Why not invest in bond fund in taxable account?

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Triple digit golfer
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Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Fri Jan 23, 2015 10:40 pm

Say someone has some money that he may need to use in 3-5 years that he wishes to take a bit of risk on in order to potentially gain a higher return. Why worry about whether the bond is taxable or not? A savings account has taxable interest and nobody thinks twice about it most of the time.

A case could be made for putting retirement money in tax advantaged accounts in the bond fund and taxable investments in equities, then selling equities in taxable and selling bonds in the tax advantaged accounts to buy equities when the money is needed (I know there's a wiki on this). But if if equities tank, this fails, so you need to have about twice as much as your potential cash needs in taxable.

If one wishes to avoid that potential problem of equities tanking and simply wishes to keep retirement money and short term money completely separate, is there a convincing reason not to use a taxable bond fund in a taxable account? Is it any worse than the tax implications of a savings account? Municipal bonds are an option but they are typically less diversified and pay lower rates.

I max out my retirement accounts but have about $30k that I expect to need in a few years. Thinking of putting it in Total Bond or GNMA or Treasuries in taxable. Bad idea?

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Re: Why not invest in bond fund in taxable account?

Post by grabiner » Fri Jan 23, 2015 10:48 pm

Triple digit golfer wrote:Say someone has some money that he may need to use in 3-5 years that he wishes to take a bit of risk on in order to potentially gain a higher return. Why worry about whether the bond is taxable or not? A savings account has taxable interest and nobody thinks twice about it most of the time.
It matters whether the bond is taxable only because your goal is to maximize after-tax return. If a corporate bond yields 2%, and a municipal bond of equal risk yields 1.5%, then you should prefer the municipal bond if your tax bracket is higher than 25%.

But with current rates, low-yielding bonds don't lose much to taxes, and low-yielding munis don't cost you much to get the tax exemption. Thus, if you are going to hold bonds for a short-term need, and thus should hold short-term bonds, it makes sense to hold them in taxable accounts. At current yields, I would prefer Vanguard Limited-Term Tax-Exempt in taxable and a stock index in an IRA over Vanguard Short-Term Corporate in an IRA and a stock index in taxable. Even intermediate-term bonds would be close.
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Re: Why not invest in bond fund in taxable account?

Post by Quickfoot » Fri Jan 23, 2015 10:53 pm

With today's yields it makes no sense to hold bonds or a bond fund for only 3--5 years, your downside potential is much higher than your upside. With a timeline that short a CD ladder would be more appropiate and is going to return more than limited term bonds. My credit union is offering 2% 4 year CDs and 1.5% 21 month CDs.

Vanguard limited term is distributing 1.54% with an ER of .20%, the 1 year after tax return is 1.71% and the 3 year average return is only 1.35%. With only a 3-5 year timeline there is insufficient return to compensate for the risk, you have time for rising interest rates to hurt your NAV but not enough time to benefit from the increased yield from the increases.


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Re: Why not invest in bond fund in taxable account?

Post by brmlburt » Sat Jan 24, 2015 12:44 pm

No one can predict future bond returns, of course, but doesn't it make sense to perform a straightforward calculation based on your marginal tax rate and your prediction of the before-tax returns on taxable and nontaxable bonds of the maturity you are interested in holding? If you know your expected marginal tax rate over your holding period, then buy a municipal bond mutual fund if its expected return is greater than the after-tax expected return on the taxable bond fund you have in mind. For some investors in low marginal tax brackets, the table bond fund is more advantageous, as you imply in your question. For investors in higher marginal tax brackets, the municipal bond mutual fund is more advantageous.

In my experience, the straightforward comparison of expected after-tax returns of the two kinds of funds can produce different answers at different points in time. At one point, for example, it was advantageous to hold PIMCO's Total Return fund outside my tax-preferred accounts. A few years ago, TIAA-CREF's wealth management advisor pointed out that the relative gross yields on good intermediate-term taxable and municipal bond funds had narrowed so much that it had become advantageous to hold municipal funds rather than taxable funds in my non-tax-preferred accounts. I sold the taxable bond funds and purchased municipal bond funds to replace them. (Also, I increased my allocation to taxable bonds in my retirement accounts.) I certainly don't check the relevant numbers every month or even every year, and I recognize the results of the comparison will differ depending on my tax situation. However, the wealth management advisor has turned out to be correct in recent years, even though holding the taxable bond fund in the non-tax-preferred account was the correct choice in earlier years. Always be sure you are comparing municipal and taxable bond funds with similar maturities when you are making your choice. It doesn't make sense to compare a limited-maturity municipal fund to an intermediate-term taxable bond fund, for example. Your exposure to capital risk is different in the two cases.

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Re: Why not invest in bond fund in taxable account?

Post by msi » Sat Jan 24, 2015 3:09 pm

Vanguard's national muni funds are diversified, well-run funds. As for the yield, you need to calculate taxable equivalent yield based on your tax bracket to see what the comparable rate really is.

If this were me personally though, and I knew I needed that money in 3-5 years, I wouldn't use any bond fund. CDs for sure.

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Re: Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Sat Jan 24, 2015 8:22 pm

Thanks for the comments.

What I really want to do is this, for simplicity and mental accounting purposes:

Keep separate "retirement" accounts and all other money - emergency fund, cash needed for near future large or one-time purchases, down payment money for my next house (3 years, maybe), allowance for home repairs, new car fund, etc. All of these items are going to come up at different times. Some will be in the next year or two, others not for 5-10 or maybe even 15 years or maybe even not at all, if I've overestimated some of them. Because of this, I'd like to put some of it into a fund like Life Strategy Income, at about 20% stocks and 80% bonds, and keep the rest in savings. The idea is that 1. I'll gain a bit of additional return and 2. If I don't touch some of it for 10+ years or never touch some of it, at least it's got a shot at higher returns over that time period.

I do not like the idea of mixing retirement and non-retirement money. I know the recommendation would be to "place cash needs in a taxable account," so that means I'd be exchanging equities for bonds in my 401(k) or Roth IRA and buying 100% equities in taxable. Then when I need the money, selling the equities in taxable and exchanging bonds for equities in my 401(k) or Roth IRA to keep the allocation in check.

I don't like that. It causes me mental accounting stress. I have decided that I need to keep "retirement" money and all other money separate, both in my head and in the accounts. It may not be logical and it may cause me a bit of extra money in taxes, and I cringe to even ask, but is it the worst thing in the world to simply put money into Vanguard Life Strategy Income in taxable?

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Re: Why not invest in bond fund in taxable account?

Post by wassabi » Sat Jan 24, 2015 11:10 pm

Triple digit golfer wrote:Thanks for the comments.


I don't like that. It causes me mental accounting stress. I have decided that I need to keep "retirement" money and all other money separate, both in my head and in the accounts. It may not be logical and it may cause me a bit of extra money in taxes, and I cringe to even ask, but is it the worst thing in the world to simply put money into Vanguard Life Strategy Income in taxable?

I went through this same struggle. I then determined that the stress wasn't worth it and began dialing my retirement accounts up to 100% equities and transferring the fixed income to my taxable. My rationale is that I don't need my retirement accounts for 25+ years (at the earliest) and so I can assume the risk in those accounts. On the taxable side, I may or may not need a chunk of change in the future. Could be 5, 10, 15 years, or never if I decide not to buy a house. So I am willing to take some risk with a combo of equities and fixed income in taxable.

But the bottom line is that it's ok to keep your taxable and retirement separate. You aren't destroying your portfolio. Do what helps you to sleep at night, otherwise you're not doing it right.

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Re: Why not invest in bond fund in taxable account?

Post by Kevin M » Sun Jan 25, 2015 12:01 am

If simplicity is very important to you, and you're sure you are OK with the risk, then LS Income probably is fine. If Federal marginal tax rate is higher than 25%, then an intermediate-term muni bond fund probably is a better bet than the Total Bond (and some international bond) in the LS fund. So you hold two or three funds instead of one, with higher after-tax expected return.

Personally, I think a direct CD earning 2.25% with an early withdrawal penalty of six months of interest is a better deal than an intermediate term bond fund. With the 5-year Treasury at about 1.3%, a CD at 2.25% is a very good deal for the retail investor; higher yield, about the same credit risk, less term risk.

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Re: Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Sun Jan 25, 2015 12:17 am

Thanks guys. I'm in the 25% tax bracket.

So Kevin, does it make more sense to hold Life Strategy Income or 80/20 Intermediate Term Tax Exempt/Total Stock? Ignore for now the international equity considerations.

I'm also considering 80/20 Intermediate Term Treasury/Total Stock due to the lack of correlation between the two.

I could just use a CD but I'd like to shoot for just a bit higher return.

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Re: Why not invest in bond fund in taxable account?

Post by Kevin M » Sun Jan 25, 2015 4:35 am

Triple digit golfer wrote:Thanks guys. I'm in the 25% tax bracket.

So Kevin, does it make more sense to hold Life Strategy Income or 80/20 Intermediate Term Tax Exempt/Total Stock? Ignore for now the international equity considerations.
Probably doesn't make that much difference. I haven't done any deep research myself, but the common wisdom seems to be that national munis (ignoring state tax) are priced assuming a marginal federal tax rate of about 25%. Assuming the bond market is pretty efficient, which I believe is the consensus here, then you are right on the border line, so either a taxable or tax-exempt fund probably is comparable on a risk-adjusted basis. If you see a higher after-tax yield from one vs. the other, then it probably has comparably higher risk.
Triple digit golfer wrote:I'm also considering 80/20 Intermediate Term Treasury/Total Stock due to the lack of correlation between the two.
True that Treasuries have gone up when stocks have gone down a lot in recent times (longer-term Treasuries even more so), but this has not always been the case. The long-term correlation of the 10-year Treasury to US stocks is close to 0, meaning that there is no long-term zig-zag effect, more of a maybe-ziz-maybe-zag, but overall not much different than the correlation of cash (or a direct CD).

You can always do some of each. Use CDs for the rock-solid, relatively high-yield asset, and use Treasuries if you want to bet on them going up when stocks go down. With the CD anchor, you could even extend your Treasury maturity some, to get more of (possible but not certain) big up when stocks are big down effect. I do something like this, but use investment-grade bond funds, mostly intermediate tern but some long term, so taking more credit risk as well as term risk. Kind of a barbell approach.
Triple digit golfer wrote:I could just use a CD but I'd like to shoot for just a bit higher return.
Well, if you go along with the common saying of "take your risk on the equity side", then take the lower risk in CDs (with higher yield for less risk), and use stocks to shoot for higher return. You're not going to get a higher return in Treasuries of same maturity if you hold maturity. Maybe you will if you play yield-curve games (like buy 5-year Treasuries and after one year sell and roll into another 5-year Treasury), but then maybe you won't. That's the nature or risk--in the long run it should pay off, but it may not, otherwise there would be no risk.

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Re: Why not invest in bond fund in taxable account?

Post by YDNAL » Sun Jan 25, 2015 6:06 am

Triple digit golfer wrote:A case could be made for putting retirement money in tax advantaged accounts in the bond fund and taxable investments in equities, then selling equities in taxable and selling bonds in the tax advantaged accounts to buy equities when the money is needed (I know there's a wiki on this). But if if equities tank, this fails, so you need to have about twice as much as your potential cash needs in taxable.
Triple digit golfer wrote:What I really want to do is this, for simplicity and mental accounting purposes:

Keep separate "retirement" accounts and all other money - emergency fund, cash needed for near future large or one-time purchases, down payment money for my next house (3 years, maybe), allowance for home repairs, new car fund, etc. All of these items are going to come up at different times. Some will be in the next year or two, others not for 5-10 or maybe even 15 years or maybe even not at all, if I've overestimated some of them. Because of this, I'd like to put some of it into a fund like Life Strategy Income, at about 20% stocks and 80% bonds, and keep the rest in savings. The idea is that 1. I'll gain a bit of additional return and 2. If I don't touch some of it for 10+ years or never touch some of it, at least it's got a shot at higher returns over that time period.
Saved money doesn't care what it is saved for.
  • 1. Regardless how you compartmentalize the savings, "if stocks do tank," NET WORTH is affected identically.
    3. Unless/Until we recognize this FACT, we then continue struggling with mental accounting issues.
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Re: Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Sun Jan 25, 2015 9:39 am

YDNAL wrote:
Triple digit golfer wrote:A case could be made for putting retirement money in tax advantaged accounts in the bond fund and taxable investments in equities, then selling equities in taxable and selling bonds in the tax advantaged accounts to buy equities when the money is needed (I know there's a wiki on this). But if if equities tank, this fails, so you need to have about twice as much as your potential cash needs in taxable.
Triple digit golfer wrote:What I really want to do is this, for simplicity and mental accounting purposes:

Keep separate "retirement" accounts and all other money - emergency fund, cash needed for near future large or one-time purchases, down payment money for my next house (3 years, maybe), allowance for home repairs, new car fund, etc. All of these items are going to come up at different times. Some will be in the next year or two, others not for 5-10 or maybe even 15 years or maybe even not at all, if I've overestimated some of them. Because of this, I'd like to put some of it into a fund like Life Strategy Income, at about 20% stocks and 80% bonds, and keep the rest in savings. The idea is that 1. I'll gain a bit of additional return and 2. If I don't touch some of it for 10+ years or never touch some of it, at least it's got a shot at higher returns over that time period.
Saved money doesn't care what it is saved for.
  • 1. Regardless how you compartmentalize the savings, "if stocks do tank," NET WORTH is affected identically.
    3. Unless/Until we recognize this FACT, we then continue struggling with mental accounting issues.
What would you do in my situation? How do I separate the accounts for mental accounting? How do I view and manage it?

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Re: Why not invest in bond fund in taxable account?

Post by YDNAL » Sun Jan 25, 2015 10:58 am

Triple digit golfer wrote:
YDNAL wrote:Saved money doesn't care what it is saved for.
  • 1. Regardless how you compartmentalize the savings, "if stocks do tank," NET WORTH is affected identically.
    3. Unless/Until we recognize this FACT, we then continue struggling with mental accounting issues.
What would you do in my situation? How do I separate the accounts for mental accounting? How do I view and manage it?
What I think is that may be stressing over things that perhaps don't deserve the stress.
Triple digit golfer wrote:I max out my retirement accounts but have about $30k that I expect to need in a few years....
Triple digit golfer wrote:What I really want to do is this, for simplicity and mental accounting purposes:

Keep separate "retirement" accounts and all other money - emergency fund, cash needed for near future large or one-time purchases, down payment money for my next house (3 years, maybe), allowance for home repairs, new car fund, etc. All of these items are going to come up at different times. Some will be in the next year or two, others not for 5-10 or maybe even 15 years or maybe even not at all, if I've overestimated some of them. Because of this, I'd like to put some of it into a fund like Life Strategy Income, at about 20% stocks and 80% bonds, and keep the rest in savings. The idea is that 1. I'll gain a bit of additional return and 2. If I don't touch some of it for 10+ years or never touch some of it, at least it's got a shot at higher returns over that time period.
The difference in potential return on $30K, by departmentalizing money and by holding 20% Equities (LS Income or similar), is relatively irrelevant in the grand scheme of all. I would do the following:
  • 1. Determine the overall risk level (Equity/Fixed split) to take with savings -- this is MOST important.
    2. Split ALL savings accordingly. One pot, all money saved, the money doesn't care what it is saved for.
    3. The amount invested in Fixed Income may be split between ST and IT duration -- this is really secondary, I believe.
    4. Hold the most tax-efficient investment in taxable (everyone's situation is different), and less efficient investment in tax-advantage.
    5. When money need arises, sell taxable and balance-out in tax advantaged. Always avoid short-term gains.
Last edited by YDNAL on Sun Jan 25, 2015 11:11 am, edited 4 times in total.
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Re: Why not invest in bond fund in taxable account?

Post by Toons » Sun Jan 25, 2015 11:00 am

I do invest in Short term investment grade and Total Bond in taxable account.. :happy
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Re: Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Sun Jan 25, 2015 11:16 am

YDNAL wrote:The difference in potential return on $30K, by departmentalizing money and by holding 20% (LS Income or similar), is relatively irrelevant in the grand scheme of all. I would do the following:
  • 1. Determine the overall risk level (Equity/Fixed split) to take with savings -- this is MOST important.
    2. Split ALL savings accordingly. One pot, all money saved, the money doesn't care what it is saved for.
    3. Hold the most tax-efficient investment in taxable (everyone's situation is different), and less efficient investment in tax-advantage.
    4. When money need arises, sell taxable and balance-out in tax advantaged. Always avoid short-term gains.
For #1, when you say overall risk level, you mean with my non-retirement money, correct? I want to take a lot of risk with retirement money that I won't touch for decades, but not with money I'll need in say, 10 years or less.

So if I have $260k total (including savings, 401k, IRA, etc.) and will need $70k in the next 5 years, I could do something like this:

Retirement/long-term money: $190k = 90/10 stock/bond allocation
Short-term money: $70k = 20/60/20 stock/bond/cash allocation
Total will be $185k stocks, $61k bonds, $14k cash

So I could do this with my current accounts:

Tax deferred (401k and Roth IRA) total balance $170k:
$61k bonds
$95k equities
$14k cash

Taxable total balance $90k
$90k equities

In this case I'd have nothing in a regular savings account.

When I need money for things (new furnace, for example) I'd sell equities in taxable and then exchange cash/bonds in tax-deferred for equities?

Is it advisable to at least keep something in savings to put off having to do this often? Maybe keep $10k in savings?

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Re: Why not invest in bond fund in taxable account?

Post by Doc » Sun Jan 25, 2015 11:28 am

Triple digit golfer wrote:For #1, when you say overall risk level, you mean with my non-retirement money, correct? I want to take a lot of risk with retirement money that I won't touch for decades, but not with money I'll need in say, 10 years or less.
Landy already answered the question.
YDNAL wrote:Saved money doesn't care what it is saved for.
1. Regardless how you compartmentalize the savings, "if stocks do tank," NET WORTH is affected identically.
3. Unless/Until we recognize this FACT, we then continue struggling with mental accounting issues.
If you have a 50/50 asset allocation overall and you are extremely "worried" about risk in the ten year "pile" just make sure that part of that 50/50 is allocated to low risk intermediate term bonds like Treasuries. You don't change the 50/50.
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Re: Why not invest in bond fund in taxable account?

Post by YDNAL » Sun Jan 25, 2015 12:09 pm

Triple digit golfer wrote:So if I have $260k total (including savings, 401k, IRA, etc.) and will need $70k in the next 5 years, I could do something like this:

Retirement/long-term money: $190k = 90/10 stock/bond allocation
Short-term money: $70k = 20/60/20 stock/bond/cash allocation
Total will be $185k stocks, $61k bonds, $14k cash
So, your investable assets AA, per below, is 71/29 and influenced by "mental Accounting" issues.

Code: Select all

Accounts	Stocks  Bonds Cash
Retirement	171	  19	  0
Other Money	14	  42	 14
Total	     185	  61	 14
AA	        71%    24%    5%
First, I believe that someone accumulating doesn't need Cash as an investment.
Second, you want $75K in *safer* assets (bonds+cash).
Third, say you maintain a comparable $70K in short- and intermediate-term bonds to match need for money, which per my previous post translates to the following:

Code: Select all

Accounts	Stocks  Bonds Cash
Retirement	120	  70	  0
Other Money	70	   0	  0
Total	     190	  70	  0
AA	        73%    27%    0%
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Re: Why not invest in bond fund in taxable account?

Post by linenfort » Sun Jan 25, 2015 1:14 pm

Quickfoot wrote:Vanguard limited term is distributing 1.54% with an ER of .20%,~
I see 0.78% and 0.86 for Vanguard Limited Tax Exempt Investor Shares and Admiral Shares respectively. Am I looking at the wrong fund? Can't find anything else with "Limited" in the name.
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Re: Why not invest in bond fund in taxable account?

Post by Triple digit golfer » Sun Jan 25, 2015 1:17 pm

Landy,

Under that scenario, what happens if the market crashes when I need the money? I'm out of luck, it seems.

How would new contributions be invested? I wouldn't want to invest new money at 73/27. 100% equities, as my short and intermediate term needs are already covered?

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Re: Why not invest in bond fund in taxable account?

Post by Kevin M » Sun Jan 25, 2015 1:41 pm

linenfort wrote:
Quickfoot wrote:Vanguard limited term is distributing 1.54% with an ER of .20%,~
I see 0.78% and 0.86 for Vanguard Limited Tax Exempt Investor Shares and Admiral Shares respectively. Am I looking at the wrong fund? Can't find anything else with "Limited" in the name.
The reference was to the distribution yield, which is 1.54% for Investor Shares. The SEC yield is indeed 0.78%.

Distribution yield for this fund has been persistently higher than SEC yield over the last four years or so--the gap has remained large longer than I would have expected. I recently took a look at this for Total Bond Fund over the last 23 years; maybe I'll do the same for this fund soon.

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Re: Why not invest in bond fund in taxable account?

Post by Doc » Sun Jan 25, 2015 2:28 pm

Triple digit golfer wrote:Landy,

Under that scenario, what happens if the market crashes when I need the money? I'm out of luck, it seems.

How would new contributions be invested? I wouldn't want to invest new money at 73/27. 100% equities, as my short and intermediate term needs are already covered?
You sell the short/intermediate term bonds. Then you use your new money to re-balance back to your original target.

Asset allocation is a long term strategy. "Emergency fund" are tactics. They are not incompatible.

In times of stress strategy asset allocation becomes a secondary priority. After you have dealt with your short term "emergency" you try to get back to your long term goal and direct new savings to re-establish your AA. As part of that your long term strategy you make allowances for short term deviations. In Landy's example he is substituting bonds for cash which is a tactic that allows you maintain the longer term strategy while allowing for the short term contingency. If you lose a little with your short/intermediate bond fund instead of having the money in cash you need to think of the difference as an insurance premium not as an investment decision.

You should also consider the difference between "emergency" and "contingency". And "emergency" is a rare and significant event that we cannot predict and may not ever happen like your house burning down. We normally insure against emergencies. A "contingency" is an smaller event that is likely to occur we just don't know when or what form it will take like a new roof or water heater or car transmission. We should have money available in some form for contingencies. Short bond funds, CD's and saving accounts come to mind. But there is no reason why these short term "contingency" funds should not be a part of the overall AA.
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Re: Why not invest in bond fund in taxable account?

Post by YDNAL » Sun Jan 25, 2015 5:07 pm

Thanks the response, Doc.

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Re: Why not invest in bond fund in taxable account?

Post by linenfort » Sun Jan 25, 2015 8:16 pm

Kevin M wrote:The reference was to the distribution yield, which is 1.54% for Investor Shares. The SEC yield is indeed 0.78%.

Distribution yield for this fund has been persistently higher than SEC yield over the last four years or so--the gap has remained large longer than I would have expected. I recently took a look at this for Total Bond Fund over the last 23 years; maybe I'll do the same for this fund soon.

Kevin
Got it. Thank you, Kevin!
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