Bonds are an important part of a typical investment portfolio. That’s especially true the closer you get to retirement and once you’ve retired.
Bonds typically lower the overall risk of your portfolio vs. putting together a portfolio comprised of 100% equities (stocks).
However, during the period following the onset of COVID-19 (when inflation jumped to more than 9% and the federal government repeatedly raised interest rates), stocks and bonds performed poorly.
If you are a buy-and-hold investor who doesn’t make too many moves long-term, you’re used to waiting things out. But many people got spooked about bonds during that period.
Also, there are multiple types of bonds. Some, like a recent Clark podcast listener, have questions about specific types.
Are Municipal Bonds Good Investments?
Are municipal bonds a good investment considering the tax advantages?
That’s what a Clark Howard listener recently asked.
Asked Sam in Ohio: “I have not heard any discussion about municipal bonds recently. Are they a good investment to avoid federal taxes, or not worth it for some reason?”
City, county and state governments issue municipal bonds. You essentially become the lender to the government, which often uses the money for parks, roads, schools and other similar things.
The tax treatment on the interest you earn on these bonds is complex. The interest is often, but not always, tax-exempt. And there are a lot of variables. Clark simplified that on the podcast by referencing tax brackets.
“Having municipal bonds, particularly if you’re in a higher-income tax bracket, they’re a good part of a portfolio,” Clark says. “And the value of bonds goes up and down with time.
“I hold a lot of municipal bonds because I am in a higher tax bracket. And I avoid federal tax on them just like you’re asking. And it is something that’s recommended.”
Why Clark Doesn’t Sell the Bonds in His Portfolio
Let’s revisit the bond market in general in the last several years. Although now recovering, the performance suffered even as stocks went down, which is a rare occurrence.
What did Clark do when that happened?
“When interest rates were artificially suppressed by the Federal Reserve, and then interest rates started to rise, the value of bonds collapsed,” Clark says. “Well now, as interest rates have normalized, being in bonds has become a smart thing again.
“I’ve had bonds as a portion of my portfolio through the years. I’ve ridden them up. I rode them down through the manipulation of rates by the Federal Reserve. And now I’m recovering. It was a rough time in between.”
In other words, Clark didn’t change the allocation of his portfolio and didn’t bail on bonds when they weren’t performing well. That’s because his time horizon is long. Conviction is an important part of long-term investing, as Clark often demonstrates with his own decisions.
Often bonds will protect your downside when stocks slide, even if that wasn’t the case in that recent period.
“A bond, whether it’s a traditional bond or a municipal bond, or a U.S. Treasury bond, they are kind of a blend of an investment and a savings vehicle,” Clark says.
“And there are times that bonds have been what’s known as ballast. They’ve been a real good protector for you in times that your stock holdings have done really poorly.”
Where Should You Buy Bonds? And What Kind of Bonds Should You Buy?
I’ll skip the mystery and move straight to the answer. According to Clark, Vanguard is the best place to buy bonds.
“I don’t buy individual bonds of any kind. I buy bond funds. And so if this is something you’re interested in, know that the best source for bond funds, municipal, U.S. Treasury or corporates, by far, it’s not close, Vanguard,” Clark says.
“Vanguard dominates the bonds space. Because being a co-op, the fees you pay for owning bond funds or bonds through their funds are much lower than they are elsewhere. And so Vanguard’s bond portfolio of municipals in your case, you should look at it and build a portfolio mixed of different maturities.”
Vanguard offers long-term municipal bonds, intermediate-term municipal bonds, short-term bonds and limited-term bonds. The latter is a bit atypical. Those limited-term bonds are longer than short but shorter than intermediate.
Final Thoughts
Bonds are a typical part of a diversified portfolio, especially as you age.
Don’t let the recent stretch of poor bond performance (even while stocks suffered) discourage you from holding bonds. That performance isn’t typical. Don’t get overly distracted by the performance in the short-term, even if that means years.
Municipal bonds usually pay tax-free interest, especially if you’re in a higher tax bracket.
