

Post by dbr »

A comment about diversification is that one might be talking about any of at least these three ideas:

1. Diversifiable risk. This means that individual issues of stocks or bonds may have idiosyncratic risk that is not associated with higher expected return and can be diversified away by holding many issues of similar investments. A result is less risk with same expected return. Portfolio theory assumes as a matter of course that diversifiable risk has been diversified away.

2. Concept according to modern portfolio theory. In this theory the risk and return of a collection of assets can be optimized as a result of the returns of different assets not being correlated. This works best when combining asset that all have significantly high risk and return. A subset is simply diluting risk in high risk assets by adding low risk assets.

3. Not all eggs in one basket concept. The obvious idea that if you want to avoid something really bad that might happen to one asset not happening to all your assets, then you hold more than one kind of asset. I guess not holding 100% of FI in TIPS is an example of this.

4. There might be a fourth, which is the idea of diversifying over risk factors by concentrating investments into different factor types. The example would be size and value tilting. I understand the return model for that, but I don't really understand the risk theory here.

I don't know how much is gained from these diversifications when applied to bonds.
typical.investor
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Re: Hold Munis Simply for Diversification?

Post by typical.investor »

GoneOnTilt wrote: Sun Jun 13, 2021 7:22 am But since munis aren't included in a total bond fund
Actually, that statement is not true.

Munis generally are viewed to be tax-exempt vehicles but that view is not true either.

For example, in 2020, roughly 30% of all new munis that were issued were taxable munis. And these taxable munis are held in Vanguard Total Bond Market Index. Granted, the allocation is small as taxable muni issuance has not alway been that high so your question perhaps still remains.

For more on taxable munis see https://www.schwab.com/resource-center/ ... ipal-bonds
Explorer
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Re: Hold Munis Simply for Diversification?

Post by Explorer »

I hold munis in my taxable account primarily due to tax considerations - and I hold national muni funds - just that simple.
NiceUnparticularMan
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Re: Hold Munis Simply for Diversification?

Post by NiceUnparticularMan »

dbr wrote: Sun Jun 13, 2021 11:27 am A comment about diversification is that one might be talking about any of at least these three ideas:

1. Diversifiable risk. This means that individual issues of stocks or bonds may have idiosyncratic risk that is not associated with higher expected return and can be diversified away by holding many issues of similar investments. A result is less risk with same expected return. Portfolio theory assumes as a matter of course that diversifiable risk has been diversified away.

2. Concept according to modern portfolio theory. In this theory the risk and return of a collection of assets can be optimized as a result of the returns of different assets not being correlated. This works best when combining asset that all have significantly high risk and return. A subset is simply diluting risk in high risk assets by adding low risk assets.

3. Not all eggs in one basket concept. The obvious idea that if you want to avoid something really bad that might happen to one asset not happening to all your assets, then you hold more than one kind of asset. I guess not holding 100% of FI in TIPS is an example of this.

4. There might be a fourth, which is the idea of diversifying over risk factors by concentrating investments into different factor types. The example would be size and value tilting. I understand the return model for that, but I don't really understand the risk theory here.

I don't know how much is gained from these diversifications when applied to bonds.
Yeah, generally speaking I don't see any particularly good reason for "diversifying" among bonds. I see them as specialized risk-management tools, and I tend to think you should use only those specific bonds which can be expected to help you manage specific risks in the desired way at acceptable costs. if you want to pursue higher returns through more exposure to risks, my feeling is you should do that through various forms of ownership instruments, aka equities.

But if you really believed there was some unique risk associated with munis and wanted exposure to that risk, you might see it as a species of Argument 4. Again, though, I am very skeptical about that.

But if you want to use munis to manage taxes, then that is another story entirely.
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