Total Bond vs Municipal Bond Funds

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oofoo2000
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Total Bond vs Municipal Bond Funds

Post by oofoo2000 » Sun Apr 24, 2016 10:39 pm

Hi Bogleheads,

The general rule of thumb for when to use muni-bond funds rather than Total Bond is when you're in the 25% or sometimes the 28% tax bracket. In my case I'm in the 28% federal tax bracket and the 9.3% california state tax bracket so I thought its quite likely that I should be using muni-bonds in my taxable account. However, when I calculate the equivalent yield of Vanguard California Intermediate Term Tax-Exempt (SEC Yield 1.29%) I get 2.057% = 1.29% / (1-0.28-0.093). In comparison, the Vanguard Total Bond Index SEC Yield is 2.09% and has a much higher credit quality, is of shorter duration and is better diversified. I realize that at higher income tax levels the muni fund may make more sense, but in my tax situation it seems like choosing the Total Bond fund in the taxable account is appropriate which totally flies in the face of conventional wisdom as I understand it. Am I totally off-base here or is this some quirk of the current interest rate environment and/or these specific funds?

amphora
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Re: Total Bond vs Municipal Bond Funds

Post by amphora » Mon Apr 25, 2016 12:03 am

You did the math right.
As for credit quality, it's a bit more complicated. Total Bond Index is 70% higher quality federal gov't bonds (regular treasuries, agency, mortgage backed securities) and 30% corporate bonds. Meanwhile the California Muni Fund is all municipal bonds. So it's a bit more complicated.

If I were in your situation, I would buy CDs (check depositaccounts.com) because they have a higher expected yield than government bond funds right now and you can potentially break the CD if interest rates go way up.
Last edited by amphora on Mon Apr 25, 2016 2:22 am, edited 1 time in total.

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Re: Total Bond vs Municipal Bond Funds

Post by saltycaper » Mon Apr 25, 2016 12:52 am

Excellent example of why it's good to view rules of thumb and conventional wisdom with healthy skepticism. I agree the yield math is not in favor of holding a muni fund in your situation at this time. As for credit quality, I don't think Total Bond is much higher, because credit ratings across different classes of bonds (government, corporate, municipal, etc.) are not equal. (AAA Treasury bonds are safer than AAA munis, which are safer than AAA corporates.) But I do think it's fair to say Total Bond is more diversified, especially when compared against a state-specific muni fund. Combined with it's high allocation to Treasuries and government-backed securities, it is the "safer" option, IMO. I second the idea of using CDs, perhaps with a portion of your fixed income in a bond fund for ease of rebalancing.
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Re: Total Bond vs Municipal Bond Funds

Post by Coles » Mon Apr 25, 2016 2:20 am

oofoo2000 wrote:when I calculate the equivalent yield of Vanguard California Intermediate Term Tax-Exempt (SEC Yield 1.29%) I get 2.057% = 1.29% / (1-0.28-0.093).
Just to nitpick, but if you itemize deductions, you should use 0.093 x (1-0.28) as the state tax rate in the above calculation. This will lower the equivalent yield.

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Re: Total Bond vs Municipal Bond Funds

Post by anakinskywalker » Mon Apr 25, 2016 6:21 am

Coles wrote:
oofoo2000 wrote:when I calculate the equivalent yield of Vanguard California Intermediate Term Tax-Exempt (SEC Yield 1.29%) I get 2.057% = 1.29% / (1-0.28-0.093).
Just to nitpick, but if you itemize deductions, you should use 0.093 x (1-0.28) as the state tax rate in the above calculation. This will lower the equivalent yield.
I think you made a mistake. To me it seems if you itemize deductions (on the federal return) you should use 0.28 * (1-0.093) as the federal tax rate in the above calculation. This assumes your tax brackets remain the same next year so you can deduct this year's CA tax on your interest income from your federal taxable income next year in the 28% bracket.

Anakin

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Re: Total Bond vs Municipal Bond Funds

Post by retiredjg » Mon Apr 25, 2016 7:35 am

You are asking "which bond fund to hold in taxable?" I think this is the wrong question unless you are saving this money for a short term goal such as your next car or a home downpayment. If this money is for retirement, your question should first be "where should I hold my bonds?"

If you hold your bonds in a tax-advantaged account, such as a 401k or IRA, you get the benefit of the higher yield without paying taxes now.

This would be in keeping with conventional Boglehead wisdom.

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oofoo2000
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Re: Total Bond vs Municipal Bond Funds

Post by oofoo2000 » Mon Apr 25, 2016 10:14 am

anakinskywalker wrote:
Coles wrote:
oofoo2000 wrote:when I calculate the equivalent yield of Vanguard California Intermediate Term Tax-Exempt (SEC Yield 1.29%) I get 2.057% = 1.29% / (1-0.28-0.093).
Just to nitpick, but if you itemize deductions, you should use 0.093 x (1-0.28) as the state tax rate in the above calculation. This will lower the equivalent yield.
I think you made a mistake. To me it seems if you itemize deductions (on the federal return) you should use 0.28 * (1-0.093) as the federal tax rate in the above calculation. This assumes your tax brackets remain the same next year so you can deduct this year's CA tax on your interest income from your federal taxable income next year in the 28% bracket.

Anakin
You are both correct! Thanks for pointing out that flaw. These changes bring the yield in the calculation down to 1.90%

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Re: Total Bond vs Municipal Bond Funds

Post by oofoo2000 » Mon Apr 25, 2016 10:18 am

amphora wrote:
If I were in your situation, I would buy CDs (check depositaccounts.com) because they have a higher expected yield than government bond funds right now and you can potentially break the CD if interest rates go way up.
saltycaper wrote: I second the idea of using CDs, perhaps with a portion of your fixed income in a bond fund for ease of rebalancing.
When I look at 5-year CDs (duration is about the same as the bond funds), the rates look pretty similar to the Total Bond Fund (~2% - 2.1%). Is the argument that CDs should be used because they provide a guaranteed return?

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Re: Total Bond vs Municipal Bond Funds

Post by NHRATA01 » Mon Apr 25, 2016 10:21 am

oofoo2000 wrote:
amphora wrote:
If I were in your situation, I would buy CDs (check depositaccounts.com) because they have a higher expected yield than government bond funds right now and you can potentially break the CD if interest rates go way up.
saltycaper wrote: I second the idea of using CDs, perhaps with a portion of your fixed income in a bond fund for ease of rebalancing.
When I look at 5-year CDs (duration is about the same as the bond funds), the rates look pretty similar to the Total Bond Fund (~2% - 2.1%). Is the argument that CDs should be used because they provide a guaranteed return?
I would say yes, all things considered a "guaranteed return" or a guaranteed protection of the capital. You potentially stand to take a capital loss on bonds should the prices fall with rising yields; that's not a risk with CD's.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Mon Apr 25, 2016 1:26 pm

oofoo2000 wrote:Hi Bogleheads,
I realize that at higher income tax levels the muni fund may make more sense, but in my tax situation it seems like choosing the Total Bond fund in the taxable account is appropriate which totally flies in the face of conventional wisdom as I understand it. Am I totally off-base here or is this some quirk of the current interest rate environment and/or these specific funds?
There is a permanent quirk with tax calculators, which makes them pretty much worthless.

The quirk is that they ignore risk. To your credit, you tried to account for this by inspecting the credit and maturity numbers yourself, but this is information that is incomplete, out of date, and in the case of ratings not even directly comparable.

Basically, what happens right now is that the market thinks the corporate bonds that are in TBM are riskier than municipal bonds. Because of this, it is demanding higher yields. The tax calculator tells you to go against the market, and it's of course wrong. It would be similarly wrong if you compared two taxable funds with "similar at first glance" risk positions, which would be a comparison of yield, where from one day to the other the recommendation to choose one over the other would change. I'm sure you can find a fund out there that you can plug into the calculator and get a higher yield than TBM, isn't that so? Acting on these yield comparisons is market timing, it assumes the market is wrong when in reality the market is probably far ahead of the bond ratings, the speed with which the funds publish their portfolio ratings, the subtleties introduced by callable bonds in both munis and TBM, and even today vs yesterday.

In my opinion, the yield itself is the best indication of risk for market instruments. It' s true that this makes comparisons across tax regimes harder, but there's no way around it since nobody other than a highly sophisticated credit analyst will tell you when two funds (munis and taxable) are actually comparable. Hence the 25% rule, which assumes that the market as a whole acts like a person in the 25% bracket when evaluating corporate vs muni bonds, and that collective wisdom is your sophisticated credit analyst.

Think about how sound (and boglehead-ish) this rule is, vs. yield comparisons: your choice only depends on your personal circumstances, not the market. Your choice does not change from one month (/year) to the other. Your choice does not change depending on exactly which fund is chosen on either side. A few years ago a tax yield calculator user would have been tempted to switch to munis even in the 0% bracket (the market was very worried about them), which would have been a crazy thing to do considering those worries.

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Re: Total Bond vs Municipal Bond Funds

Post by oofoo2000 » Mon Apr 25, 2016 2:40 pm

ogd wrote: In my opinion, the yield itself is the best indication of risk for market instruments. It' s true that this makes comparisons across tax regimes harder, but there's no way around it since nobody other than a highly sophisticated credit analyst will tell you when two funds (munis and taxable) are actually comparable. Hence the 25% rule, which assumes that the market as a whole acts like a person in the 25% bracket when evaluating corporate vs muni bonds, and that collective wisdom is your sophisticated credit analyst.

Think about how sound (and boglehead-ish) this rule is, vs. yield comparisons: your choice only depends on your personal circumstances, not the market. Your choice does not change from one month (/year) to the other. Your choice does not change depending on exactly which fund is chosen on either side. A few years ago a tax yield calculator user would have been tempted to switch to munis even in the 0% bracket (the market was very worried about them), which would have been a crazy thing to do considering those worries.
Ok, so now I'm even more confused. Your post suggests that since I'm in the 28% tax bracket that I should follow the rule of thumb and buy tax-exempt bond funds (without comparing yields) since I need to place bonds into my taxable account (out of space in my 401k). However, if I follow this line of logic, since my target portfolio is the three-fund portfolio with TBM shouldn't I be using TBM in taxable since in the words of Bogle I'll be owning the entire haystack (its risks and rewards) as opposed to a small slice of the bond market (tax-exempt municipals) and its associated concentrated risks and rewards which you note above? Or is that concept only applicable to the equities side of the portfolio? If I am choosing bond funds and the yield is effectively equivalent to the risk, then doesn't this mean that if both funds have equivalent yields they're effectively identical? If so then it doesn't matter at all which one I choose? At least on the surface, this doesn't make sense to me.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Mon Apr 25, 2016 3:30 pm

oofoo2000 wrote: However, if I follow this line of logic, since my target portfolio is the three-fund portfolio with TBM shouldn't I be using TBM in taxable since in the words of Bogle I'll be owning the entire haystack (its risks and rewards) as opposed to a small slice of the bond market (tax-exempt municipals) and its associated concentrated risks and rewards which you note above?
Well TBM doesn't include tax-exempt bonds, for good reasons -- e.g. it would be a terrible idea for 401k buyers -- so you can see that the "entire haystack" concept is not applicable to bonds beginning with fund construction. It also doesn't include TIPS, for different reasons but also related to personal circumstances -- some investors need more inflation protection than others, specifically those with very high fixed income allocations.

Both the national muni and the CA muni funds are diversified enough vs individual issues. They are exposed to sectoral issues, true, but the free lunch you get from an above-average tax deduction may or may not be too big to ignore. My diversification rule of thumb is to keep munis below 50% of fixed income (in all accounts) and state munis below 33% of fixed income. Note that your 401k (and mine) can go a good distance towards fulfilling the non-muni side of the equation.
oofoo2000 wrote:Or is that concept only applicable to the equities side of the portfolio?
Equities have fairly uniform taxation. If you had tax-exempt equities you'd see the same split-and-choose that you see with TBM and munis, I assure you.
oofoo2000 wrote:If I am choosing bond funds and the yield is effectively equivalent to the risk, then doesn't this mean that if both funds have equivalent yields they're effectively identical? If so then it doesn't matter at all which one I choose? At least on the surface, this doesn't make sense to me.
This would be true before tax considerations. For example, when it comes to taxable bonds I don't see you agonizing whether to choose TBM vs corporate-only vs high yield bonds, comparing yields etc -- you intuitively understand that it doesn't really matter and it's just a risk/reward tradeoff.

With tax considerations, the rationale is this: the market price (or yield) comparison of a taxable and a tax-exempt bond cannot possibly be right for an investor in the 0% tax bracket and an investor in a 35% tax bracket at the same time. One of those investors is getting a bad deal in at least one of those bonds, and they should make different choices. So yes, when considering one's personal tax situation it does matter which bonds you choose, except somewhere in the middle (25% bracket) where the choices are about even.
oofoo2000 wrote:Ok, so now I'm even more confused.
I thought it was the yield comparison that made you confused, and not the rationale for the rule of thumb you started with :wink: You were looking for a "quirk" that reconciled the two, and I'm just explaining that the quirk is that yield comparisons are IMHO as useless as they'd be between bond funds that fall the same tax category.

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Re: Total Bond vs Municipal Bond Funds

Post by oofoo2000 » Mon Apr 25, 2016 6:12 pm

ogd wrote: With tax considerations, the rationale is this: the market price (or yield) comparison of a taxable and a tax-exempt bond cannot possibly be right for an investor in the 0% tax bracket and an investor in a 35% tax bracket at the same time. One of those investors is getting a bad deal in at least one of those bonds, and they should make different choices. So yes, when considering one's personal tax situation it does matter which bonds you choose, except somewhere in the middle (25% bracket) where the choices are about even.
Ok, I've chewed on this a little and I think I get it. This may be obvious to many, but is this how I should think of all of this: non-muni fund yields / risk can be compared with each other because they're on a level playing field (i.e. all taxable, yield=risk). Muni-bond yields are what they are such that they're attractive to a specific tax bracket (e.g. 25% or 28% and higher). Since the underlying bonds are the same for each investor, the risk is the same no matter your tax bracket. However, the 0% bracket investor is not getting enough yield for the risk they are taking, while the 35% bracket investor is getting "free" yield and the sweet spot is somewhere around 25%-28%?

If one can't use equivalent tax yield and an examination of duration / credit quality to determine whether to choose between muni vs. non-muni funds, how is this 25-28% sweet spot calculated in order to generate this rule of thumb?

Thanks!

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Mon Apr 25, 2016 6:28 pm

oofoo2000 wrote:Ok, I've chewed on this a little and I think I get it. This may be obvious to many, but is this how I should think of all of this: non-muni fund yields / risk can be compared with each other because they're on a level playing field (i.e. all taxable, yield=risk).
Yes, pretty much. Using an after-tax yield calculator is the same as comparing taxable bonds on yield, i.e. not a very good idea.
oofoo2000 wrote:If one can't use equivalent tax yield and an examination of duration / credit quality to determine whether to choose between muni vs. non-muni funds, how is this 25-28% sweet spot calculated in order to generate this rule of thumb?
You've hit upon a chink in my armor: I don't actually have a good single source for this. My own ideas about this number are based on having seen a low of -15% spread between munis and Treasuries before 2007, so the discount has to be at least that because munis were obviously still riskier. At the same time, the sweet spot can't be very high, or the high bracket buyers above it would not generate much demand. 25-28% seemed to agree with what I read here and other places, so that was it for me.

I think for you it's not necessarily a slam-dunk until you include CA tax and buy CA bonds. Then it is.

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Re: Total Bond vs Municipal Bond Funds

Post by saltycaper » Mon Apr 25, 2016 11:55 pm

oofoo2000 wrote:When I look at 5-year CDs (duration is about the same as the bond funds), the rates look pretty similar to the Total Bond Fund (~2% - 2.1%). Is the argument that CDs should be used because they provide a guaranteed return?
Yes. FDIC-insured--as good as a Treasury bond really. Plus if it is a direct bank CD, as opposed to a brokered CD, you can (usually) withdraw early if rates move much, and the option/penalty to do so is comparatively cheap to what it would be if large institutional players were in the same market.
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Re: Total Bond vs Municipal Bond Funds

Post by saltycaper » Tue Apr 26, 2016 12:24 am

ogd wrote:You've hit upon a chink in my armor: I don't actually have a good single source for this. My own ideas about this number are based on having seen a low of -15% spread between munis and Treasuries before 2007, so the discount has to be at least that because munis were obviously still riskier. At the same time, the sweet spot can't be very high, or the high bracket buyers above it would not generate much demand. 25-28% seemed to agree with what I read here and other places, so that was it for me.
It'd be great if someone could quantify this with more data on spreads, but that might not be enough.

To confuse the idea of the market's long-term "breakeven" bracket further, if, on a scale of 1 to 10, with one being the least risky U.S. investment-grade bond and 10 being the most risky U.S. investment-grade bond, I would think, based on historic default rates, that a Treasury bond and a municipal bond of equal duration and credit rating might be only 1 ranking removed, while similarly rated corporate and municipal bonds would be at least 2 rankings removed from each other.

But, qualitatively, the potential for future default on a Treasury bond compared to a municipal bond must be far different than 1 ranking, as the federal government controls the money supply. Omitting this fact, it might even make sense for a person in the 15% bracket to invest in municipal bonds over Treasuries, but taking it into consideration, it may never make sense for anyone to substitute municipal bonds for Treasuries, no matter their tax bracket.

The market sees the truth as somewhere in between, but this is a problem (for me), as it's a bit like valuing the chance of an either/or situation at 50%, when it will either happen or it won't. I don't think the market is very good at pricing low-probability events with extraordinary consequences, such as a series of significant municipal bond defaults. Not that I or anyone I know can price it better, but that seems to be what we have to do when deciding what spreads to use between munis and whatever alternative bond fund is under consideration. So, we came up with the 25% rule of thumb because nobody really knows.
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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Tue Apr 26, 2016 1:48 am

saltycaper wrote: I don't think the market is very good at pricing low-probability events with extraordinary consequences, such as a series of significant municipal bond defaults. Not that I or anyone I know can price it better,
saltycaper: I think that in reality the snippets in bold are functionally equivalent. We might think that the market gets some things wrong, but if we can't do any better then we should still follow it. The market on occasion gets equities horribly wrong, by like 50%, yet it's extremely hard to beat it.
saltycaper wrote:So, we came up with the 25% rule of thumb because nobody really knows.
The rule of thumb simply says that the market operates as a credit analyst better than you, operating in the 25% bracket.
saltycaper wrote:It'd be great if someone could quantify this with more data on spreads, but that might not be enough.
Here's another justification for the sweet spot being somewhere in the middle: as you hypothetically increase it, you can reason that not only are there fewer and fewer tax payers above that spot, but the free lunch is less attractive to them as well. So if I'm in the 39% bracket and the sweet spot would be 35%, I'd be far less excited about a 4% free lunch than about a 14% free lunch and I might not bother or choose diversification instead. The combination is a quadratic effect of sorts that should push the sweet spot towards the arithmetic middle, more than you'd think from the mere distribution of taxpayers.

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Re: Total Bond vs Municipal Bond Funds

Post by saltycaper » Tue Apr 26, 2016 11:19 pm

ogd wrote:Here's another justification for the sweet spot being somewhere in the middle: as you hypothetically increase it, you can reason that not only are there fewer and fewer tax payers above that spot, but the free lunch is less attractive to them as well. So if I'm in the 39% bracket and the sweet spot would be 35%, I'd be far less excited about a 4% free lunch than about a 14% free lunch and I might not bother or choose diversification instead. The combination is a quadratic effect of sorts that should push the sweet spot towards the arithmetic middle, more than you'd think from the mere distribution of taxpayers.
All good points, ogd. I hadn't though to approach the question by quantifying the investors rather than the bonds. So you are saying that as the breakeven bracket drops, you have 1) more individuals who stand to benefit, and 2) they are all salivating more for this free lunch. These two factors produce a sort of quadratic effect for the demand of tax-exempt bonds, such that the breakeven bracket can't really drop below 25%, because there would be too many people who stand to benefit too much for prices to withstand overwhelming demand, and that it can't be much higher than 25%, because the diminishing attractiveness of the lunch would not entice enough buyers.

I'll just add that if we are going to talk about a free lunch--even one that has a tiny possibility of being spoiled or stolen--it seems to make more sense to compare munis to Treasuries than it does to compare them to corporates, as I read "free lunch" as getting a much better after-tax yield without taking on much additional risk. The comparative yields between an intermediate-term Treasury fund and an intermediate-term muni fund certainly seem to mesh more with a 25% breakeven bracket than something like Total Bond. The tendency to compare TE to the latter seems to produce many similar threads.
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Re: Total Bond vs Municipal Bond Funds

Post by Da5id » Wed Apr 27, 2016 7:07 am

saltycaper wrote: I'll just add that if we are going to talk about a free lunch--even one that has a tiny possibility of being spoiled or stolen--it seems to make more sense to compare munis to Treasuries than it does to compare them to corporates, as I read "free lunch" as getting a much better after-tax yield without taking on much additional risk.
Munis aren't all equal either, one can just ask those who have Puerto Rico bonds. And Illinois has it's credit issues too. I went looking for a current bond rating by state as of 2016, but didn't find a recent one (probably easy to find, but I didn't see it). Are you saying that you feel like a Muni of a given credit rating is better than a corporate of similar rating, other than the tax benefit? Or are you just saying that the range of corporate ratings is generally broader?

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Wed Apr 27, 2016 9:37 am

saltycaper wrote:I'll just add that if we are going to talk about a free lunch--even one that has a tiny possibility of being spoiled or stolen--it seems to make more sense to compare munis to Treasuries than it does to compare them to corporates, as I read "free lunch" as getting a much better after-tax yield without taking on much additional risk. The comparative yields between an intermediate-term Treasury fund and an intermediate-term muni fund certainly seem to mesh more with a 25% breakeven bracket than something like Total Bond. The tendency to compare TE to the latter seems to produce many similar threads.
It looks that way now, doesn't it. But go back to Fall 2013 and you will find Vanguard's muni fund yielding 2.7% and Total Bond Market yielding 2.2%, and all you heard about was California, Illinois, Detroit and (for the true visionaries) Puerto Rico. It didn't work out that way, but you can't accuse the market of not worrying about munis. They looked, and probably were, more risky than corporates.

Relating to the subject of this thread, what we heard back then from tax calculators was why not use munis even in the 0% bracket, i.e. the opposite from now. It should be clear that tax calculators always choose the higher risk instrument. Once again, choosing munis in low brackets actually worked out, that time, but it could have easily been different and you definitely went against the market.

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Re: Total Bond vs Municipal Bond Funds

Post by rjbraun » Wed Apr 27, 2016 10:30 am

saltycaper wrote:
oofoo2000 wrote:When I look at 5-year CDs (duration is about the same as the bond funds), the rates look pretty similar to the Total Bond Fund (~2% - 2.1%). Is the argument that CDs should be used because they provide a guaranteed return?
Yes. FDIC-insured--as good as a Treasury bond really. Plus if it is a direct bank CD, as opposed to a brokered CD, you can (usually) withdraw early if rates move much, and the option/penalty to do so is comparatively cheap to what it would be if large institutional players were in the same market.
I've been thinking about this topic for a while and remain confused :?

Based on a quick search just now, it seems that the upper-end of rates for a 2-year CD is about 1.5%. The Vanguard Short-term Government Bond Index - Admiral Shares ("VSBSX")is virtually entirely US governments (98.8%); 1.9 year average duration, 0.8% stated yield to maturity.

VSBSX's 1.9 year average duration is roughly comparable to the duration of a 2-year CD, right? Of course, the CD's 1.5% yield trumps VSBSX's 0.8%, though I'm not sure it's a pure apples-to-apples comparison.

Year-to-date through 3/31 VSBSX is up 0.89%. The CD's "return" would be something like 0.38%, is that right?

Based purely on these statistics, I would think someone investing at the beginning of the year would have been better off owning VSBSX (or the equivalent in Investor Shares). On top of the higher return they would have daily liquidity and not had to face the CD's early redemption fee.

But I keep reading that CDs now and in the recent past have offered better value. What am I missing? Is my example simply a "one-off" and things could have simply gone the other way? I suppose that's true, but does that make VSBSX overvalued now, relative to where it traded on January 4?

Edit: Apologies for unintentionally highjacking OP's thread and original question

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Wed Apr 27, 2016 10:41 am

rjbraun wrote: Year-to-date through 3/31 VSBSX is up 0.89%. The CD's "return" would be something like 0.38%, is that right?

Based purely on these statistics, I would think someone investing at the beginning of the year would have been better off owning VSBSX (or the equivalent in Investor Shares). On top of the higher return they would have daily liquidity and not had to face the CD's early redemption fee.
That fund started the year at 0.98% yield. It ended March at 0.77%. That's the source of the extra return. Liquid bonds will sometimes do that -- front-load part of their return at the expense of later returns. For someone buying now, the fact that it did well YTD is a negative and it makes the fund less attractive vs a CD (assumed unchanging) than it used to be. At other times, liquid bonds will delay part of their return as an effect of interest rate risk -- negative in the short term, higher in the long term. That makes the fund more attractive vs a CD of unchanging yield.

Yes, the investor in hindsight would have been well advised to buy VSBSX in January and sell it in March. They would have been even better advised to buy stocks and make 3%+. Such are the markets. But that doesn't invalidate the decision to buy an instrument with higher yield and known same risk (i.e. none), in January -- it was the right thing to do at the time.

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Morningstar Calculator

Post by Taylor Larimore » Wed Apr 27, 2016 10:51 am

oofoo2000:

You may find this helpful: Morningstar Tax-Equivalent Yield Calculator

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Total Bond vs Municipal Bond Funds

Post by rjbraun » Wed Apr 27, 2016 11:27 am

ogd wrote:
rjbraun wrote: Year-to-date through 3/31 VSBSX is up 0.89%. The CD's "return" would be something like 0.38%, is that right?

Based purely on these statistics, I would think someone investing at the beginning of the year would have been better off owning VSBSX (or the equivalent in Investor Shares). On top of the higher return they would have daily liquidity and not had to face the CD's early redemption fee.
That fund started the year at 0.98% yield. It ended March at 0.77%. That's the source of the extra return. Liquid bonds will sometimes do that -- front-load part of their return at the expense of later returns. For someone buying now, the fact that it did well YTD is a negative and it makes the fund less attractive vs a CD (assumed unchanging) than it used to be. At other times, liquid bonds will delay part of their return as an effect of interest rate risk -- negative in the short term, higher in the long term. That makes the fund more attractive vs a CD of unchanging yield.

Yes, the investor in hindsight would have been well advised to buy VSBSX in January and sell it in March. They would have been even better advised to buy stocks and make 3%+. Such are the markets. But that doesn't invalidate the decision to buy an instrument with higher yield and known same risk (i.e. none), in January -- it was the right thing to do at the time.
Thank you, that's helpful.

In that case, is the idea be that, the greater a 2-year CD's quoted yield compared to VSBSX, the more compelling the case for an investor, confident that they will not need to redeem prior to 2 years, to buy the CD?

And, to the extent that investor may have a small chance of needing the money prior to 2 years one would need to factor the penalty for early withdrawal into the decision

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Re: Morningstar Calculator

Post by ogd » Wed Apr 27, 2016 11:34 am

Taylor Larimore wrote:oofoo2000:

You may find this helpful: Morningstar Tax-Equivalent Yield Calculator

Best wishes.
Taylor
Hi Taylor,

In my posts above I'm arguing that one shouldn't use tax-equivalent yield calculators any more than they should choose the higher-yielding fund of two taxable funds, or two tax-exempt.

Such calculators ignore risk. They will almost always (particularly in the middle tax brackets where the decision is the most pressing) choose the higher-risk fund. If we try plugging in two taxable funds like TBM and Corporate Index, this is abundantly clear. It is only a little less so with different tax treatment.

IMHO, the fact that tax calculators ignore risk and we have no way of really knowing whether two funds from different sectors are similar in risk, except the yield itself, makes them not useful.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Wed Apr 27, 2016 11:38 am

rjbraun wrote:In that case, is the idea be that, the greater a 2-year CD's quoted yield compared to VSBSX, the more compelling the case for an investor, confident that they will not need to redeem prior to 2 years, to buy the CD?
Yes, certainly. The reason CDs are exempt (so to speak) from the rationale that higher yield is indicative of higher risk is that they are insulated from the market, and their FDIC insurance allows us to know the risk -- which is for all intents and purposes zero. Perhaps the only thing less risky than even government bonds, since in a crunch small investors would be the very last ones to get hurt, for political reasons. Even in Cyprus ... (disallowed topic).

However, I would usually choose a 5 year CD which even after penalty pulls in front of shorter terms pretty quickly. Allowing the possibility of holding longer than intended (and not paying the penalty at all) as a bonus.

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Bond tax-calculators

Post by Taylor Larimore » Wed Apr 27, 2016 1:54 pm

IMHO, the fact that tax calculators ignore risk and we have no way of really knowing whether two funds from different sectors are similar in risk, except the yield itself, makes them not useful.
ogd:

You make an excellent point that "risk" is much more important than "return" when comparing bonds and bond funds.

Thank you and best wishes.
Taylor
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Re: Total Bond vs Municipal Bond Funds

Post by saltycaper » Thu Apr 28, 2016 1:14 am

Da5id wrote:
saltycaper wrote: I'll just add that if we are going to talk about a free lunch--even one that has a tiny possibility of being spoiled or stolen--it seems to make more sense to compare munis to Treasuries than it does to compare them to corporates, as I read "free lunch" as getting a much better after-tax yield without taking on much additional risk.
Munis aren't all equal either, one can just ask those who have Puerto Rico bonds. And Illinois has it's credit issues too. I went looking for a current bond rating by state as of 2016, but didn't find a recent one (probably easy to find, but I didn't see it). Are you saying that you feel like a Muni of a given credit rating is better than a corporate of similar rating, other than the tax benefit? Or are you just saying that the range of corporate ratings is generally broader?
I never really considered it on a state-by-state basis, as I myself would not invest in a state-specific muni fund--simply not the type of risk I wish to take. Then again, I don't live in a state with a high income tax, and perhaps I would feel differently if I did.

I do generally view a municipal bond as less risky than an equally rated corporate bond, and I believe historical default rates back this up. (In fact, I think one reason for investing in a muni fund even if a tax calculator favors a fund that includes corporates is in cases where you want to lower the risk of your bond portfolio.)

If, however, I was forced to invest in both individual municipal and individual corporate bonds, I'm sure there would be specific issues or categories of issues that would not fit this perception. Here's a tangentially relevant anecdote:

While I have no experience purchasing individual munis, for a short time, I purchased small oddball lots of individual investment-grade corporates that other individuals seemed to be having trouble selling to dealers, trying to earn a liquidity premium. That endeavor doesn't appear to have done me much harm, but it wasn't really productive or efficient either, so I stopped doing it. It was, however, fun and informative. One thing I learned while reading reports by analysts and trying to form my own lay opinions was the wide array of reasons one can conjure for why a company might fail to pay its creditors, from hard numbers like the debt load or revenue growth to softer qualities such as the ethics and strength of the management team. I tended to value the latter more than most analysts, as far as I could tell. It was also interesting to ponder whether analysts--and this was especially true when looking at the financial sector--really, truly, honestly, 100% understood the fine details behind the financial statements, or if they simply took all numbers at face value. Obviously the financial crisis was impacting my perception, but it was a lot easier for me to respect a dollar of assets owned by a company issuing an industrial bond than it was a dollar on a bank's balance sheet. I'm sure there are sectors in the muni space that have historically higher default rates and that there would be other reasons why within the muni market an 'A' rating here would not suffice for me as much as an 'A' rating there.

Anyway, my reason for the elaboration on my experience, which, however little it says about the corporate bond market says even less about the complexities of the municipal bond market, is to suggest how difficult it must be to assign an appropriate difference in risk between corporates and munis. Comparing to Treasuries is more sensible to me because you have practically zero credit risk with Treasuries, so you have a point from which to start--one of the variables is already known. I'm not saying munis == Treasuries when it comes to credit risk, although I believe my interpretation of ogd's "free lunch" reference was incorrect, and that he was not referring to risk but rather a tax free-lunch for those above the 25% bracket, and that certainly confused what I was saying.

As for whether the range of corporate ratings are broader, I've not really examined bonds below investment grade, so couldn't say, but I'd at least be willing to make the uneducated guess that the average of all muni ratings is higher than the average of all corporate ratings, if only because there are so few AAA/AA corporates. Due to the large pool of corporate junk, I'd guess the median muni bond would be rated higher than the median corporate bond too.

oofoo2000: FWIW, ogd has convinced me to change my opinion on the breakeven bracket, so I could see you utilizing munis for a portion of your portfolio.
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Re: Total Bond vs Municipal Bond Funds

Post by dltnfs » Thu Apr 28, 2016 2:21 am

ogd wrote:Here's another justification for the sweet spot being somewhere in the middle: as you hypothetically increase it, you can reason that not only are there fewer and fewer tax payers above that spot, but the free lunch is less attractive to them as well. So if I'm in the 39% bracket and the sweet spot would be 35%, I'd be far less excited about a 4% free lunch than about a 14% free lunch and I might not bother or choose diversification instead. The combination is a quadratic effect of sorts that should push the sweet spot towards the arithmetic middle, more than you'd think from the mere distribution of taxpayers.
I agree that demand for munis should increase with increasing yield for two reasons, both the expanded pool of buyers and the increased premium paid to buyers who were already in the pool. But shouldn't your starting distribution be weighted by the value of the bonds that each taxpayer wants to hold in taxable? That seems like it should push way up; "normal people" might own bonds in a 401(k), or CDs in taxable, but I don't think bonds in taxable are too common, and net worth obviously tends to increase with tax rate.

That makes the 25% surprisingly low to me. Maybe wealthy retired people are pushing it down? I guess it's hard to get into the 39.6% bracket off 401(k) withdrawals...

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Re: Total Bond vs Municipal Bond Funds

Post by TigerNest » Thu Apr 28, 2016 2:43 am

I consider the stable value of a CD to be a bit of a mirage. Its intrinsic value is impacted by interest rates just like publicly-traded bonds, but we can't see it because it's not publicly traded.

If you've locked in your money in a CD for 10 years at 3%, and then interest rates suddenly jump to 7%, you'll incur an opportunity cost of that lost extra 4% because you've tied up your money and can't get the new higher yield. If the CD was a publicly traded instrument, the price would've declined proportionately.

I do like CDs, and own a few. They have have added benefits like FDIC protection (so no default risk) and often have reasonable early withdrawal penalties (which I suppose functions like an option against interest rate risk). I prefer to rely on municipal bond funds for my planned expenses 2-5 years out though, despite the daily fluctuations in price, since I think it's almost unavoidable on risky investments.

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Re: Total Bond vs Municipal Bond Funds

Post by Da5id » Thu Apr 28, 2016 5:40 am

TigerNest wrote:I consider the stable value of a CD to be a bit of a mirage. Its intrinsic value is impacted by interest rates just like publicly-traded bonds, but we can't see it because it's not publicly traded.

If you've locked in your money in a CD for 10 years at 3%, and then interest rates suddenly jump to 7%, you'll incur an opportunity cost of that lost extra 4% because you've tied up your money and can't get the new higher yield. If the CD was a publicly traded instrument, the price would've declined proportionately.

I do like CDs, and own a few. They have have added benefits like FDIC protection (so no default risk) and often have reasonable early withdrawal penalties (which I suppose functions like an option against interest rate risk). I prefer to rely on municipal bond funds for my planned expenses 2-5 years out though, despite the daily fluctuations in price, since I think it's almost unavoidable on risky investments.
As you say at the end, not locked in at all. You can generally surrender some months interest and turn your 3% CD into a 7% one. Ability to do so insulates CDs somewhat. So a CD has much less risk in that way...

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Re: Total Bond vs Municipal Bond Funds

Post by 209south » Thu Apr 28, 2016 6:06 am

Good thread - I'm in New Jersey and just rechecked the math...interesting to see the SEC yield on Vanguard's NJ tax-exempt fund is 108 basis points higher than the Cali fund - 2.36% vs. 1.28% - duration is one year longer in NJ but that is a big spread - I know our economy is a basket case but I at least thought California shared our misery :wink:

While I've moved some of my fixed income exposure to CDs I'll keep the munis at 2.36% net, but if I were in Cali I would probably shift more to CDs.

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Re: Morningstar Calculator

Post by Allan Roth » Thu Apr 28, 2016 9:48 am

ogd wrote:
Taylor Larimore wrote:oofoo2000:

You may find this helpful: Morningstar Tax-Equivalent Yield Calculator

Best wishes.
Taylor
Hi Taylor,

In my posts above I'm arguing that one shouldn't use tax-equivalent yield calculators any more than they should choose the higher-yielding fund of two taxable funds, or two tax-exempt.

Such calculators ignore risk. They will almost always (particularly in the middle tax brackets where the decision is the most pressing) choose the higher-risk fund. If we try plugging in two taxable funds like TBM and Corporate Index, this is abundantly clear. It is only a little less so with different tax treatment.

IMHO, the fact that tax calculators ignore risk and we have no way of really knowing whether two funds from different sectors are similar in risk, except the yield itself, makes them not useful.
Hi Taylor. Thanks for pointing out the Morningstar Bond Calculator. It appears to do what I've seen many people ignore which is the fact that the state taxes paid on a taxable bond are typically tax-deductible from Federal taxes. Thus, if one is in the 28% Federal tax bracket and 9.3% state, you can't just take the rate and divide by 1-(.28+.093).

I also totally agree with ogd that these calculators (or any math) merely convert the rates and don't address risk. One must then determine if the extra yield is worth the risk just like one would have to do on taxable bonds. For example, is the yield on an investment grade taxable bond worth the extra default risk over a Total Bond Fund with about 64% US Government holdings?

My opinion is that one should not load up on munis as they have substantial risk from pension and health care obligations. Munis represent roughly 10% of the investment grade bond market and I recommend no more than 20% of one's fixed income portfolio be in munis - and muni bond funds (Vanguard) are far superior to owning individual bonds. Remember, one recovers from interest rate risk but not so much from default risk. Just ask holders of GM bonds. I practice what I preach and roughly 85-90% of my fixed income is backed by the US Government as most are in CDs.

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Bond-Equivalent Calculators?

Post by Taylor Larimore » Thu Apr 28, 2016 10:17 am

Allan:

Thanks to you, ogd and grabner, I am going to stop recommending bond-equivalent calculators.

Once again, I continue to learn more from the Bogleheads Forum than I contribute.

Thank you.

Best wishes.
Taylor
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Re: Bond-Equivalent Calculators?

Post by Allan Roth » Thu Apr 28, 2016 10:33 am

Taylor Larimore wrote:Allan:

Thanks to you, ogd and grabner, I am going to stop recommending bond-equivalent calculators.

Once again, I continue to learn more from the Bogleheads Forum than I contribute.

Thank you.

Best wishes.
Taylor
Taylor - I think good bond calculators like the one you posted are fine and I'd recommend them to convert yields. Risk just needs to be accounted for separately.

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Re: Total Bond vs Municipal Bond Funds

Post by Taylor Larimore » Thu Apr 28, 2016 10:40 am

Taylor - I think good bond calculators like the one you posted are fine and I'd recommend them to convert yields. Risk just needs to be accounted for separately.
Allan:

I've changed my mind (again). If I do recommend a bond calculator I'll be sure to add your caveat.

Taylor
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Re: Total Bond vs Municipal Bond Funds

Post by dltnfs » Thu Apr 28, 2016 12:37 pm

Da5id wrote:As you say at the end, not locked in at all. You can generally surrender some months interest and turn your 3% CD into a 7% one. Ability to do so insulates CDs somewhat. So a CD has much less risk in that way...
That's what he meant by the "option". People usually say that CDs price that option cheaper than e.g. a derivatives trader would sell it for, I guess because it's inconvenient enough to exercise that most people don't; though I'm not sure how you distinguish between the underpriced interest rate option and the underpriced bond (since CDs also pay higher yield than equivalently riskless Treasury bonds). It's a (small) free lunch either way.

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Re: Total Bond vs Municipal Bond Funds

Post by abuss368 » Thu Apr 28, 2016 12:51 pm

Ha ha oh no! Excellent thread. I did not see this earlier. I also have a thread going with a lot of the same questions.

This is excellent!
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Re: Total Bond vs Municipal Bond Funds

Post by Artsdoctor » Thu Apr 28, 2016 1:17 pm

Regarding bond yield calculators, I'm going to make it even MORE complicated.

One may think he's in a "28% bracket" but that may not be correct. Especially in high tax states, AMT can come into play frequently and rates can vary widely. In order to really compare yields (and not addressing risk), one would have to figure out his marginal rate. It's not as easy to just predict your "bracket" because you could be subject to other taxes, such as the net investment tax, PEP/Pease phase outs, and AMT as mentioned. High-tax state rates can also vary. To make matters worse, one year's marginal tax rate can be substantially different from another year's, and since we're committed to being long-term investors, you'd need to be prepared for some variability.

I'm not sure I'd be so restrictive as to limit my muni holdings to 15% of my fixed income holdings, but I think it would be wise to have some diversification in your fixed income holdings regardless of the yield looks like right this minute.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Thu Apr 28, 2016 7:25 pm

Allan Roth wrote: I also totally agree with ogd that these calculators (or any math) merely convert the rates and don't address risk. One must then determine if the extra yield is worth the risk just like one would have to do on taxable bonds. For example, is the yield on an investment grade taxable bond worth the extra default risk over a Total Bond Fund with about 64% US Government holdings?
Thanks for chiming in, Allan. My main question is, how is one supposed to determine the risk and decide whether the extra yield is worth the risk at any specific point in time? It's a really hard thing to do [*], and what we do in all other portions of our allocation is let the market determine it, buy something reasonable and let it ride regardless of the yield.

(* For example, in this very thread we have someone from New Jersey unaware of the state's major budget problems. For which I don't actually blame them, since I am similarly unmoved when it comes to my stock allocation and predictions for the economy -- I simply shrug and assume I am fairly rewarded for the risk taken, or at least market participants think so and they're better at it than I am. Are we supposed to all watch the muni and corporate bond markets around the clock?)

The rationale for avoiding the calculators is like so:
1) It's really hard to determine an exact, up-to-date measure of risk compatible with the yield.
2) The best such measure is the yield itself, discounted by a market-average tax rate for taxable bonds.
3) Whereby, the yield calculator becomes superfluous: if two bonds are comparable i.e. they have similar risk by the yield measure, then the answer of the yield calculator will always go the same way -- use tax-exempt if one's bracket is above the market average, use taxable otherwise.

My problem with yield calculators is not so much that they're tautological, but that they're very commonly misused -- their recommendation taken at face value without any measure of risk. The simple way to combat that use is to ask the user to compare TBM and a HY fund, and observe how HY always wins, because the calculator has no answer for which investment is actually appropriate.

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Re: Total Bond vs Municipal Bond Funds

Post by abuss368 » Thu Apr 28, 2016 7:43 pm

Bogleheads,

This has been an excellent thread but I am a little confused as I really can not see a consensus. Dare I suggest there may be inconsistencies.

1) For argument purposes lets assume bonds or some type of fixed income is needed in a taxable account.

2) Many posts in this thread suggest CDs. This is 100% taxed at federal and state rates. The risk is low.

3) What is investors prefer simple Treasuries in taxable? 100% federal taxed however there are no state or local taxes.

So....drumroll......What is that "bad" about Total Bond Index int taxable? 2/3 is Treasuries and thus no state or local taxes. Much less risk. I think this should be discussed.
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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Thu Apr 28, 2016 7:54 pm

abuss368 wrote:So....drumroll......What is that "bad" about Total Bond Index int taxable? 2/3 is Treasuries and thus no state or local taxes. Much less risk. I think this should be discussed.
Unfortunately, California and a couple other states only give you the exemption if 50% or more assets of a fund are invested in US govt obligations by a certain definition. That number is 40% for TBM, so it doesn't qualify.

A pure Treasury fund would be a reasonable choice. I think it's part of David Grabiner's tax optimization strategy: short-govt in taxable, long-corporate in tax exempt.

I would agree that CDs are a good deal in taxable, even in California. I use them. The yield (and zero risk, and limited term risk) is too much of an advantage to ignore.

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Re: Total Bond vs Municipal Bond Funds

Post by abuss368 » Thu Apr 28, 2016 8:01 pm

ogd wrote:
abuss368 wrote:So....drumroll......What is that "bad" about Total Bond Index int taxable? 2/3 is Treasuries and thus no state or local taxes. Much less risk. I think this should be discussed.
Unfortunately, California and a couple other states only give you the exemption if 50% or more assets of a fund are invested in US govt obligations by a certain definition. That number is 40% for TBM, so it doesn't qualify.

A pure Treasury fund would be a reasonable choice. I think it's part of David Grabiner's tax optimization strategy: short-govt in taxable, long-corporate in tax exempt.

I would agree that CDs are a good deal in taxable, even in California. I use them. The yield (and zero risk, and limited term risk) is too much of an advantage to ignore.
So if one lives in the 49 other states, needs bonds in taxable, and prefers safety, Total Bond is fine. No different from CDs and a Treasury bond fund from a tax standpoint.
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Re: Total Bond vs Municipal Bond Funds

Post by slickwillbo » Thu Apr 28, 2016 8:30 pm

Sure, the SEC yield for VCAIX is 1.28%, but it's actually distributing 2.60%. Total bond is distributing 2.51%.

Of course those could change, but the distribution yields have been relatively steady. That should change your calculations just a bit.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Thu Apr 28, 2016 9:18 pm

slickwillbo wrote:Sure, the SEC yield for VCAIX is 1.28%, but it's actually distributing 2.60. Total bond is distributing 2.51%.

Of course those could change, but the distribution yields have been relatively steady. That should change your calculations just a bit.
By that measure, I have a 1 year Treasury distributing 8% to sell you, despite all these complaints about low yields. Really -- here it is -- in today's WSJ quotes:

5/15/2017 8.750 108.5000 108.5156 0.0078 0.557

Divide the 8.75% coupon by the 108.5 price and you get 8%! The catch -- that $8.5 premium will be gone by next year (face value is $100), leaving the yield the paltry 0.557% that you'd expect.

This is what's happening inside of the CA fund. It holds a lot of older premium bonds and it is distributing at a cost to capital value. Unlike Total Bond, it's in no rush to replace them because the tax treatment for these bonds is very good, as you might imagine -- large tax-exempt distributions, tax deductible capital loss. For Total Bond Market, it's best to reduce distributions to about the SEC yield (hard to manage less) so they do that.

This is not to say that in certain conditions (steep, persistent yield curve) the fund can't make returns larger than SEC yield; but the same applies to Total Bond. It's best to compare funds in the SEC yield. While in the short term, the high distributions impact tax calculators (which I already think are not worth using), we're planning for the long term here and VCAIX will not be that much better than Total Bond, I can promise you.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Thu Apr 28, 2016 9:22 pm

ogd wrote:This is what's happening inside of the CA fund. It holds a lot of older premium bonds and it is distributing at a cost to capital value.
Just to clarify -- the Vanguard fund isn't doing this maliciously, it really is the better thing to do tax-wise. But some managed funds hold premium bonds to attract investors via high, unsustainable distributions, which is why the SEC mandates the SEC yield figure and why one should always use that to compare funds.

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Re: Total Bond vs Municipal Bond Funds

Post by abuss368 » Thu Apr 28, 2016 11:40 pm

Makes sense.
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Re: Total Bond vs Municipal Bond Funds

Post by Da5id » Fri Apr 29, 2016 6:59 am

abuss368 wrote:
So if one lives in the 49 other states, needs bonds in taxable, and prefers safety, Total Bond is fine. No different from CDs and a Treasury bond fund from a tax standpoint.
New York also has the 50% requirement. Or as IT-203 says:
Dividends you received from a regulated investment company (mutual fund) that invests in obligations of the U.S. government and meet the 50% asset requirement each quarter qualify for this subtraction. The portion of such dividends that may be subtracted is based upon the portion of taxable income received by the mutual fund that is derived from federal obligations.
Between CA and NY (and Connecticut too), covers quite a few people, what 20% of the country? But the rest are good far as I know :)

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Re: Total Bond vs Municipal Bond Funds

Post by slickwillbo » Fri Apr 29, 2016 4:41 pm

ogd wrote:
slickwillbo wrote:Sure, the SEC yield for VCAIX is 1.28%, but it's actually distributing 2.60. Total bond is distributing 2.51%.

Of course those could change, but the distribution yields have been relatively steady. That should change your calculations just a bit.
By that measure, I have a 1 year Treasury distributing 8% to sell you, despite all these complaints about low yields. Really -- here it is -- in today's WSJ quotes:

5/15/2017 8.750 108.5000 108.5156 0.0078 0.557

Divide the 8.75% coupon by the 108.5 price and you get 8%! The catch -- that $8.5 premium will be gone by next year (face value is $100), leaving the yield the paltry 0.557% that you'd expect.
That's a pretty insulting point, and also incorrect.

I'm obviously not confusing the yield with the coupon- the average coupon for VCAIX is 4.4%. Additional yield is not generated by amortizing principal. That would be returned to investors as a return of capital, and VCAIX hasn't returned capital since at least 10/2014 (as far back as Vanguard's website shows). All of the distributions since then have been income, and the actual distribution yield hasn't fallen below 2.60%, despite the much-lower SEC yield. You can also simply look at a chart and see that VCAIX has significantly outperformed VBMFX - even on a pre-tax basis - over the past 1 and 5 year periods, despite the lower SEC yield.

The extra income is likely generated by rolling bonds*, selling the bonds at the short-end of intermediate, while buying bonds at the long-end of intermediate. This generates 'extra income' (really, an increase in price) whenever the yield curve is positively sloped. It's not a free lunch, but your speculations are yield are far off-base.

*Edit: with muni funds, much of the additional yield is from uncalled bonds; total bond doesn't have nearly as many callable bonds. The SEC yield uses yield-to-worst, so if any premium bond is uncalled, the actual distribution yield will be higher than the SEC yield.

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Re: Total Bond vs Municipal Bond Funds

Post by ogd » Sat Apr 30, 2016 1:04 pm

slickwillbo wrote:That's a pretty insulting point, and also incorrect.

I'm obviously not confusing the yield with the coupon- the average coupon for VCAIX is 4.4%.
I apologize for going too basic for your level -- some people genuinely don't understand this and think of bonds primarily in terms of coupon.

Still, the point remains that this is the source of the extra distribution yield and you should not point to the higher distribution yield as an indication (implied or explicit) that one can expect higher returns going forward. In fact, pre-tax VCAIX is expected to have barely half of the returns of TBM.

The average bond in VCAIX has coupon 4.34%, price 112 per 100 and yield 1.28%. For TBM, the numbers are 3.23% coupon, 106.5 price, 2.08% yield. Clearly, VCAIX has bonds that are "more premium", so it's expected to distribute more, but make less return.

Saying that the higher distribution yield is an indication of higher return is (a much more complicated version of) saying that the Treasury in my example is better than the 0.5% coupon Treasuries that are typical today.
slickwillbo wrote: Additional yield is not generated by amortizing principal. That would be returned to investors as a return of capital,
Not if the bonds were bought at much higher yield, i.e. "less premium". Only the premium at the time of purchase is required to to be distributed. The difference with VCAIX is that muni yields were much higher in the recent past (2.7% intermediate in 2013!), so it was able to buy bonds that today are "very premium" at a much smaller premium, or none. The other difference is that the tax treatment makes it preferable to keep them as long as possible, rather than turning them over (which would be an advantage for taxable funds).
slickwillbo wrote: The extra income is likely generated by rolling bonds*, selling the bonds at the short-end of intermediate, while buying bonds at the long-end of intermediate. This generates 'extra income' (really, an increase in price) whenever the yield curve is positively sloped. It's not a free lunch, but your speculations are yield are far off-base.
TBM does that too (ride the yield curve), so it's not a difference between the funds.
slickwillbo wrote: You can also simply look at a chart and see that VCAIX has significantly outperformed VBMFX - even on a pre-tax basis - over the past 1 and 5 year periods, despite the lower SEC yield.
The reason (or even symptom) for that is not the distribution yield, it's the fact that muni yields have dropped much more than TBM-type bonds in these period:
5 year: VCAIX 3.23% -> 1.28% , TBM 2.80% -> 2.08. Rounding durations to 5 and 5.5 years respectively, this alone predicts outperformance of 5.8% during the period. The actual number was 11%, the rest probably accounted for by the generally higher SEC yield of VCAIX for much of the period.

1 year: VCAIX 1.48% -> 1.28%, TBM 1.78% -> 2.08%. This predicts outperformance of 2.65%, which is pretty close to what happened (2.46%).

So that's the summary. The outperformance has mainly to do with the present low yield, which helped the past but hurts the future. The higher distribution yield is merely an indication of the composition of the fund and not an indicator of future returns. I expect VCAIX to underperform TBM going forward, but be safer.
slickwillbo wrote:*Edit: with muni funds, much of the additional yield is from uncalled bonds; total bond doesn't have nearly as many callable bonds. The SEC yield uses yield-to-worst, so if any premium bond is uncalled, the actual distribution yield will be higher than the SEC yield.
TBM has plenty of those from mortgage bonds and some people really don't like that. The effect of callability seems much more pronounced in TBM if you look at the difference between maturity and duration. Anyways, that's my understanding.

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