Diversifying Attorney Municipal Bond Portfolios

Diversifying attorney municipal bond portfolios is, in my experience, completely overlooked by financial advisors.Many AmLaw 100 partners in Manhattan are relatively conservative in their investments.  There are good reasons for them having a conservative investment approach, including:

• Potential capital calls from the firm;
• Having to pay for benefits as a partner instead of an employee;
• The potential for investing side-by-side with firm clients;
• The cyclicality of transactional business or, for plaintiffs attorneys, lumpy cash flows from litigation outcomes.

Because of these reasons and their high tax brackets, many attorneys get recommended large allocations of individual municipal bonds.  For attorneys in and around New York City, many of the municipal bonds recommended to them are from local and state issuers.This is a mistake.An attorney who lives and works in Manhattan (or lives within commuting distance of Manhattan) already has too much exposure to the city.  These exposures include:

• New York City's economic health;
• The firm’s physical location;
• The health of the capital markets;
• The individual’s home or apartment.

These are all forms of Company Town Risk®, which I have written about previously here.  Voluntarily adding additional New York City exposure through the purchase of New York City issued municipal bonds is an unforced error.

Diversifying Attorney Municipal Bond Portfolios Nationally

AmLaw 100 attorneys living in and around Manhattan would be much better served by owning a nationally diversified basket of municipal bonds.While this is slightly less tax efficient because New York State and City income tax will have to be paid on non-New York State municipal bond interest, it is worth the reduction in risk.Furthermore, unlike equities, it is much easier for fixed income managers to outperform the indicies, so some of the increased taxes can be offset by higher returns.An example is the Vanguard Intermediate Term Tax-Exempt Fund (VWIUX), which has outperformed its peers by 0.69 percent over the past five years.  (A 36 percent difference, putting the fund in the 82nd percentile.)For a New York State resident, the annual increased taxes on a $10 million intermediate term national municipal bond portfolio yielding 2.86% would be approximately $30,428, or about a 10.64% increase on $286,000 in income.However, the fund has outperformed the index by 21 basis points over the past five years, which equates to $21,000 per year in additional income.  This would offset roughly two-thirds of the additional income tax.

The Tax Advantage of Municipal Bond Funds

Furthermore, municipal bond funds have a tax advantage when it comes to capital gains.Unlike individual investors that must reduce their cost basis on premium bonds as they amortize principal payments, bond funds do not.  Instead, they can take losses on premium bonds that mature at par, even though those premiums were paid.In effect, tax losses are generated even though no economic losses are generated.This means that most municipal bond funds realize no (or very small) amounts of capital gains.  For instance, the Vanguard Intermediate Term Tax-Exempt Fund has realized no capital gains over the past five years.

Financial Planning 101: De-Risking Portfolios

AmLaw 100 partners face many risks (examined in detail here), some of which are existential for their firms.  For example, over the past 33 years only four of the top 10 grossing firms have remained there.[1] Furthermore, many firms disappeared completely from the AmLaw 100.  For instance, between 2007 and 2015 the following bold-face names fell off the list:[2]

• Sutherland;
• Womble Carlyle;
• Stroock, Stroock & Lavan
• Finnegan Henderson;
• Shook Hardy;
• Sonnerschein;
• Thelen;
• Howrey;
• Dewey Ballantine;
• LeBoeuf Lamb;
• Heller Ehrman;
• Bingham McCutchen;
• Patton Boggs;
• Dickstein Shapiro;
• Thelen Reid, and;
• Edwards Angell.

Because of this, de-risking an attorney’s total wealth by diversifying Company Town Risk® should be first step when evaluating and allocating investments, especially for those in Manhattan. Please review our financial planning for attorneys page for more information.