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4. Taxationtheir return generating process. It is important for financial planners to beaware of this in the asset allocation process.g. For all of their effort, how good are bond fund managers at predicting credit risk?Cici and Gibson (2010) find that bond fund managers fail, on average, to selectbonds that outperform others with similar characteristics. They also find that bondfunds have rather limited factor-timing ability. They find that the return contributionfrom both security selection and factor timing is less than management fees andtransaction costs.(1) Example: The return contribution from security selection and factortiming was 27 basis points per year, on average, for actively managedinvestment-grade bond funds. However, management fees and transactioncosts were 88 basis points per year. The return contribution from securityselection and factor timing was 4 basis points per year, on average, foractively managed high-yield bond funds. However, the management feesand transaction costs were 138 basis points per year. Cici and Gibsonattribute this underperformance largely to the bond market being moreefficient than the stock market due to a higher proportion of the marketparticipants being informed traders. Perhaps it is this relative efficiencythat underpins Domian and Reichenstein’s (2010) finding that one of thestrongest predictors of bond fund returns is expenses.a. Clients who own bonds or bond funds in taxable accounts should be aware thattheir tax treatment will differ depending on whether they invest in treasuries,municipal bonds, or corporate bonds.(1) The interest on treasuries is not subject to state taxation.(2) The interest on municipal bonds is not subject to federal taxation.(3) If the issuer of a municipal bond is of the same state the investor is aresident of, then the interest on municipal bonds is generally not subject tostate taxation either.(4) The interest on corporate bonds is fully subject to both state and localtaxation.b. The tax advantages of municipal bonds come at a cost of lower yields. It thereforemakes little sense for municipal bonds to be considered for inclusion in qualifiedaccounts. They should be considered for inclusion in taxable accounts only if theafter-tax expected return on the municipal bonds exceeds the after-tax expectedreturn on corporate bonds. Longstaff (2009) finds that the break-even marginaltax rate is roughly equivalent to the maximum federal marginal tax rate, whichsuggests that municipal bonds are most suitable for high income investors.c. Treasuries are unique in that they are considered by most to be free of credit riskand also have an inflation-protected variety known as TIPS. Because treasuriesare considered by most to be free of credit risk, they are a rather attractivecandidate for laddering strategies. TIPS take the guesswork out of estimatinginflation because they automatically adjust for changes in consumer prices.Therefore they protect a portfolio from inflation risk.7.8