Affluent Retirees: Don't Rule Out Taxable Bonds

Affluent retired readers know the drill: When withdrawing money from a portfolio to pay living expenses, it's best to start with taxable accounts first, to preserve the tax-saving benefits of IRAs and company retirement plans for as long as possible. And what to keep in those taxable accounts if you expect to tap your capital soon? Municipal bonds, of course, because their income is generally free from federal income taxes and might be free of state and local taxes, too.

That's not a bad rule of thumb. But should your whole taxable fixed-income portfolio consist of munis? Maybe not. Even though you can diversify geographically with municipal bonds, and you can also spread your muni portfolio across securities with varying credit qualities and levels of interest-rate sensitivity, it's wise to consider more than just munis for your taxable bond portfolio, especially if you're retired and actively tapping the money in your account for living expenses.

A Performance-Smoothing Benefit
One of the key benefits of venturing beyond municipal bonds is straightforward: diversification. Just as one could expect small-cap emerging markets stocks to exhibit a different performance pattern than U.S. blue chips, so will certain taxable-bond sectors tend to behave a lot differently than municipal bonds at various points in time.

In 2003, for example, the Barclays Municipal Bond Index returned 5.3%--a perfectly respectable, even strong, rate of return, at least in absolute terms. Meanwhile, Treasury Inflation-Protected Securities returned 8.4% that year, and the Barclays High-Yield Corporate Index posted a scorching 29.0% return. High-quality corporates gained 8.0%.

And diversifying beyond munis doesn't just provide potential benefits on the upside: In years like 1999, when we had a rising-interest-rate environment that punished high-quality bonds, venturing outside of munis would've provided a hedge against volatility. Mortgaged-backed bonds, TIPS, and high-yield securities all edged solidly into the black that year, whereas the Barclays Municipal Index lost 2%. (See Figure 10 in this Vanguard research paper for a graphic depiction of the annual returns of various bond sectors.)

But investors needn't delve into TIPS and high-yield bonds to diversify a portfolio that's anchored in munis. Take, for example, a portfolio that consists solely of  Vanguard Intermediate-Term Tax-Exempt (VWITX) versus one that has 75% in the muni fund and another 25% in  Vanguard Total Bond Market Index (VBMFX). It's a wash on the performance front: Although the muni-only portfolio has underperformed the combined muni/taxable portfolio during the past three-, five, and 10-year periods, it would likely make up that ground on an aftertax basis. (The taxable bond fund's income would be taxed at an investor's highest income tax rate, whereas the majority of the muni fund's income would be tax-free.) But the muni/taxable portfolio has the edge on the volatility front--a standard deviation of 3.8 during the past three years versus 4.4 for the muni-only portfolio. For a bit of context, the worst three-month loss on the muni-only portfolio during the past three years came between November 2010 and January 2011, when it lost 3.9%. The muni/taxable hybrid had its worst loss during that same period, but it was a milder 3.3% drop.

Within a broad portfolio framework, high-quality taxable bonds, as represented by Barclays Aggregate Bond Index, also appear to do a better job of diversifying equity exposure than do munis. Although both munis and the Barclays Aggregate have a negative correlation with the Dow Jones Wilshire 5000 Index during the past decade, the correlation between stocks and the Barclays Aggregate is slightly lower than is the case for munis and stocks.

Let Asset Location Do the Heavy Lifting
Of course, it's possible to obtain the diversification benefits of owning multiple bond sectors while also tending to tax efficiency. Under the basic principles of asset location, you hold the taxable bonds in tax-sheltered accounts while reserving munis for taxable accounts. After all, some fixed-income sectors--TIPS and high-yield bonds--in particular, are notably poor choices for a taxable account. TIPS investors are taxed not just on any interest they receive but also on the inflation adjustments they receive on their principal values when the Consumer Price Index heads up. And high-yield bonds also kick off a high level of income in absolute terms, and that income is taxed at an investor's ordinary income tax rate. For these asset classes, wise investors should mind the rules of asset location and stash them within the confines of a tax-sheltered wrapper, such as an IRA or company retirement plan.

But for retired investors who are withdrawing money from their taxable accounts, the need for diversification and portfolio stability is practical, not just theoretical. Pulling assets from a portfolio that is more volatile than it needs to be could force a retiree to recalibrate his or her withdrawal rate or, perhaps worse, to sell securities when they're at a low ebb.

In the interest of stability, retirees for whom munis make sense should first take pains to diversify their municipal portfolios over bonds of varying interest-rate sensitivities, geographies, and credit qualities. In addition, they should also consider adding a dash of taxable-bond exposure. It needn't be TIPS, high-yield, or international bonds; even though those categories have all behaved differently than munis, they can also be costly from a tax standpoint. Rather, high-quality corporates, Treasury bonds, or mortgage-backed bonds would function well in this role without greatly diluting the portfolio's tax efficiency.

A version of this article appeared on August 24, 2011.