Maximizing Cash Savings Returns With Municipal Bonds

By: S. G. Lacey

The U.S. Federal Reserve (FOMC) has raised the federal funds rate, the interest rate banks charge each other for overnight loans, steadily over the past few years, before pausing at 2.5% in December 2018.  As a result, one can now achieve yields above the current inflation level, which is just under 2% depending on the metric used, at least allowing investors to protect their purchasing power.

There are many reasons for holding money in cash such as an emergency fund for unexpected bills, savings for a home down payment in the near future, or simply waiting for a desirable investment opportunity.  There are a variety of options for preserving capital while maintaining high liquidity including bank saving accounts, certificates of deposit (CDs), U.S. Treasury issued securities, and, as focused on in this article, municipal bonds. 

High-yield savings accounts typically combine higher interest rates and lower fees, often in an online wrapper.  The main drawback of these accounts is that they may require a minimum balance or offer tiered interest payments; however, these restrictions are rarely an issue when used as a primary savings vehicle. does a nice job of updating the best high-yield savings accounts, this month’s list is linked below.

CDs, offered by a wide range of commercial banks, are common instruments for cash savings which don’t have to be accessed for a known period of time.  Typically sold in durations ranging from 3 months to 5 years, investors put down a specific amount at purchase, receiving the principal plus the agreed upon interest payment back at the maturity date.  Current returns for 5-year CDs are around 3.0% annual percentage yield (APY), with 1-year duration CDs sacrificing only 30 basis points (0.3%) per annum.

U.S. Treasury issued fixed income securities come in several forms and maturities: bonds (30 years), notes (2 to 10 years) and bills (4 to 52 months).  The benefit of U.S. Treasury debt is that it’s backed by the full faith of the U.S. government.  Another interesting advantage is that the interest from these bonds is exempt from state and local taxes, which can influence returns depending on which part of the country one lives in.  U.S. Treasuries are sold directly at monthly auctions in $100 increments; there are also a multitude of ETFs which track this actively traded secondary market (bonds = VGLT, notes = VGIT, bills = VGSH). 

Since both CDs and U.S Treasuries have a fixed duration which can be long, investors often create a ladder, or series of holdings, in which some portion of the total portfolio matures and can be reinvested each year.  This approach has the benefit of providing steady income while allowing for bond holding adjustments based on interest rate changes over time.

Surprisingly, traditional banking and investment accounts through large brokerage firms are actually one of the worst places to hold a large cash account balance.  These financial institutions typically offer lower than market rate yields, but do allow an investor to quickly shift into more risky investment options as conditions dictate.  Jason Zweig has written a very interesting piece for the Wall Street Journal on the reasons for the extremely low money market yields in many of these accounts, feel free to review the link below if you have an WSJ subscription.

It’s clear from the summary above that there are a lot of options for an investor with a significant cash position who doesn’t want to lose purchasing power to inflation.  The table below summarizes the various account options available for boosting the yield in cash savings accounts, with some key comparative metrics listed assuming a one-year holding period.

As shown in the table above, the last cash savings investment vehicle worth mentioning is municipal bonds.  Munis are offered by states and localities to fund capital expenditures like building roads or maintaining schools.  Municipal bonds come in 2 main flavors: general obligation bonds which are broader in scope and paid from the issuer’s overall budget, and revenue bonds where the income to bondholders is tied to a specific cash flow like a bridge toll or camp site rental fees.

One major benefit of municipal bonds is that the interest payments are exempt, not only from federal taxes, but potentially state taxes as well, depending on residency status and the specific muni holdings.  As a result, for the current median 24% federal income tax bracket, a municipal bond needs to yield only 1.79% to match the take-home income of 2.35% for a current 1-year U.S. Treasury bill.   

Municipal bonds are unsurprisingly less prone to default than corporate bonds, as they are backed by the entire strength of a local government’s budget revenue, rather than the cash flows of an individual company.  However, municipal bond defaults are possible as a result of poorly managed projects or insolvent public balance sheets, and revenue bond streams tend to be more cyclical, and therefore risky, when compared to general obligation debt.

Like any bond, munis are issued over a specific timeframe at a set recurring coupon payment, so changes in banking interest rates can affect the value of the underlying bond holding.  Also, like corporate debt, municipal bonds come in a wide range of durations and qualities.  As is typical, investors are rewarded with higher yields for taking on longer holding periods or more risk of default.  This phenomenon is shown in the graph below; for the 10-year timeframe displayed total muni bond returns increase proportionally for short-term (red), intermediate (blue), long-term (green), and lower quality high-yield (pink) offerings.

Another element of diversification in the municipal bond space is geography.  All munis are free from federal income tax, but some ETFs target specific states, offering additional local tax benefits; California and New York are states where this practice is most common.

Before exploring the options for investing in municipal bonds, it’s important to note that there are differing opinions in the financial community on whether to hold individual bonds or bond funds.  The benefit of bond funds is that they provide diversification, typically hundreds of bond holdings can be purchased via a single ETF offering.  In this case, the risk of default is mitigated; individual bonds can sometimes become worthless, meanwhile these outliers get averaged out in a broad portfolio of bond assets. 

However, bond funds typically roll their purchases, buying new holdings as the old ones mature; this results in no set maturity date, and therefore more sensitivity to interest rate movement, which is not a concern for individual bonds held all the way to maturity.  

One compromise here is to invest in bond ETFs with a target maturity date, IBDL is an investment grade corporate bond example of this approach.  In such a structure, a portfolio of bonds is purchased, all with the same general maturity timeline, in IBDL’s case December 2020.  The ETF provides interest income monthly, eventually distributing the entire invested principal back via the closing price at the target date.

Assuming that the average retail investor does not have the time or knowledge to research and assemble a diverse portfolio of individual municipal bonds, the table below highlights some of the better ETFs in the muni bond space, with key bond research factors (duration, maturity, yield, quality) identified.  Some additional ETF metrics relevant specifically to municipal bond investing are also listed.

In the table shown above, ETF municipal bond offerings for short-term, intermediate, long-term, and high-yield are all shown.  It’s valuable to notice how the cost, duration, and yield vary for these different classes of muni bonds. 

These ETFs are listed in order of increasing yield to maturity.  The yield of the overall portfolio is an important component of investor returns, and is typically distributed through monthly interest payments for ETFs.  Yield is a function of a bond’s credit quality, along with duration, a metric related to a bond’s interest rate sensitivity, and maturity, the time until the invested principal for a bond is returned.

The grey highlighted rows represent focused, actively managed funds, while the white rows are highly diversified, traditional indexes.  As are typical, active management results in higher fees and more concentration with fewer bond holdings.  The actively managed offerings are also smaller and newer entrants to the ETF space, but do differ noticeably in state concentration from the California and New York dominated municipal bond index landscape.

For every muni ETF shown, revenue bonds make up a larger percentage of the portfolio than the general obligation holdings.  Also, with the exception of HYD, all these ETFs have fairly high bond credit ratings for their portfolios as a whole. 

It’s important to note that in the past few years municipal bond prices have been bid up somewhat.  This is likely a result of high state tax occupants looking for alternative options after the reduction of the SALT (State and Local Tax) deduction which was part of the 2017 tax law changes made by Congress. 

This fact does bring up one of the potential risks of owning municipal bonds.  While the federal tax deduction for muni interest has been in place for over a century, there’s no guarantee that this legislation will remain in the future.  Changes to the tax treatment of municipal bonds would have a profound effect on the relevance of this asset class in one’s investment portfolio.

Since the municipal bond benefits are a United States federal law, there’s not much motivation for investors outside the America muni offerings.  Also, at under $4 trillion total, the municipal bond space is fairly small relative to the entire U.S. bond market, so trading liquidity is another consideration.  The current breakdown in U.S. bond offerings at the end of 2018 as compiled by SIFMA is shown below; munis represent less than 10% of the outstanding tradable domestic debt.

In summary, nearly every investor has some level of cash holdings which varies in magnitude through time based on life circumstances and market conditions.  It’s worth taking a few minutes to look into the yield being generated on one’s current money market account and make efforts maximize yield without taking on too much additional risk or sacrificing liquidity.  Maintaining purchasing power over time relative to inflation and currency fluctuation is an important component of calculated real returns in a portfolio.

For those who choose to use municipal bond ETFs for this capital preservation activity, selecting the right municipal bond ETF for one’s specific portfolio in critical.  Investors should consider the credit quality of the underlying bond holdings which dictates default risk, plus the time duration relative to potential future interest rate movements, as the combined return from both current interest yield and price appreciation will dictate a muni bond ETF’s total performance over time.

As always, the goal of this column is to simplify investing, using fundamental terms and concepts, while still being accurate and comprehensive; don’t hesitate to reach out if you have any additional questions or thoughts. 

Invest wisely and don’t forget the power of low fee, automatic investment combined with compounding growth over time.

Disclaimer: This article is for informational purposes only; investments or strategies mentioned may not be suitable for everyone and the material does not take into account individual objectives or financial situations.  The author may own shares of some of the funds discussed.

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