Bond Options

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sdvan
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Bond Options

Post by sdvan » Mon Oct 23, 2017 7:20 pm

I have decided to buy bond mutual funds with the proceeds from individual California muni-bonds that are redeemed early. But, I'm struggling with deciding the right fund. Up to this point, I've put the money into Vanguard's Cal Tax exempt fund (VCADX) and I've been very happy with that fund. It does better than vanguard total bond and I don't have to pay tax on the distributions. Win/Win. However, I still have stocks in my IRA (long story). As a result, I've been considering Vanguard's total bond (VBTLX).

Also, many of the bonds are held at fidelity. As a result, it would be easiest to buy Fidelity funds and I could use this opportunity to buy bonds in the IRA and buy stock in the after tax accounts. I have looked at Fid US Bond (FSITX) and it looks very similar to Van total bond. In fact, it has a lower expense ratio. But, neither fund does as well as VCADX. I also looked at Fid Cal Muni Income (FCTFX). But, the expense ratio is .46 (although the returns are similar to Vanguard's tax exempt fund (historically higher)).

So, my question is whether I should continue to use tax free bond funds in after tax accounts when I have stock in my IRA, just because I like those funds better than the total bond funds that I'd put into the IRA. Also, any thoughts on VCADX versus FCTFX.

Thanks for any thoughts.

SDVAN

JBTX
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Re: Bond Options

Post by JBTX » Tue Oct 24, 2017 1:17 am

Not a bond expert, mainly bumping hoping somebody else will chime in.

It would help to have a more complete picture, such as your estimated marginal tax rate.

You are correct, over the long term VCADX out returns FSITX. I'm not exactly sure why. It may have something to do with FSITX having an overall "higher quality" of portfolio, resulting in lower returns.

http://quotes.morningstar.com/chart/fun ... ture=en-US

http://quotes.morningstar.com/chart/fun ... ture=en_US

The yield on the CA fund is currently lower than the Fidelity bond fund.

I suspect the higher returns for the CA muni fund over last 10 years, is because they started at a lower point. Ten years ago we were starting into the economic downturn, and people were seeking high quality bonds. There was some fear that munis were going to run into trouble, so they were not as popular. Over the following years, as those fears have subsided, they have somewhat caught up to the high quality taxable bonds.

I would doubt you will see continued out performance in the muni fund going forward, but I really don't know.

If you really like the Vanguard VCADX, you can probably buy it at Fidelity, you just may have to pay a one time upfront fee of around $75. Not knowing how much you have invested, it is hard to tell if $75 is "material" or not.

As you point out, FCTFX does have higher fee, but have slightly higher returns. The higher returns may have something to do with its longer duration than the Vanguard fund (6.59 vs 5.32). All else equal, typically you would expect to see higher duration funds outperform when interest rates are flat or falling.

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oldcomputerguy
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Re: Bond Options

Post by oldcomputerguy » Tue Oct 24, 2017 5:29 am

sdvan wrote:
Mon Oct 23, 2017 7:20 pm
So, my question is whether I should continue to use tax free bond funds in after tax accounts when I have stock in my IRA, just because I like those funds better than the total bond funds that I'd put into the IRA.
You didn't mention whether your IRA is a Traditional or a Roth. But I would point out that, if your stock holdings are in a Traditional IRA, you'll end up likely paying higher taxes than if you were to hold the same amount of stock in your taxable accounts. Any gains in stocks held in a Traditional IRA will ultimately be taxed at your marginal rate (when you withdraw those funds from the IRA). If those stocks were held in a taxable account, any long-term gains would be taxed at the lower tax rates that are applied to qualified dividends and long-term capital gains. That long-term advantage is lost for stocks held in traditional IRAs.

Of course, the above does not apply if the stocks are in a Roth IRA.

Just a thought.
Anybody know why there's a 20-pound frozen turkey up in the light grid?

inbox788
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Re: Bond Options

Post by inbox788 » Tue Oct 24, 2017 11:17 am

I'm a fan of VCADX in taxable. I've been finding that if you correctly make tax adjustments throughout all your decisions, it's a fairly moot point where things are kept. Any perceived difference is really a function of altering AA because of failure to take into account taxes. I do what's convenient and live with the slight variations in AA from taxes, varying returns and rebalancing.

sdvan
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Re: Bond Options

Post by sdvan » Wed Nov 01, 2017 7:59 pm

Thanks for the responses. In thinking about this I am really asking two questions (and debating them with myself):

1. I have over 20% of my portfolio in stocks in non-Roth IRA's and 401K's. I know traditional logic is to put bond funds in the tax deferred accounts to lower future RMD's. I have individual muni bonds that are being called early (gradually). I could take that money and buy stock in the after tax account and then sell stock in the IRA/401K to buy bond funds. The net result is that I then have the same amount of stock but it is in after tax and the same amount in bonds but it is now in the pretax and in a bond fund. This is appealing simply because I am starting to really worry about RMD craziness. So, the first question is should I make this swap as bonds are called?

2. One of the reasons that I have not made this swap previously is that I love tax exempt bonds (individual or funds). If I can earn a similar or better return from a tax free bond compared to a taxable bond (individual or fund), then I am really earning an even better return after tax. For example, the YTD return on VCADX (Cal tax free muni bond fund) is 4.58% while taxable total bond (VBTLX) is 3.14%. In fact, over 1 year, 3 years, 5 years, and 10 years, VCADX beats VBTLX every time. The Fidelity equivalent funds have similar returns. So, while I would like to get out of owning stocks in my pre-tax accounts, I'm resisting because I like the tax free bond funds better than the taxable bond funds that I would buy for the pre-tax accounts. As a result, I keep making my future RMD problem worse. But, I get a better return on the muni-bond fund that is even better because it is tax free. Plus, the duration on the tax free fund is shorter than total bond. So, in theory it should be a bit safer in a rising interest rate environment. So, the second question is whether I would be better off making the swap to bonds in the pre-tax accounts even if I use the total bond fund with lower returns than the tax free muni-bond fund?

Thanks for any thoughts! I just keep debating with myself. I had a relatively significant early redemption today so it is time for me to make a decision.

mega317
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Re: Bond Options

Post by mega317 » Fri Nov 03, 2017 1:31 am

The number to look at with bond funds is the SEC yield. VCADX tax-equivalent SEC yield in the 25/9.3% bracket is nearly the same as total bond. That makes sense because they have similar credit risk and duration. VCADX is a little more volatile so would be expected to beat total bond over some time periods, but returns have been very close.

If you are in an intermediate tax bracket the two strategies are close and I'd favor putting bonds in tax-deferred. If you're in a very high bracket munis in taxable start to look more attractive since stock dividends will be more highly taxed for you than most of us.

(I am 28/9.3% and have a chunk of CA munis. I don't want all stock in taxable because a 50% stock drop will make my taxable account too small for me.)

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Noobvestor
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Re: Bond Options

Post by Noobvestor » Fri Nov 03, 2017 1:45 am

I can't figure out who would want CA tax-exempt over regular tax-exempt. I've considered it but rejected it personally. Consider these four funds and their yields (I'm using Vanguard's SEC yields):

CA intermediate yield: 1.67%
National intermediate yield: 1.74%

CA long yield: 2.14%
National long yield: 2.29%

I plugged in 33% for fed, 10% for state taxes and get tax-equivalent yields as follows:

CA intermediate yield: 2.77%
National intermediate yield: 2.60%

CA long yield: 3.55%
National long yield: 3.42%

But wait - there's more! The CA funds have slightly longer duration and lower-quality holdings. CA intermediate is only 6% AAA and regular intermediate is 23% AAA. There's also state-specific risk. Basically, on a risk-adjusted basis, the CA funds look to me to come out behind.

So you get up to a .17% yield increase for taking on state-specific concentration risk, a bit of duration/quality risk too. Is that really worth it?
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

mega317
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Re: Bond Options

Post by mega317 » Fri Nov 03, 2017 2:14 am

This is good analysis. You come up with the same answer looking at the municipal money market funds. The credit and duration risk are basically 0 and the after-tax yields are identical. (And in my tax bracket, both are about identical to Prime MM.)

I do think you overweight the credit risk. While the national funds have more AAA bonds, they also have more below AA, especially the long-term funds. And the durations are essentially identical.

So in my own case, where I am willing to basically ignore the single state risk because most of my bonds are in total bond in tax-deferred, I decided that a small yield increase is worth it. The opposite conclusion would also be valid.

sdvan
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Re: Bond Options

Post by sdvan » Sat Nov 04, 2017 8:36 pm

I've been looking into one additional option. I can buy CD's in my Fidelity IRA from a huge number of banks. Why not buy a 5 year CD with a 2.4% rate as opposed to a Fidelity Bond fund with a duration longer than 5 years and a return over the last 5 years of less than 2%? With FDIC insurance, there is zero risk and inside an IRA there is no tax difference. If interest rates go up, I am happy because my bond fund value didn't go down and I can reinvest at the end of 5 years. If interest rates go down, I am happy to lock in a higher rate. It is certainly more work than a bond fund. But, not much work using the Fidelity website to buy CD's from a huge variety of banks. And, the available rates for new issue CD's appear to be very close to the top rates available.

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welderwannabe
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Re: Bond Options

Post by welderwannabe » Sun Nov 05, 2017 7:42 am

sdvan wrote:
Sat Nov 04, 2017 8:36 pm
I've been looking into one additional option. I can buy CD's in my Fidelity IRA from a huge number of banks. Why not buy a 5 year CD with a 2.4% rate as opposed to a Fidelity Bond fund with a duration longer than 5 years and a return over the last 5 years of less than 2%?
I am in your camp. I keep half of my bond 'Treasury' allocation at Fidelity in CDs. I kept my duration at 2 years, but there is nothing wrong with a 5-year plan. I would consider laddering it so you can take advantage of higher rates as (and if) they rise.

My bond allocation at fidelity is:

50% LQD (iShares intermediate term corporate ETF, no trading fees)
25% FIBAX Fidelity® Intermediate Treasury Bond Index Fund - Premium Class
25% 2-Year CDs
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

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