Moms Bond Fund Question

[Splais]

My mom has $100k invested in the American Funds Tax-Exempt Bond C TEBCX. She has had this fund for a few years now and it has done ok for her. She is interested in just one thing - preservation of principal. My problem is she lives off the interest and social security and we all know how interest is doing. She has another $600K that is 2/3 in CD's and one third is the mortgage on my house that I give her 5% on. This was purely to help her out because CD rates are so low. I am starting to worry about the money she has in this fund. When she bought it it was somewhat lower than now at $12, so she has some downside. But I'm afraid the bubble is going to pop at any time and this bond fund may tank. The only positive thing is that this fund is fairly stable when you look at its long term chart.

Question: considering all I've said, would you leave the money in this fund or put it someplace else? Any comments appreciated; I'm trying to read and learn this stuff, but soooo much to learn.

[BrandonBogle]

At the very least, assuming she doesn't have much of a tax hit (I wasn't clear if she bought at $12 and is up now or bought at something and is 12% down), I'd suggest she move to Vanguards Intermediate or Long Term Tax Exempt. Both have around the same duration but MUCH lower expense ratios. This ticker has a 1.34% expense ratio.

I left the original post in place, but now I understand that she bought at $12.

At the very least, move as much as you can while keeping her overall tax bill low (may need to spread it out over more than one year) to Vanguard's Intermediate or Long Term Tax Exempt. Both have around the same duration but MUCH lower expense ratios. This ticker has a 1.34% expense ratio.

[pkcrafter]

My mom has $100k invested in the American Funds Tax-Exempt Bond C TEBCX. She has had this fund for a few years now and it has done ok for her. She is interested in just one thing - preservation of principal. My problem is she lives off the interest and social security and we all know how interest is doing. She has another $600K that is 2/3 in CD's and one third is the mortgage on my house that I give her 5% on. This was purely to help her out because CD rates are so low. I am starting to worry about the money she has in this fund. When she bought it it was somewhat lower than now at $12, so she has some downside. But I'm afraid the bubble is going to pop at any time and this bond fund may tank. The only positive thing is that this fund is fairly stable when you look at its long term chart.

Question: considering all I've said, would you leave the money in this fund or put it someplace else? Any comments appreciated; I'm trying to read and learn this stuff, but soooo much to learn.

Ug, there is nothing more evil than a C class tax-exempt bond fund with a expense ratio of 1.34%. A C class fund adds a 1% commission to the expense ratio of the fund. This fund has a longer duration than Vanguard long term tax exempt, has lower quality, and an interest rate more than 1% less. The high expense ratio is eating up the interest your mom should be getting. An advisor/broker who would recommend such a fund ought to be barred.

There is no question that the fund should be dumped, so the next question is what to replace it with. Bond funds will see some volatility in prices when interest rates rise, but that will be offset by better interest rates. If you mom is depending on an all cash/bond portfolio she needs to go out a little in duration to get some decent yield, but she should not keep a fund with a duration of over seven like TEBCX. I would not recommend longer duration bonds right now, but it might depend on how much income she really needs. How much does she need and what is her age?

Paul

[BL]

You don't say how old she is, but inflation can erode the purchasing value of her money, even if it stays the same numerically.
I see she has no equities which might help keep up with inflation. There might be different suggestions if she were 80 vs. 65. Also does she have any IRAs or similar tax-sheltered accounts? Also what is her tax bracket? Tax-exempt funds make sense if she is above the 15% bracket, otherwise she might get more interest with a regular bond fund.

I-bonds tend to keep up with inflation, but are inconvenient for regular income (fine for a secondary emergency fund) and are only available at treasurydirect.gov

I see that others have found that the fund is a high-cost one. I agree that you should dump it and get a low-cost fund at Vanguard where there is no salesman to collect from her income before she gets it. If she were to earn 4% on the fund (doubtful), the salesman is getting 1% of that (25% of the interest earned and still more if it is earning less than 4%)!

[Splais]

All she has is what I posted in original post. Mom is 94, but going strong.

[BL]

Since she is 94, I wouldn't worry much about inflation.
I would try to get her out of the expensive fund so she would get more of the interest, but keeping her happy is even more important.
I wouldn't worry about the CDs. She has enough so she really doesn't have to worry, and shouldn't have to worry at her age. If money is tight, it would be nice if she could pull out some equity, but only if that would not create stress. You are very kind to have an arrangement where she gets 5% on some of her money and has that regular income. I hope she has many more good years!

[House Blend]

She is interested in just one thing - preservation of principal.

Why? At age 94, she can and should spend principal if she needs the income. (And I agree with others that the VG tax exempt funds offer a much better deal--I would move that money to VG Intermediate-Term Tax Exempt.)

Sounds like she has $100K in a tax-exempt fund, $400K in CDs, and she loaned you $200K to pay down your mortgage which you are paying back with 5% interest. So ignoring return of principal, that's $10K per year of interest income.

How much more income/year does she need beyond her SS benefits?

[Splais]

mom does not need anymore income. She is only interested in preserving principle to leave to us kids. While I don't personally agree with that, it is what she wants and the only thing she lives for. Five years ago I had to really work to get her to take any money out of CD's; now I am convinced staying in this American bond fund is a bad idea.

[john94549]

Doing a quick mental calculation, it would appear qualified dividends would not be taxable to her. You might consider swapping the bond fund for a low-cost equity fund (VBIAX comes to mind). FWIW, my Mom is 97, is very much into safety, and still has roughly 20% of her investable assets in QD-paying equities.* The distribution yield on her state-tax-exempt bond fund (FUSGX) has been sinking, along with the NAV. Fortuneately, she doesn't harvest the fund dividends (yet).

Like many retirees, she was always accustomed to see her bond fund throw off a decent dividend and appreciate in value as well. Now, we're just hoping the dividend can offset the slippage.

*Throwing off an average of 2.5%, might I add.

[House Blend]

mom does not need anymore income. She is only interested in preserving principle to leave to us kids. While I don't personally agree with that, it is what she wants and the only thing she lives for. Five years ago I had to really work to get her to take any money out of CD's; now I am convinced staying in this American bond fund is a bad idea.

OK, no point in making her upset if unnecessary. Do what you can.

If leaving money to her kids was her priority, then she'd be better off with everything--CDs included--in a balanced fund such as VG Target Retirement Income or VG Lifestrategy Conservative or Wellesley Income. But even if you could get her to agree to taking on equity risk, you'd also have to get her adjusted to having distributions only on a quarterly basis.

[Splais]

Please help with this part of my reading. Vanguard long term (VWLTX) gets 4 stars and an "A" rating. Vanguard short term (VWSTX) gets 2 stars and a "C-" rating. There has been some suggestions I go with the short term fund because if things start to tank the short term will be less likely to have a major hit. Is this correct? Can anyone give me the nutshell answer as to why the long term is rated so much better than the short term? Thanks.

[House Blend]

I wouldn't and don't pay much attention to ratings, although a low rating is usually a sign that something is wrong.

In the case of the VG muni funds, one thing to be aware of is that VG actually has *two* short term national muni funds: Short Term Tax Exempt and Limited Term Tax Exempt.

Limited Term has avg duration of 2.4 years, Short Term is 1.2 years, which is really short compared to peers. Probably it is getting poor grades because it is getting lumped into a pool of funds that are taking on more risk. Without even checking, I am willing to bet that Limited Term has higher ratings.

Likewise VG's Long Term fund has a duration of 6.1 years, which is only one year longer than Intermediate (5.1 years). I would also bet that this is much shorter than most Long Term Muni Funds. To the extent that it is getting a higher rating than other Long Term funds my first guess is that this is explained by the extent to which risks have shown up, and my second guess is managerial luck.

One should also be aware that VGs muni funds are actively managed. At some other point in time, there could be a much bigger duration gap between Intermediate and Long-Term. (Hence, more risk.)

[Scooter57]

If you are looking at M* ratings, the stars represent recent returns compared to similar stocks. Howevet similar bond funds invest in much riskier products than Vanguard's short term bond fund. Some buy mortgages and floating rate loans, others buy bonds from companies with weak credit.

[grabiner]

Please help with this part of my reading. Vanguard long term (VWLTX) gets 4 stars and an "A" rating. Vanguard short term (VWSTX) gets 2 stars and a "C-" rating. There has been some suggestions I go with the short term fund because if things start to tank the short term will be less likely to have a major hit. Is this correct? Can anyone give me the nutshell answer as to why the long term is rated so much better than the short term? Thanks.

First, past performance is not an indication of future results.

Morningstar and Lipper both compare mutual funds within peer groups. This often leads to odd ratings when a fund does not have a peer group with similar holdings, and that is what happens with Short-Term Tax-Exempt. Most short-term muni funds have a duration of about three years. Short-Term Tax-Exempt has a one-year duration, and thus much lower risk than other funds in the category; in 2008, when interest rates rose, Short-Term Tax-Exempt wasn't hurt at all and was near the top of its category. But the lower risk is also reflected in the lower yields of its bonds; you expect lower returns for taking on less risk, and when rates fall, you get even lower returns for low-duration bonds.

Vanguard's fund which is comparable to the peer group is Limited-Term Tax-Exempt, with a duration of 2.4 years, and that fund does behave as you would expect; it usually beats the category average by a small amount because of its low expenses, and that gives it a four-star rating. (Even this fund is less risky than the category average, as is indicated by its strong performance in 2008 and underperformance in 2009.)

[Call_Me_Op]

If her only interest is preserving principal [as you say above], the money should be in a series of FDIC-insured CD's or US treasuries.

[Splais]

Gosh, this is so complicated. I know you can't give me a giant lesson here, but can someone help me with one thing.

Mom had (we just closed it) American funds Tax Exempt Bond C fund (TEBCX). It was paying her around $240 a month in dividends. I have been looking at the Vanguard Short Term Tax Exempt Fund (VWSTX). I just checked and it's last monthly distribution on $100K was only something like $80. Can anyone tell me why the big difference in these two? Secondly, am I correct that by getting the Vanguard fund she is giving up some income for less volatility if things tank. thanks.

[BrandonBogle]

VWSTX has a significantly shorter duration and thus lower risk. In exchange for less potential principal loss, it pays less. If you want similar duration as what she had, pick the Vanguard Long Term Tax Exempt fund. If you want to cut down some risk but keep decent income, pick intermediate. Personally, I have my mom in some long term and some total bond. The long term has an extra year of duration for over a half a percent more. For our goals, that's a worthwhile risk. I personally use long term tax exempt for my personal taxable bonds, but I've got a longer horizon than my mom already in retirement.

[BL]

Not that I am recommending it, but Vanguard High-Yield Corporate Fund Investor Shares yield something like 4.34%. But this is also high-risk for bonds, possibly similar to what you had before. So there is always a risk/return choice to be made. I don't have it and don't intend to buy it.

[grabiner]

Not that I am recommending it, but Vanguard High-Yield Corporate Fund Investor Shares yield something like 4.34%. But this is also high-risk for bonds, possibly similar to what you had before. So there is always a risk/return choice to be made. I don't have it and don't intend to buy it.

This fund is not suitable for an investor who is interested in principal preservation, as its 2008 returns will show. High-yield bonds, unlike most other bonds, are likely to default, causing a loss of principal.

As a separate point (in response to other posters), if she is living off interest and Social Security, she is in a low tax bracket and probably shouldn't be in municipal bonds at all; a general fund makes more sense. (Municipal bond interest, while not taxed, does count as income for the purpose of making Social Security taxable; thus, if she is in the phase-in range and has a 27.75% marginal tax rate on bond interest, she has a 12.75% marginal tax rate on muni interest, and munis still aren't worthwhile.)

[Splais]

David, Mom's AGI was $16,500 this year. She also had another $13K of tax exempt income. Her SS was $23K with $2K of it taxable. Could you suggest a couple of low risk funds other than the muni's I could look at. thanks.

[grabiner]

David, Mom's AGI was $16,500 this year. She also had another $13K of tax exempt income. Her SS was $23K with $2K of it taxable. Could you suggest a couple of low risk funds other than the muni's I could look at. thanks.

Total Bond Market is a common recommendation on this board; it holds Treasuries, GNMAs, and high-quality corporate bonds. If she is concerned about inflation (that is, losing the real value of her portfolio, not the dollar value), then I-Bonds are guaranteed to match inflation until they are cashed in, and she can also use TIPS such as Vanguard's Inflation-Protected Securities fund.

Is that $13K of tax-exempt income a typo? Your mother has $100,000 in a tax-exempt bond fund, which would not produce anywhere near $13,000 in one year. Also, a single taxpayer will have $2000 of taxable SS if half her SS plus all her other income is $29,000. Since half your mother's SS is $11,500, this implies other income of $17,500, for a total income of $19,500. Her adjusted gross income (as reported on Form 1040) could only be $16,500 if her tax-exempt income were $3000, not $13,000.

[Splais]

My numbers are correct for her AGI and how much of her SS was taxable. She did have other income that factored in.

[grabiner]

My numbers are correct for her AGI and how much of her SS was taxable. She did have other income that factored in.

I think I figured out what is going on with the taxes.

If she had $13,000 of municipal-bond income, then much more than $2000 of her SS should have been taxable. However, she may also have some income which is not taxable at all. For example, she holds the mortgage on your house. The interest on that mortgage is taxable income for her, but the principal payments are not taxable, just as they are not deductible to you.

Regardless, she shouldn't be holding municipal bonds in the 10% tax bracket (which is where AGI of $16,500 would put her).

[Splais]

When we got talked into getting that American fund four or five years ago as CD rates plummeted, I knew even less than now. But it was paying her around $250 a month on a $100K investment. At the time the share price was relatively low. When I closet out the American Fund a few days ago she realized a profit of about $9K. Well now both bond and stock fund prices are relatively high although I notice a lot of the bond funds share price has been declining. I will look at the one fund you suggested a couple posts back. But, because I think these bond funds are about due for a serious decline in share price, I'm not sure what to do. It wouldn't be such a big deal if she was cost averaging over a long period, but she will be plunking down a $100K all at once. With what little I know, it may be best just to park it for a few months and see what happens to share prices. Don't know.

[BrandonBogle]

I wouldn't park it. It won't really be earning anything over that time frame and any potential decline she sees in a new fund would have been just as likely had nothing changed and she stayed in the old fund.

[grabiner]

When we got talked into getting that American fund four or five years ago as CD rates plummeted, I knew even less than now. But it was paying her around $250 a month on a $100K investment. At the time the share price was relatively low. When I closet out the American Fund a few days ago she realized a profit of about $9K.

Note that this will increase her tax bill slightly; while she pays 0% taxes on capital gains (assuming she hasn't reinvested any dividends for short-term gain), the capital gain will make more of her Social Security taxable. You need to be prepared for a slightly larger tax bill next year, and increased further based on the taxable bond interest.

The change was still worth doing. Given your numbers, a $9000 capital gain would make $5900 more of Social Security taxable, for an additional tax bill of about $700 (depending on how far she gets pushed into the 15% tax bracket). The 12b(1) fee on the municipal-bond fund would cost her more than $700 for the rest of this year alone.

But, because I think these bond funds are about due for a serious decline in share price, I'm not sure what to do. It wouldn't be such a big deal if she was cost averaging over a long period, but she will be plunking down a $100K all at once.

The share price decline won't actually hurt her if she holds the fund for a number of years equal to the duration. Suppose that she buys a fund with a 2% yield and a 5-year duration. If interest rates rise to 3%, the fund value will drop in value by 5%, but the yield will now be 3%, so she will make 1% more each year (not necessarily paid out to her), and in five years, she will be back to even.