Bonds, taxes, limited funds to choose from (edited title)

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Bonds, taxes, limited funds to choose from (edited title)

Postby notsure » Sun Apr 21, 2013 11:51 am

Hello,
I'm new to posting on Bogleheads. I'm investing a large lump sum (about $900,000) I inherited, and am particularly uncertain about how I should invest the bond allocation. I have no current investment portfolio and cannot invest in tax-advantaged accounts because I'm a graduate student in my 20s earning no income.

Emergency funds: $50,000
Debt: $0
Rental income from a property I own: $50,000 (pre-tax)
Tax filing status: Married filing separately (my wife has no earned income as she is also a graduate student)
State of residence: NY (NYC city tax)
Age: 20s
Desired asset allocation: 80-90% stocks/10-20% bonds, ideally in a 2 or 3 fund portfolio where the U.S./international allocations are globally weighted

As mentioned, I have no current investment portfolio, and no tax-advantaged accounts.

My Vanguard bond fund options are restricted to:

Vanguard Total Bond Market ETF (BND)
Vanguard Short-Term Bond Fund ETF (BSV)
Vanguard Intermediate-Term Bond Fund ETF (BIV)
Vanguard Long-Term Bond Fund ETF (BLV)

I'm restricted to just these 4 Vanguard bond fund ETFs because they're the only Vanguard bond funds that have U.K. reporting fund status. As a U.S. green card holder and U.K citizen, it's important to invest in funds with U.K. reporting fund status. (VTI and VXUS are U.K. reporting funds, making stocks fund choices self-explanatory.)

My main uncertainty is:

Should I invest in the Vanguard Total Bond Market ETF (BND) and be done with it? My understanding is that this is not a tax efficient move when my entire portfolio will be in a taxable account. I'm also concerned about BND's average duration.

Or should I accrue I-bonds instead for my bond allocation, given their superior tax efficiency in taxable accounts, especially as I live in New York CIty and have to pay high State/City Taxes? I'm aware there's a $10,000 annual I-bond investment limit, which will at first amount to much less than a 10%-20% bond allocation.

Or perhaps there's another way for me to meet my bond allocation as tax efficiently as is possible when I currently have no tax-advantaged accounts?

I would be extremely grateful for any help with this! These forums have been immensely informative -- thank you for that already. I'll try my best to give any additional details that are needed. And if I'm doing anything stupid with the non-bond aspect of my portfolio please don't hesitate to tell me.
Last edited by notsure on Tue May 07, 2013 7:38 pm, edited 18 times in total.
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Re: Help a young man plan!

Postby ieee488 » Mon Apr 22, 2013 7:49 am

Bumping this up for you

Hope someone can help.
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Re: Help a young man plan!

Postby notsure » Tue Apr 23, 2013 8:10 am

Since posting my query I've been searching Bogleheads a lot for advice about using I-bonds as part (or all) of ones bond allocation. There doesn't seem to be complete agreement about this. Am I right to think that an I-bonds bond allocation would make my portfolio considerably less diversified than holding the Total Bond Market ETF? In which case, shouldn't diversification be my primary concern, rather than tax efficiency?
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Re: Help a young man plan

Postby tibbitts » Tue Apr 23, 2013 8:45 am

I think nobody is answering because of your complicated legal/tax situation, and very few people are expert on that. The other reason is that it probably won't matter much.

Some of the appeal of ibonds has to do with provisions that most of us don't know well enough to know whether they apply to you (education benefits, for example.) While you mention diversification, some of its value is in reducing the credit risk of non-credit-risk-free securities, and that benefit doesn't apply to government bonds. Obviously diversifying in types of fixed income might still be valuable, but a portion of forum members don't do that, so diversification in fixed income is not necessarily considered a requirement by everyone here.

Honestly I'd just do whatever you believe is the simplest option (considering future redemptions/taxation), and not waste a lot of effort worrying about the "best" option.

Paul
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Re: Help a young man plan

Postby notsure » Tue Apr 23, 2013 9:00 am

Paul (tibbitts), thank you very much for your reply. Just to confirm, are you suggesting that I do not necessarily need a bond allocation? From reading the forum, I'm aware that a bond allocation is recommended firstly to avoid reacting unwisely to ones portfolio value plummeting in a crash, and secondly to sell bonds to buy stocks cheaply when rebalancing ones allocation during a crash. But if an all stocks portfolio doesn't miss out on return, perhaps that is the best solution in my situation.

The I-bond education benefit might be useful for my wife and me but we don't have children yet. Hopefully my situation isn't too complex for forum members to understand, since there seem to be so few Vanguard Funds I can invest in! I suppose it's a question of whether a 10% bond allocation held in the Vanguard Total Bond Market ETF is worthwhile in a portfolio with a long-term horizon that is exclusively held in a taxable account.
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Re: Help a young man plan

Postby snowman » Tue Apr 23, 2013 9:30 am

notsure,

I would not change a thing on the equity side if I were you. On the FI side, mainly given your age and only partially your tax considerations, I would skip the bond allocation for now. I don't want to list all conditions for this to be the right course of action, you know what they are if you have been reading this site for a while. You would start adding bonds later in your life according to plan you create now, whether it's based on your age, availability of tax-deferred space, some combination of the two, or other factors. That's what I would do if I were in your shoes, given MY level of risk tolerance.

If, after careful consideration, you decide that having 10-20% in bonds now is the right AA for you (a very good long term plan, BTW), than I would just buy BND. Yes, it's not perfect, but neither are other ETFs you mentioned. Since the main function of bonds in YOUR portfolio is risk reduction and rebalancing opportunity, not income or inflation protection, BND is the best overall choice for you - it is very inexpensive, broadly diversified bond fund for easy rebalancing action when your equities tank.

Given your young age, I would also suggest to resist temptation in the future to further diversify by adding additional ETFs to your portfolio. You could end up just a tiny bit better, or a lot worse off. Once you pick your plan, stay with it forever (or at least for a few decades), the results will follow. Where your first bond funds are located at this point in your life will make zero difference in the long run.
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Re: Help a young man plan

Postby dbr » Tue Apr 23, 2013 9:42 am

notsure wrote:Paul (tibbitts), thank you very much for your reply. Just to confirm, are you suggesting that I do not necessarily need a bond allocation? From reading the forum, I'm aware that a bond allocation is recommended firstly to avoid reacting unwisely to ones portfolio value plummeting in a crash, and secondly to sell bonds to buy stocks cheaply when rebalancing ones allocation during a crash. But if an all stocks portfolio doesn't miss out on return, perhaps that is the best solution in my situation.

The I-bond education benefit might be useful for my wife and me but we don't have children yet. Hopefully my situation isn't too complex for forum members to understand, since there seem to be so few Vanguard Funds I can invest in! I suppose it's a question of whether a 10% bond allocation held in the Vanguard Total Bond Market ETF is worthwhile in a portfolio with a long-term horizon that is exclusively held in a taxable account.


A couple of points. One is that a bond allocation as low as 10% is neither here nor there, in fact may not be worth the hassle. That small amount also has no meaningful tax cost, especially at current interest rates. If you are concerned about volatility in stocks, and I don't assume you are, you would want 25% or much more in bonds to have a meaningful effect. That also applies to any concept of configuring a somewhat more optimal portfolio, A second point is that rebalancing is something one is obligated to do to keep risk in line; it is not an opportunity to buy stocks cheap as on average holding bonds reduces returns. The so-called rebalancing bonus is a tricky thing that involves a great deal of rather equivocal analysis.

I bonds are a helpful way to hold bonds due to special properties such as tax deferral, inflation adjustment, education benefits, and so on. There is also a downside that they stop paying interest and taxes are assessed at the end of thirty years, so young investors should plan for that.

I have no idea what particular considerations apply to non-citizen investors in the US.
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Re: Bonds, taxes, limited funds to choose from

Postby notsure » Tue Apr 23, 2013 11:16 am

snowman and dbr, thank you for your suggestions. You have both made me feel confident in a 100% stock portfolio, together with what I've read on Oblivious Investor regarding young investors. (I had been considering 100% stocks recently.)

I identify with snowman's recommendation to keep the portfolio simple and do not intend to diversify beyond the two funds. Indeed, I think I will simplify further and only invest in the Vanguard Total World Stock ETF (VT), which is also available to me as a U.K. reporting fund. (I have edited my original post to reflect this.) I'm aware that the Total World Stock Market ETF (VT) currently holds just 4871 stocks as opposed to a combined 9421 stocks in the Total Stock Market (VTI) and Total International Market (VXUS) ETFs; and that the VT expense ratio would be higher (0.19% as against an averaged 0.105%, I think). But VT seems to be tax efficient in a taxable account and the simplicity of a single fund approach is worth a lot to me.

If there's any essential reading about how to shift into bonds over such a long-term horizon, I would be very curious to find out. My inclination is to accumulate bonds gradually, ideally using new contributions, either with I-bonds (bearing in mind the 30 year assessment, as dbr points out) or once tax advantaged accounts become available to me, or probably both -- but perhaps this strategy is insufficiently scientific.
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Re: Bonds, taxes, limited funds to choose from

Postby snowman » Tue Apr 23, 2013 3:06 pm

As far as buying VT only and be done with it, it certainly is an option, and not a bad one. I don't do it myself mostly for the reason you outlined - ER. My spreadsheet keeps track of current AA very accurately, so new funds get invested to restore balance, it's super easy. For me personally, VT would have to be cheaper than VTI/VXUS combo to even consider investing in it.

Regarding further education on bonds - I don't think it's crucial for you right now. If you enjoy investments topic - I assume you do - you may read books recommended on this site. I would avoid books focusing solely on bonds. Instead, I would go through the classics written by Malkiel, Ellis, Bogle, Ferri, Roth etc. Just take your time, let it soak in, understand what bonds do (and don't do) in your portfolio. Don't change your AA based on what you just read. Over time, as years pass you by, you will have better idea where you are in life, amount of savings you have, where you would ideally want to be later on, the amount of risk you are willing to take (it will decline as your portfolio grows).

Since everyone's situation and risk tolerance is different, it's impossible for me (or anyone else) to recommend the right course of action. You may want to give yourself a deadline of say 2-3 years from now to come up with glide path for adding bonds to your portfolio. There are different ways to approach it, so it may not make sense to just come up with some numbers now without further education. There is no rush - in investing, the slower you go, the better.
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Re: Bonds, taxes, limited funds to choose from

Postby dbr » Tue Apr 23, 2013 3:19 pm

Just to be clear, I have no position on whether or not a person might choose a 100% stock portfolio under any given circumstances. My observation was to be sure to understand that deciding among 0-10%-20% is not much of a choice anyway.

There isn't and can't be a rule that is known to be superior to all other choices about how much to control portfolio volatility when. It is really a question of preference and judgement. Personally I am impressed by a general concept of moderation in all things and would tend to see the advice of Benjamin Graham that one should hold no less than 25% and no more than 75% in stocks as wise. It is pretty much how things work that when one has continued ability to earn and one is accumulating assets that volatility is not the enemy it is when one is withdrawing from a portfolio, but that does not mean unrestrained volatility is necessarily good. The general idea of a flight path (Rick Ferri) makes sense, but the specifics are hazy. The rule "age in bonds" is a reminder of the concept, and it is an expression of wisdom, but I don't think there is any necessity to use this as a formula.
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Re: Bonds, taxes, limited funds to choose from

Postby notsure » Tue Apr 23, 2013 4:15 pm

snowman and dbr, those are helpful clarifications. I understand, dbr, that your point was about the very limited effect of a 10% bond allocation and not about advocating for 100% stocks. And thank you for the reading ideas, snowman.

snowman wrote:As far as buying VT only and be done with it, it certainly is an option, and not a bad one. I don't do it myself mostly for the reason you outlined - ER. My spreadsheet keeps track of current AA very accurately, so new funds get invested to restore balance, it's super easy. For me personally, VT would have to be cheaper than VTI/VXUS combo to even consider investing in it.


I see the point about expense ratios. I guess I would prefer to be less involved as an investor, which VT allows for, and to not create tax bills from rebalancing. When computing the likely difference in expense ratios for my portfolio in $ terms each year, it would certainly amount to a considerable amount of money. But, for me, the expense might be worth avoiding distraction from work and being tempted to not stick to allocations. Hopefully VT's expense ratio will continue to get lowered by Vanguard, too.

snowman wrote:Since everyone's situation and risk tolerance is different, it's impossible for me (or anyone else) to recommend the right course of action. You may want to give yourself a deadline of say 2-3 years from now to come up with glide path for adding bonds to your portfolio. There are different ways to approach it, so it may not make sense to just come up with some numbers now without further education. There is no rush - in investing, the slower you go, the better.


I'll certainly try to educate myself and take it slowly. Working towards dbr's 25% bond allocation via new, tax-advantaged contributions, so that I have a less volatile portfolio eventually, might be one strategy for me to think about.
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Re: Bonds, taxes, limited funds to choose from

Postby notsure » Fri Apr 26, 2013 10:04 pm

To update, I think I'm no longer likely to go 100% stocks -- more like 80% stocks/20% bonds with the aim to raise the bond allocation to 25% with new contributions. My starting portfolio could total as much as $900,000 and I've started to think about how the stakes will get much higher with that size portfolio and about how I'll probably want less volatility than with a portfolio a third of that size, which I could be calmer around. I've learnt from the Oblivious Investor that the Vanguard short-term bond ETF (BSV) is my most tax-efficient bond ETF option given everything will be in a taxable account.
Last edited by notsure on Tue May 07, 2013 7:25 pm, edited 2 times in total.
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Re: Bonds, taxes, limited funds to choose from

Postby notsure » Sun May 05, 2013 11:55 am

I've slowly built up a little more knowledge from reading many great Bogleheads threads, the Bogleheads Guide to Investing, and The Elements of Investing. My portfolio plan has evolved.

Long-Term Investor was extremely helpful in outlining how to achieve a globally-weighted stocks allocation (equivalent to the Vanguard Total World Stock ETF [VT]) when investing in Vanguard Total Stock Market (VTI) and Vanguard Total International (VXUS).

Given I'm in my 20s, I now wondered if the Vanguard short-term bond ETF (BSV) is a good option in my long-term investment situation?

I understand that BSV is more tax-efficient and less risky than BND -- and that I would be taking my risks on the equities side of my portfolio à la Bernstein by choosing BSV (even though he disapproves of bond funds, I gather).

The general bogleheads consensus seems to be that it's foolish not to hold some bonds when you have a large portfolio, although I find the bond fund choice incredibly difficult, especially in the current bond environment and am tempted to regard my rental income (from a rental property that could eventually be sold) as an investment that offsets some of the need for bonds.
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Still dislike VGIT (Intermediate-Term Government Bond ETF)?

Postby notsure » Wed May 08, 2013 7:00 pm

I posted a question previously about bond funds but accidentally gave incomplete information about the funds that were available to me. I now realize I can invest in the Vanguard Intermediate-Term Government Bond ETF (VGIT), too. VGIT is a tax-efficient option for someone in my situation (investing in a taxable account so interest would be exempt from state and local income taxes), but my sense from reading older threads was that VGIT wasn't that popular. Do you still dislike VGIT relative to other intermediate-term bond funds?
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Re: Bonds, taxes, limited funds to choose from (edited title

Postby LadyGeek » Fri May 10, 2013 11:17 am

^^^ Welcome! I moved your post into your first thread, there's no need to start a new one. It's best to keep all the information in one spot so we can help you better.
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