Question: We’re hoping to get your advice on an investment we’re considering outside of our retirement accounts. I’ll try to keep this brief.
My wife and I have paid off the mortgage on our primary residence, and the only debt we have is a rental home that we plan to sell eventually (it currently covers itself month-to-month). We have maxed out our 401ks (50/50 domestic and global index funds). We’ve got relatively small ROTH IRAS (in PCRDX), and we just started doing the back-door ROTH contributions in 2013 and 2014. We’ve got 2 kids who have 529 accounts that have been funded at about $2,500 per year (since birth).
We are currently subject to AMT (due to my wife’s income & annual RSA’s), and we’ve been considering taking a lump sum that represents about 10% of our net worth (outside of real estate) and either investing it into the kids’ 529 accounts or in a North Carolina municipal bond fund NTFIX (as we live in North Carolina). From what I can tell, NTFIX doesn’t appear to have any
“private activity” that would result in AMT kicking in.
If we do invest in NTFIX, would it be a mistake to take the monthly income and invest that money into the 529 plans rather than rolling it back into the fund?
Answer: First off, congratulations on your overall approach. Regular savings, a commitment to growth, and a global focus for equities all demonstrate sound judgment. The hedge in commodity futures is optional but certainly acceptable. For those who can handle the hassles of landlording, I have no great objection to owning rental properties, so long as it doesn’t represent an exaggerated and highly leveraged portion of your net worth, as it has for others who came to grief in previous real-estate crises. You’re in great shape overall.
Your question, though, is an odd one, because 529 plans and municipal bonds have very different purposes. So I would take you back to your goals.
If you’re thinking about additional 529 contributions, then one goal is obviously college. Now that North Carolina has eliminated the state tax-deduction for 529 contributions in 2014 and beyond, there’s no special incentive to spread out the contributions to get the annual deduction that was available through 2013. If you have spare cash, maximizing the number of years of tax-free growth by making a bigger contribution this year to your 529 plan would be my choice.
As for municipal bonds, what’s the goal? Inflation could easily zero out the small return on NTFIX and, while North Carolina is in better shape than most other states, virtually none of the bonds in the portfolio are AAA-rated, since states don’t have a printing press to guarantee repayment and municipal bonds can and do sometimes default. NTFIX has benefited from an interest-rate tailwind, as evidenced by the fact that the bonds in the portfolio are, on average, trading at a significant premium to par value (more than 8% as of the end of last month). Why is this important? Well …
The bonds in NTFIX have a median actual maturity date that is more than 15 years off, so you’re making an awfully big bet that inflation and interest rates won’t pick up over the next decade-plus. And what if inflation stays benign? Well, the median EFFECTIVE maturity date of NTFIX is less than five years, which means that these bonds are generally callable in the near future, most likely at a price near par (and below the current trading price). That means the debt issuers will soon have the right to reacquire these bonds at prices below current trading prices (and can then refinance at lower rates). So you’re playing a game of heads you tie, tails you lose: you’re fully exposed to rising inflation and interest rates but will gain very little benefit from continued low rates.
Callable bonds really irritate me: the issuer expects the investor to take on all of the risk of rising inflation and interest rates but then takes away most of the potential reward from falling rates. Treasury bonds are no longer callable, nor are most corporate bonds, but most municipalities continue to include these provisions, and most of the North Carolina bonds in NTFIX are now trading at prices that virtually ensure they will be called in within the next few years unless interest rates soar. And if they do soar, the price of the bonds will collapse and the effective maturity dates of the bonds will head back toward the 15-plus-years actual maturity dates. They’re long-term bonds when it benefits the municipalities and short-term only when it benefits you.
So my extreme dislike of long-term municipal bonds is not limited to obvious cases of weak local governments where defaults can and do occur, but extends to the financially healthy municipalities that promise you an interest rate with their fingers crossed behind their backs. If you want to keep your money safe but can accept modest fluctuations for something better than the sub-inflation rate earnings of most bank accounts, go with TIPS. Or at least stick to bond funds which have an ACTUAL maturity date that is less than five years away, not just an EFFECTIVE one.