VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

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VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Tue Mar 14, 2017 9:08 pm

Does anyone know a source for the historic (past ten years) SEC yield for VWIUX? The distribution yield is available on the Vanguard site, but not the SEC yield.

I am interested in seeing how the distribution yield has compared to the SEC yield over time. For the past couple of years it has stayed well above the SEC yield.

I know many advise using the SEC yield when making comparisons but the problem I have with that is the distribution yield is real, its what the fund actually payed out, whereas the SEC yield is a mathematical calculation but does not reflect what the fund paid so how relevant is it really?

Others have suggested that the distribution yield is higher than the SEC yield because VWIUX is paying out principle (yield from bonds purchased at premium), but that does not seem sustainable as eventually the VWIUX would run out of principle that way. Plus the average coupon for VWIUX is +4% yet the distribution yield is currently 2.8% so clearly VWIUX is not distributing the full coupon.

Appreciate hearing from anyone who knows where I can get historical SEC yield data, or who can explain how VWIUX continues to distribute yields far above its SEC yield.

Thanks

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by LadyGeek » Tue Mar 14, 2017 9:19 pm

This thread is now in the Investing - Theory, News & General forum (general question). I also retitled the thread to help with the ticker symbol.
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by grabiner » Tue Mar 14, 2017 10:04 pm

The SEC yield is actually more real. If the distribution yield is higher than the SEC yield, the fund pays out more than it actually gains, as the price of the bonds will decline as they approach maturity.

For example, suppose a bond was bought years ago for $1000 with a 3% yield; every year, it pays out $30. The bond is now one year from maturity, and is worth $1020. A fund holding the bond will distribute $30 in that last year, but your return will be only $10. The SEC yield on the bond is 0.98% (10/1020), while the distribution yield is 2.94% (30/1020).

If the fund sells that bond, and buys a new bond for $1020 which will pay $10 next year and be worth $1020 at maturity, the SEC yield won't change, but the distribution yield will drop to 0.98%. You won't be any worse off as an investor (except that the fund will distribute a $20 capital gain, which might be taxable).
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by kolea » Tue Mar 14, 2017 11:54 pm

underwood wrote:Others have suggested that the distribution yield is higher than the SEC yield because VWIUX is paying out principle (yield from bonds purchased at premium), but that does not seem sustainable as eventually the VWIUX would run out of principle that way. Plus the average coupon for VWIUX is +4% yet the distribution yield is currently 2.8% so clearly VWIUX is not distributing the full coupon.

Appreciate hearing from anyone who knows where I can get historical SEC yield data, or who can explain how VWIUX continues to distribute yields far above its SEC yield.


I am sure Kevin will come along and post some links as he has looked at this a lot.

My view on SEC vs. distribution yield is that SEC is too much influenced by recent interest rate changes, due to the way it is calculated. There are lots of debates about SEC yield vs other yields around here but my personal feeling is that if I want to know what my cash flow is going to be in the near future the best estimate of that is the distribution yield. But if I want to know what my short term total return will be, SEC is probably better.
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by grabiner » Wed Mar 15, 2017 8:52 am

kolea wrote:My view on SEC vs. distribution yield is that SEC is too much influenced by recent interest rate changes, due to the way it is calculated. There are lots of debates about SEC yield vs other yields around here but my personal feeling is that if I want to know what my cash flow is going to be in the near future the best estimate of that is the distribution yield. But if I want to know what my short term total return will be, SEC is probably better.


This is correct, with one exception. If the SEC yield is lower than the distribution yield, you are likely to get more cash than the distribution yield, because the fund holds bonds at a premium and may sell them (or have them called) for a capital gain.

However, do you really want to look at cash flow this way? If you have an investment which is guaranteed to lose principal, spending the cash flow is effectively invading the principal even if you don't actually sell any shares. The main reason that distribution yield is useful is the tax situation; if your taxable bond fund has a 3% distribution yield, you expect to have $300 of taxable income next year on a $10,000 investment, regardless of the SEC yield.
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Wed Mar 15, 2017 11:29 am

Thanks for the replies;

However, do you really want to look at cash flow this way? If you have an investment which is guaranteed to lose principal, spending the cash flow is effectively invading the principal even if you don't actually sell any shares.


I want to look at the cash flows in a way that is the best representation of actual cash flows I will receive. Hence the question of if anyone knows a source for historic SEC yields for VWIUX so I compare SEC to actual distribution. Which is the better indicator of what the fund will pay out over time, the distribution yield or SEC yield?

The SEC yield is actually more real. If the distribution yield is higher than the SEC yield, the fund pays out more than it actually gains, as the price of the bonds will decline as they approach maturity.


I don't understand how a fund could consistently pay out more than it receives and be sustainable, yet VWIUX distribution yield has been higher than its SEC yield for some time now (again that is why I am interesting is seeing historic SEC yields).

I did a simple analysis of distributions from VWIUX for the past 10 years. If an investor bought a share of VWIUX on 3/1/2007 (random date) it would cost them -$13.38; it they held it for 10 years they would have received distributions of $4.77 and then sell it on 3/1/2017 they would get $13.94 back for a total IRR of 4.04%. Perhaps the fund was paying out principle from premium bonds along the way but the investor has no way of knowing, they did not pay a premium to buy and they received full principle (plus some) back. To them it was like buying a 10 year bond at par with a coupon of 4%.

I would greatly appreciate if anyone can point me to data that proves that VWIUX is juicing up its distribution yield by paying out principle.

Assume you have the option of buying individual 10 year bonds and AA-A credit rating yielding 2-2.25% or purchasing VWIUX that is currently distributing 2.87% with a SEC yield of 2.15% . This is buy and hold money, you are looking for the cash flow and not looking to make money on price movements, nor do you anticipate needing liquidity. So which would you view as the better investment ?? (also assume you believe it is more likely that interest rates will rise than fall during the next 10 years).

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Phineas J. Whoopee » Wed Mar 15, 2017 4:09 pm

underwood wrote:...
I don't understand how a fund could consistently pay out more than it receives and be sustainable, yet VWIUX distribution yield has been higher than its SEC yield for some time now (again that is why I am interesting is seeing historic SEC yields).
...

That's the point. It isn't sustainable. It's because of past history changing the market value of the bonds which already were issued.

As a bond approaches maturity its market value must approach its face value, whether higher or lower, and that's accounted for in the SEC yield. Who would pay much more, or accept much less, than $1000 for a 30-year $1000 face value bond that matures tomorrow?

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Wed Mar 15, 2017 5:23 pm

underwood wrote:Does anyone know a source for the historic (past ten years) SEC yield for VWIUX? The distribution yield is available on the Vanguard site, but not the SEC yield.

Click on Price & Performance tab, then click Search for more historical price information. This takes you to Vanguard - Price History Search. You can retrieve one year at a time and copy/paste into a spreadsheet.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Wed Mar 15, 2017 5:26 pm

underwood wrote:I am interested in seeing how the distribution yield has compared to the SEC yield over time. For the past couple of years it has stayed well above the SEC yield.

I've done this analysis for several funds. Try this Google search: sec yield distribution yield "kevin m" site:bogleheads.org. First link is: Total Bond: 23 years of SEC yield and distribution yield - Bogleheads.org. Enjoy!

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Wed Mar 15, 2017 5:31 pm

underwood wrote:Others have suggested that the distribution yield is higher than the SEC yield because VWIUX is paying out principle (yield from bonds purchased at premium), but that does not seem sustainable as eventually the VWIUX would run out of principle that way. Plus the average coupon for VWIUX is +4% yet the distribution yield is currently 2.8% so clearly VWIUX is not distributing the full coupon.

They don't pay out principle. Distribution yield is higher than SEC yield because the fund holds premium bonds for which the current yield is higher than the yield to maturity. Distribution yield is lower than average coupon rate because premiums that existed when the bonds were purchased are amortized, and that reduces the income distributions, and also because current yield is more relevant to distribution yield than coupon rate.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by grabiner » Wed Mar 15, 2017 7:36 pm

underwood wrote:I don't understand how a fund could consistently pay out more than it receives and be sustainable, yet VWIUX distribution yield has been higher than its SEC yield for some time now (again that is why I am interesting is seeing historic SEC yields).


Distribution yields are higher than SEC yields when rates have fallen; they are lower when rates have risen. The reason is that the distribution yield on a bond barely changes as the bond price changes, while the yield to maturity (and SEC yield) change much more.

If rates are stable, distribution yields will still be slightly higher than SEC yields. Suppose that a fund holds 5-10 year bonds; it buys 10-year bonds, and sells them after five years. The distribution yield will be the yield on 10-year bonds, while the SEC yield will be the average yield on bonds maturing in 5-10 years, which is slightly less. (And the actual distributions will be higher than both; if the fund buys a 10-year bond and sells it when the bond has a lower yield as a 5-year bond, it will distribute a capital gain.)
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Wed Mar 15, 2017 8:02 pm

I think it's often useful to use basic bond math to see how things work for an individual bond. A bond fund is more complicated, but since it's a collection of individual bonds, the bond math that applies directly to the individual bonds applies indirectly to the bond fund.

Take the 2/28/2017 average values for the fund and apply it to an individual bond.

4.50% Coupon rate
2.10% Yield to maturity
8.7 years to maturity

The price for this bond is 118.90, which results in a current yield of 3.78% (= 4.5/118.90). So the current yield already is well below the coupon rate. Throw in some amortization of bond premium, and that could be reduced to 2.87%, which is the fund distribution yield as of 2/28.

For example, say the bond was bought with 15 years to maturity and a yield of 3%, which would be a price of 117.91. That's a premium of 17.91, which amortized over 15 years is -1.19 per year. Including the amortization in the income distribution gives a "distribution yield" of 2.78% = (4.5 - 1.19)/118.90, which is lower than the fund distribution yield of 2.87%.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by kolea » Wed Mar 15, 2017 8:15 pm

grabiner wrote:However, do you really want to look at cash flow this way? If you have an investment which is guaranteed to lose principal, spending the cash flow is effectively invading the principal even if you don't actually sell any shares. The main reason that distribution yield is useful is the tax situation; if your taxable bond fund has a 3% distribution yield, you expect to have $300 of taxable income next year on a $10,000 investment, regardless of the SEC yield.


To tell the truth, I spend very little time estimate yields - distribution or SEC - at this point. But I do eye-ball things from time to time to get a sense of where things are headed.

Your comment on spending cash flow - the parts of my portfolio that are in taxable (equities + Muni bond funds) I spend the cash flow. The difference between that amount and the withdrawal I want to make I take with capital gains. I suppose I could reinvest and then take the entire withdrawal as cap gains but I see no advantage to that. I make withdrawals quarterly so it is not like money is sitting around un-invested. Am I missing something here?
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Wed Mar 15, 2017 9:26 pm

Thanks for the excellent replies, and Kevin thanks for the links to other threads on this topic. Very helpful.

For me this question came up starting about a year ago when my advisor suggested selling my VWIUX to buy individual bonds. As we got further into the details it appeared to me that moving to the individual bonds would decrease my income cash flow. He said the bonds he wanted to buy yield about the same as the SEC yield for VWIUX so that would not be the case. My push back is that its the distribution yield that I actually receive and it was 50bps better than the bonds he was proposing. (And its been that way for all the past year.)

Now I am moving some funds out of equities into bonds and the question has come up again. Do I buy more VWIUX or build a ladder of individual bonds. Which got me once again debating with my advisor which is more relevant, distribution yield or SEC yield. He claims that the distribution yield is higher because the fund is paying out principle, which if I understand correctly is not the case.

VWIUX distribution yield is still greater (~50bps) than what I can get from bonds of similar duration/credit risk so from a cash flow perspective VWIUX still seems the better route. Another factor is I believe interest rates are likely to go up more than down and expect so expect the distributions from VWIUX will slowly inch up further increasing my cash flow whereas with individual bonds I am locking in the yield when I buy so no upside. Am I thinking about this right?

Thanks

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by ogd » Wed Mar 15, 2017 9:40 pm

underwood wrote:Now I am moving some funds out of equities into bonds and the question has come up again. Do I buy more VWIUX or build a ladder of individual bonds. Which got me once again debating with my advisor which is more relevant, distribution yield or SEC yield. He claims that the distribution yield is higher because the fund is paying out principle, which if I understand correctly is not the case.

Do not buy a ladder of individual muni bonds. There is no good reason to, and many reasons not to: liquidity, the chance of getting bad deals including getting ripped off by the advisor or their firm, difficulty of management, diversification. At best, the individual investor can get away with doing this for Treasuries, which are highly liquid and essentially interchangeable, but things that are diverse, have arcane pricing and can sometimes fail are far better left to a fund.

Listen to our forum friend and author Rick Ferri on this one, someone who used to make a portion of his living managing individual bond portfolios:

Rick Ferri, in 2013, wrote:I managed several hundred million dollars in municipal bond portfolios for many years. Not any more. My choice now is a low-cost Vanguard tax-exempt fund. The costs is very low, the fund has overnight liquidity, and the portfolio is well diversified. It's really a great option - I own a couple of the funds myself.


underwood wrote:Another factor is I believe interest rates are likely to go up more than down and expect so expect the distributions from VWIUX will slowly inch up further increasing my cash flow whereas with individual bonds I am locking in the yield when I buy so no upside. Am I thinking about this right?

I'd say, not quite right. The yield of VWIUX (and eventually distributions) inching up is a direct result of the fund taking higher interest rate risk by keeping duration constant rather than allowing it to naturally decline, like in the case of individual bonds. You'd get that result by continuing to buy on the higher end just as well, and even if you don't it's a higher risk / higher reward trade that's merely fair, not a big positive.

You can make that tradeoff with just individual bonds like I mentioned, or with just funds in any direction you'd like. Duration risk / reward should NOT be a factor in choosing between bonds and a fund. While I highly recommend the fund, we need to keep the discussion fair.

underwood wrote:Thanks for the excellent replies, and Kevin thanks for the links to other threads on this topic. Very helpful.

Yup, he provided excellent coverage as usual.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by grabiner » Wed Mar 15, 2017 10:02 pm

underwood wrote:VWIUX distribution yield is still greater (~50bps) than what I can get from bonds of similar duration/credit risk so from a cash flow perspective VWIUX still seems the better route. Another factor is I believe interest rates are likely to go up more than down and expect so expect the distributions from VWIUX will slowly inch up further increasing my cash flow whereas with individual bonds I am locking in the yield when I buy so no upside. Am I thinking about this right?


The more important issue is that, with the fund, you can control your own cash flow. If you need an extra $1000 in cash from a fund, you can sell $1000 of shares; if the fund yields $2000 in dividends you didn't need, you can reinvest them. With individual bonds, this doesn't work; you can't sell part of a bond, and if you sell a whole municipal bond before maturity, there will be high transaction costs.
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Thu Mar 16, 2017 12:37 pm

underwood wrote:VWIUX distribution yield is still greater (~50bps) than what I can get from bonds of similar duration/credit risk so from a cash flow perspective VWIUX still seems the better route.

I'm not recommending that you buy individual munis, but are you sure about this? With a search of muni bonds with credit rating AA (about the average for the fund), I find a bond with these numbers:

6.00% coupon
2.78% ytm
8.22 years to maturity

This results in a price of 123.38, so a current yield of 4.86% (=6/123.38), so much larger cash flow than the fund. The duration of this bond is somewhat longer at 6.7 years, but I'd guess that if you look enough you could find a bond with same duration as fund and similar or greater current yield.

Now if you do what the fund does and count the amortization of the premium against your current yield, you get a "distribution yield" of 2.56%. So a bit lower than the fund, but the premium amortization isn't a cash-flow item for you, so from a pure interest cash-flow perspective this bond is better.

However, the premium amortization is of course a factor in the total return, which of course is best indicated by the ytm of 2.78%. Ignoring reinvestment risk, and assuming no default, you're going to earn about 2.78% on this bond if held to maturity.

Of course the fund doesn't just buy one bond and hold it to maturity, so if you want to compare individual bonds to the fund, you'd build a ladder of bonds with similar risk/yield characteristics as the fund. It will be impossible for you to do as well as the fund, because you'll have higher transaction costs, and you can't hold enough bonds to get the same diversification as the fund, not to mention the much better liquidity of the fund. These benefits far outweigh the annual fund cost of 0.09%.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Fri Mar 17, 2017 10:51 pm

I'm not recommending that you buy individual munis, but are you sure about this? With a search of muni bonds with credit rating AA (about the average for the fund), I find a bond with these numbers:

6.00% coupon
2.78% ytm
8.22 years to maturity


Kevin; thanks for the thoughtful response. I greatly appreciate the time you take to respond (same for all posters!)

Am I sure? No I still have a long learning curve ahead when it comes to bonds. I should have clarified by cash flow I meant interest cashflow; I understand I can get a higher coupon payments by paying a premium but that appears to me as part interest, part return of principle so I net out the principle repayment.

Now if you do what the fund does and count the amortization of the premium against your current yield, you get a "distribution yield" of 2.56%. So a bit lower than the fund, but the premium amortization isn't a cash-flow item for you, so from a pure interest cash-flow perspective this bond is better.


Not sure I follow. VWIUX distribution yield is 2.87: ; close but a little higher than the bond you found . Can you explain further why you say the interest cashflow from the bond you mentioned is higher?

To compare bonds to a fund I build a spreadsheet with the cash flows and then calculate XIRR. I believe (hope) this accounts for buying/selling at premium or discount. The challenge with funds is that neither the "coupon" (distribution yield) or NAV is fixed so I have to make assumptions about future distribution yield and NAV. This raises another question; the average duration of VWIUX is 5.2 ; is it a reasonable assumption that if interest rates go up 1% that the NAV of VWIUX will go down by 5.2%? Conversely is there a way to estimate if rates go up 1% how long it will take for the distribution yield of VWIUX to adjust up?

In my cashflow IRR model I assume that the distribution yield will stay constant, (even though I would expect it to rise in a rising interest rate environment) and that the NAV will stay about the same. These may be fatal assumptions to the analysis but not sure of another way to do it.

Certainly open to other ways to make a comparison of individual bonds to bond fund.

Thx

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Sat Mar 18, 2017 5:27 pm

underwood wrote:I should have clarified by cash flow I meant interest cashflow; I understand I can get a higher coupon payments by paying a premium but that appears to me as part interest, part return of principle so I net out the principle repayment.

The coupon payment from a bond is the interest cashflow. The gradual reduction in market price as the bond approaches maturity is not "return of principle". There is no actual cashflow involved in this part, so it has nothing to do with actual interest payments you receive.

If you factor in the reduction in market value as the bond approaches par, you are looking at total return, not income (cashflow), in which case you should just look at yield to maturity, which factors in both coupon payments and price change as the bond approaches maturity.

Some funds actually do include return of capital in their distributions. This is an actual cashflow item that also reduces the share value. You can see return of capital distributions in the Vanguard REIT fund: Vanguard - REIT Index Fund Investor Shares - Distributions. You won't see any such distributions for your bond fund.

Not sure I follow. VWIUX distribution yield is 2.87: ; close but a little higher than the bond you found . Can you explain further why you say the interest cashflow from the bond you mentioned is higher?

Because amortization of the individual bond premium is not cashflow, as explained above. It is just a bookkeeping and tax item for you, and has no impact on the cash flowing from the bond into your pocket. However, the bond fund does actually subtract the premium amortization from the coupon payments, thus reducing the dividend amount. So for the bond fund the premium amortization does factor into the cashflow.

So your actual cashflow from the bond in the example would be higher. From a total return perspective this is being offset by the gradual reduction in market value. The bond fund retains the cash to offset the premium amortization, reducing the dividend distribution instead of reducing the share price.

To compare bonds to a fund I build a spreadsheet with the cash flows and then calculate XIRR.

XIRR is just a spreadsheet implementation of IRR, and IRR is essentially YTM for a bond. Each is the discount rate that equates current price with the present value of future cashflows.

What you need to understand is that a bond fund is just a collection of bonds. If you held the same collection of bonds and managed it the same way as the fund, your return would be the same as the fund except for the difference in costs (you will pay higher costs). Unless you are comparing an identical collection of bonds managed the same way the fund manages its bonds, you are comparing apples to oranges, so the comparison doesn't really have much meaning.

I believe (hope) this accounts for buying/selling at premium or discount.

For an individual bonds it does, since if you do it correctly, your XIRR calculation will just be recalculating the YTM of the bond (assuming you hold to maturity), which you can calculate directly using the YIELD or RATE functions. For a bond fund there are too many complications for you to use this to compare directly to an individual bond.

The challenge with funds is that neither the "coupon" (distribution yield) or NAV is fixed so I have to make assumptions about future distribution yield and NAV.

Aside from the fact that the coupon is not the same as distribution yield (remember the premium amortization), yes, you are twisting yourself into knots trying to compare a large collection of bonds that are constantly being bought and sold to an individual bond held to maturity.

This raises another question; the average duration of VWIUX is 5.2 ; is it a reasonable assumption that if interest rates go up 1% that the NAV of VWIUX will go down by 5.2%?

Roughly speaking, yes, since that is one of the definitions of duration. But the catch is that there are many interest rates, not just one, and the only rate that matters for a particular bond is the yield for that bond (and comparable bonds). You could have shorter-term rates go up while longer-term rates go down (by less), resulting in little or no change in the NAV.

This is why the more accurate way to say it is for a parallel shift in the yield curve of one percentage point, the NAV will move by about the duration percent in the opposite direction. In this case, yields for all maturities (for bonds in the fund) are assumed to move up or down by the same amount.

Conversely is there a way to estimate if rates go up 1% how long it will take for the distribution yield of VWIUX to adjust up?

Well, if all yields moved up by one percentage point quickly, the share price would drop by about 5%, but the actual distribution amount wouldn't change much, other than the normal monthly variations. Since the distribution amount would be about the same, the distribution yield would be a little higher. For example, with a share price of 10, YTM of 2%, and distribution yield of 2.5%, if YTM increased to 3% with a price decline to 9.50, distribution yield would increase to 2.63%.

If you're asking how long it would take for distribution yield to reach 3%, it depends on how the bonds in the fund are managed. To get a sense of the range of possibilities, let's take a look at the chart of YTM and distribution yield for total bond fund for 1993-2015:

Image

Note that in 1999, SEC yield increased by somewhat more than one percentage point, and although distribution yield didn't increase as much, it did increase by almost one percentage point. However, in 2005 SEC yield increased almost one percentage point, but distribution yield actually decreased.

Taking a look at the longer view, we see that SEC yield and distribution yield generally move in the same direction, but over shorter periods the relationship is not definitive.

In my cashflow IRR model I assume that the distribution yield will stay constant, (eveen though I would expect it to rise in a rising interest rate environment) and that the NAV will stay about the same. These may be fatal assumptions to the analysis but not sure of another way to do it.

Certainly open to other ways to make a comparison of individual bonds to bond fund.

I just think you're trying to do something that can't be done with any precision at all.

If you want to own intermediate-term muni bonds, then you're almost certainly better off just sticking with the fund. Usually there is no free lunch in the bond market, although the diversification you get with a good muni bond fund is a very inexpensive lunch compared to what you'd pay to try to replicate similar risk/return with individual bonds.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Sun Mar 19, 2017 10:18 am

Kevin;

Thanks so much for the response and helping me along the learning curve. Clearly I have a long way to go.

A couple of comments.
The coupon payment from a bond is the interest cashflow. The gradual reduction in market price as the bond approaches maturity is not "return of principle". There is no actual cashflow involved in this part, so it has nothing to do with actual interest payments you receive.


Agreed; the coupons are all cashflow. The way I was thinking about it is the premium above par paid to get a higher coupon is not returned at redemption (I will only get back par), rather it is returned overtime via the stream of higher coupons. Therefore it seemed reasonable (perhaps not from a tax accounting perspective, but as these are non taxable bonds not concerned about tax impacts) to think of the coupon paid from bonds purchased at a premium to contain interest plus repayment of the premium paid above par. I understand that I could also look at the premium as being lost to devaluation over time but I knew the bond would only redeem at par when purchasing so struggle with devaluation concept. I knew it was only worth par when purchasing, I simply agreed to pay more, so did it really devalue?

yes, you are twisting yourself into knots trying to compare a large collection of bonds that are constantly being bought and sold to an individual bond held to maturity.
Agreed!!! The background I have an advisor wanting to build and manage a bond ladder for me and claims they can do better than VWIUX. When I ask for evidence I am showed a collection individual bonds which best I can tell provide no greater IRR than the fund (without taking greater credit or duration risk). So trying my best to stay open minded and informed while trying to compare apples to oranges.


Roughly speaking, yes, since that is one of the definitions of duration. But the catch is that there are many interest rates, not just one, and the only rate that matters for a particular bond is the yield for that bond (and comparable bonds). You could have shorter-term rates go up while longer-term rates go down (by less), resulting in little or no change in the NAV.

This is why the more accurate way to say it is for a parallel shift in the yield curve of one percentage point, the NAV will move by about the duration percent in the opposite direction. In this case, yields for all maturities (for bonds in the fund) are assumed to move up or down by the same amount.


This is a concept I had not even thought about (thank you). In my simplistic thinking I was thinking there was just one interest rate and the yield curve would shift in parallel when that interest rate changed. Obviously that is not the case but it leads to questions like who sets the yield curve in the first place, how does the market keep track and does everyone use the same yield curve?

Bonds on the surface seemed simple, but clearly a lot of underlying complexity.

I just think you're trying to do something that can't be done with any precision at all.
Yes, that's the story of my life...

Again I really appreciate the help and education. Thank you

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Sun Mar 19, 2017 3:44 pm

underwood wrote:A couple of comments.
The coupon payment from a bond is the interest cashflow. The gradual reduction in market price as the bond approaches maturity is not "return of principle". There is no actual cashflow involved in this part, so it has nothing to do with actual interest payments you receive.

Agreed; the coupons are all cashflow. The way I was thinking about it is the premium above par paid to get a higher coupon is not returned at redemption (I will only get back par), rather it is returned overtime via the stream of higher coupons. Therefore it seemed reasonable (perhaps not from a tax accounting perspective, but as these are non taxable bonds not concerned about tax impacts) to think of the coupon paid from bonds purchased at a premium to contain interest plus repayment of the premium paid above par. I understand that I could also look at the premium as being lost to devaluation over time but I knew the bond would only redeem at par when purchasing so struggle with devaluation concept. I knew it was only worth par when purchasing, I simply agreed to pay more, so did it really devalue?

For all investments, total return consists of income plus price change. This is a very standard way to look at it, and Vanguard even breaks total return for its funds into Capital Return and Income Return (Price & Performance tab -> See cumulative, yearly, and quarterly historical returns); Capital Return includes price change and capital gains distributions, and Income is the dividend distributions (coupon payments minus premium amortization plus discount accretion).

For your individual bonds, premium amortization is a negative value in the price change / capital return column, and has nothing to do with the income column. For a bond fund it's different, because the fund subtracts the premium amortization from the coupon payments to determine the dividend distributions.

A nice thing about bonds is that, assuming no default, and ignoring reinvestment risk, both components of total return are known in advance. Yield to maturity (YTM, or just "yield") gives you a very good approximation of your expected total return, with default and reinvestment rate being the only unknowns.

So YTM is the standard way to factor in the price change and income components. I recommend just using the standard bond metrics instead of trying to morph a price change item into a cash flow item. Total return is really what matters, unless you really have cashflow constraints that require you to place a higher value on income (always keeping in mind that you can generate income by liquidating capital, although there may be tax and other cost considerations).

So I just wouldn't get too hung up on trying to compare distribution yield of a fund to coupon payments minus premium amortization for individual bonds. I'd mainly focus on yield (to maturity) vs. risk (credit and term), and just not worry much about how the yield is delivered.

Duration, the best measure of term risk, factors in how much of and how soon the total return is delivered in the form of higher coupon payments. For a given maturity, higher coupon payments lower the duration, and hence the term risk, because more of the cashflow is discounted at a lower rate, and a larger proportion of the discounted cashflows are delivered to you earlier. So I'd focus on duration rather than distribution yield or coupon payments.

Kevin M wrote:yes, you are twisting yourself into knots trying to compare a large collection of bonds that are constantly being bought and sold to an individual bond held to maturity.
underwood wrote:Agreed!!! The background I have an advisor wanting to build and manage a bond ladder for me and claims they can do better than VWIUX. When I ask for evidence I am showed a collection individual bonds which best I can tell provide no greater IRR than the fund (without taking greater credit or duration risk). So trying my best to stay open minded and informed while trying to compare apples to oranges.

OK, so a bond ladder is closer to the fund than a single individual bond, so closer to apples to apples. The fund is actively managed, so will not just hold bonds to maturity, but will buy and sell to some extent based on trying to game the yield curve. They also will use their judgment take more or less credit risk than their benchmarks. You will see language to this effect in the annual and semiannual reports:

• With investors continuing to reach for yield through much of the fiscal year, the funds
added value by having higher weightings than their benchmarks in municipal securities
rated A and BBB and in sectors where credit spreads tend to be wider.

• Security selection and an overweight allocation to premium callable bonds were
positives for the funds. Overweighting securities at the long end of the yield curve
in the longer funds also worked out well.


So one question is whether you think your advisor can to a better job than the Vanguard bond experts in security selection and the other judgments they bring to bear in terms of credit risk and term risk. Then there's also the fact that your advisor simply cannot match the low transaction costs of institutional investors like Vanguard.

Putting these details aside, you can construct a bond ladder that has similar metrics as the Vanguard fund, focusing on yield to maturity, credit risk (average credit quality), and term risk (duration). You probably won't be able to do quite as well after costs, but these are the metrics to look at in trying. Don't get distracted by coupon rates, distribution yields, and premium amortization, which are all subsumed by yield (to maturity) and duration.

You don't need to bother with IRR calculations, since this is what yield (to maturity) tells you. As you've acknowledged, you're making unrealistic assumptions anyway in your IRR calcs for the bond fund, so instead just focus on YTM. Your YTM will change over time for both the bond fund and bond ladder, so all you know is the yield as of today. Ditto for share price or bond ladder market value, since price is just the flip side of the price/yield coin.

Since the muni bond market usually is pretty efficient, it's highly unlikely that your advisor has knowledge or skill, beyond that of the Vanguard bond fund managers, that can be used to construct a bond ladder that has higher expected return than the fund on a risk-adjusted basis. Your advisor obviously is going to throw you a pitch that tries to spin whatever they're doing in a positive light--that's what they get paid for.

I used to buy lots of individual bonds using a really nice bond guy at Schwab. It was fun and it worked out OK, but I eventually came to accept the kind of reasoning I'm sharing here, so just gradually moved everything to Vanguard and went with their excellent bond funds. Of course if you've read many of my posts, you'll know that I've since shifted the vast majority of my fixed income into direct CDs (but still have some in muni bond funds in taxable accounts).

underwood wrote:In my simplistic thinking I was thinking there was just one interest rate and the yield curve would shift in parallel when that interest rate changed. Obviously that is not the case but it leads to questions like who sets the yield curve in the first place, how does the market keep track and does everyone use the same yield curve?

Usually references to "the yield curve" are referencing the Treasury yield curve, which is updated on a daily basis here: Daily Treasury Yield Curve Rates. On that page you can read how these yields are determined:
Treasury Yield Curve Rates. These rates are commonly referred to as "Constant Maturity Treasury" rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of quotations obtained by the Federal Reserve Bank of New York. The yield values are read from the yield curve at fixed maturities, currently 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.

So yields (rates) are determined by the supply and demand in the Treasury bond market, which is dominated primarily by institutional investors and governments. You can see daily Treasury yields and prices here: U.S. Treasury Quotes - Markets Data Center - WSJ.com.

Each type of bond has its own yield curve, and will deviate from the Treasury yield curve based on credit risk and other specific bond characteristics (which for munis, includes exemption from income taxes). You can construct a yield curve for AAA munis, AA munis, etc. You can get a sense of the variation in yield curves for different types and qualities of bonds buy looking here: Vanguard: Find CDs and bonds. You'll see that the Treasury yields are close to what you see on the Treasury.gov site, and you'll see the differences in yields for various quality Munis, for example.

You can think of yield curves for non-Treasury bonds as the Treasury yield curve plus a spread, with the spread for a particular type and quality of bond varying depending on the bond market's perception of the additional credit risk for that particular bond of a given maturity (and for munis, factoring in the income tax exemption).

Since VWIUX consists of muni bonds of different credit ratings, there are multiple muni bond yield curves that affect the average yield and average credit rating for the fund.

underwood wrote:Bonds on the surface seemed simple, but clearly a lot of underlying complexity.

Yeah, if you really dig into them, which for some of us nerdy types is really fun. But fundamentally bonds are simpler than stocks, since bonds have a more certain income stream (including principal repayment). Stock dividends are not as certain as bond coupons, and future stock prices are vastly more uncertain than future bond prices (especially for bonds held to maturity).

underwood wrote:Again I really appreciate the help and education. Thank you

You're very welcome.

Kevin
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Sun Mar 19, 2017 8:32 pm

Kevin;

Thanks for helping me gain perspective; slowly it is all beginning to make more sense!

So I just wouldn't get too hung up on trying to compare distribution yield of a fund to coupon payments minus premium amortization for individual bonds. I'd mainly focus on yield (to maturity) vs. risk (credit and term), and just not worry much about how the yield is delivered.


What proxy for YTM you recommend when looking at a fund? The SEC yield or distribution yield, or something else? My advisor keeps saying look the bonds I am recommending have YTM higher than the SEC yield for VWIUX; my response so far is been that its the distribution yield I have gotten from VWIUX for the past 10 years so why should I care about SEC yield...

What questions should I be asking of my advisor when he recommends selling my VWIUX to buy a bond ladder?

Thanks

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by grabiner » Sun Mar 19, 2017 9:27 pm

underwood wrote:
So I just wouldn't get too hung up on trying to compare distribution yield of a fund to coupon payments minus premium amortization for individual bonds. I'd mainly focus on yield (to maturity) vs. risk (credit and term), and just not worry much about how the yield is delivered.


What proxy for YTM you recommend when looking at a fund? The SEC yield or distribution yield, or something else?


SEC yield is based on yield to maturity.

My advisor keeps saying look the bonds I am recommending have YTM higher than the SEC yield for VWIUX; my response so far is been that its the distribution yield I have gotten from VWIUX for the past 10 years so why should I care about SEC yield...

Your advisor is right here. Suppose you have a bond worth $1000 which will pay $30 next year and then mature for $980, and I have a bond worth $1000 which will pay $10 next year and then mature for $1000. Your bond has a 3% distribution yield, and mine has a 1% distribution yield, but both of us will have $1010 next year, and both of us have a YTM (and SEC yield) of 1%.

What questions should I be asking of my advisor when he recommends selling my VWIUX to buy a bond ladder?


What are the credit risk and duration of the bonds you will be buying? A bond with a 3% yield may not be better than a bond with a 2% yield if the higher-yielding bond has a longer duration (more interest rate risk) or a lower rating (more credit risk).

Are the bonds callable? If your individual bonds are called, that will interfere with your plan of building a ladder, as you may not get the return you want for the period you expected. Bond funds have to deal with calls as well, but they report a duration which is adjusted for the likely calls.

Finally, you need to decide whether a ladder is the right way for you to invest. See Individual Bonds vs a Bond Fund on the wiki.
David Grabiner

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by convert949 » Mon Mar 20, 2017 6:41 am

grabiner wrote:
underwood wrote:I don't understand how a fund could consistently pay out more than it receives and be sustainable, yet VWIUX distribution yield has been higher than its SEC yield for some time now (again that is why I am interesting is seeing historic SEC yields).


Distribution yields are higher than SEC yields when rates have fallen; they are lower when rates have risen. The reason is that the distribution yield on a bond barely changes as the bond price changes, while the yield to maturity (and SEC yield) change much more.

If rates are stable, distribution yields will still be slightly higher than SEC yields. Suppose that a fund holds 5-10 year bonds; it buys 10-year bonds, and sells them after five years. The distribution yield will be the yield on 10-year bonds, while the SEC yield will be the average yield on bonds maturing in 5-10 years, which is slightly less. (And the actual distributions will be higher than both; if the fund buys a 10-year bond and sells it when the bond has a lower yield as a 5-year bond, it will distribute a capital gain.)

My question then is how do we compare fund returns for a comparison of Tax Free vs. Taxable investing?

Having owned VWIUX on and off for many years (when working) and then holding it into retirement, I had kept the fund as the Tax Free cash distributions (sent to my bank) exceeded those of taxable funds of similar quality and duration. During that time, the NAV of the fund also continued to rise. It was only during the most recent interest rate bump that the NAV fell and I sold the fund to take advantage of the TLH opportunity.

Is that when you are called to "pay the piper"? If not, then how do we compare whether the muni fund is advantageous on an after tax basis. It seems that using the traditional SEC comparison is less than perfect...

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Mon Mar 20, 2017 2:28 pm

underwood wrote:Kevin;

Thanks for helping me gain perspective; slowly it is all beginning to make more sense!

So I just wouldn't get too hung up on trying to compare distribution yield of a fund to coupon payments minus premium amortization for individual bonds. I'd mainly focus on yield (to maturity) vs. risk (credit and term), and just not worry much about how the yield is delivered.

What proxy for YTM you recommend when looking at a fund? The SEC yield or distribution yield, or something else?

Most people use SEC yield. Definitely not distribution yield.

SEC yield is average YTM over a trailing 30-day period, so it's a form of YTM. Due to the 30-day averaging, SEC yield and share price won't be related by the precise mathematical formula that relates bond price to bond YTM, so sometimes you'll see wacky things, like both price and SEC yield moving in the same direction on a given day. Still, SEC yield is what most people use.

You also can view average YTM for the fund, but it is only updated monthly, and does not subtract expenses. Currently SEC yield for VWIUX is 2.14% and average YTM as of 2/28 is 2.1%, so pretty close. On 2/28 SEC yield was 2.12%, so even closer to average YTM on that date.

As we've discussed, distribution yield is comparable to bond current yield (annual coupon divided by price), but with premium amortization and discount accretion added in, so this is not something you'd compare to YTM for a bond ladder.

My advisor keeps saying look the bonds I am recommending have YTM higher than the SEC yield for VWIUX; my response so far is been that its the distribution yield I have gotten from VWIUX for the past 10 years so why should I care about SEC yield...

As we've discussed, you want to compare YTM, term risk (duration), and credit risk (quality) of the bond ladder to the fund (using SEC yield as an after-cost approximation of YTM). Be sure to include transaction costs for the bond ladder.

If the bond ladder your advisor is recommending has higher average YTM than the bond fund, then the bonds are riskier. Period. You generally don't get higher yields in the bond market without taking more risk (unlike CDs, for which a retail investor can definitely get higher yields with the same or even lower risk).

Look at the example AA muni bonds I mentioned earlier. One had a YTM of 2.78%, but duration was 6.7 years, so more term risk than the fund with average duration 5.1 years. Two other bonds I looked at had yields of 2.1% and 2.15%, so comparable to the fund, but had durations of 7 years or more, so even more term risk.

You might think the first bond is a better deal, with higher yield and lower duration, but it's highly likely that the credit risk of this bond is deemed to be higher than the other two bonds (despite the same rating). Or it could just be a small lot that someone just wants to get rid of, and maybe it is indeed a better deal (that does happen), but maybe you can't buy enough of these bonds to make much difference in your ladder.

You could have a higher distribution yield but lower total return, or vice versa, so distribution yield is not a good measure to use to compare bonds and bond funds. Bond fund managers can play all kinds of games to manipulate distribution yield, and there's not a consistent definition of distribution yield, which is one reason the SEC requires that all bond funds publish SEC yield using the exact same formula.

What questions should I be asking of my advisor when he recommends selling my VWIUX to buy a bond ladder?

Personally I wouldn't ask the advisor anything, but just use the Vanguard fund.

However, if you want to discuss it with your advisor, I've already elaborated at length on the bond characteristics you want to use to compare a bond fund to a bond ladder (average YTM or SEC yield, average duration, average credit quality, costs), but also keep in mind that there's no way you'll get the same diversification with your bond ladder. If one of your 10-20 bonds (for example) defaults, it will have a much larger impact than if one of the fund's 6,355 bonds defaults.

Kevin
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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Tue Mar 21, 2017 9:38 am

Personally I wouldn't ask the advisor anything, but just use the Vanguard fund.

However, if you want to discuss it with your advisor, I've already elaborated at length on the bond characteristics you want to use to compare a bond fund to a bond ladder (average YTM or SEC yield, average duration, average credit quality, costs), but also keep in mind that there's no way you'll get the same diversification with your bond ladder. If one of your 10-20 bonds (for example) defaults, it will have a much larger impact than if one of the fund's 6,355 bonds defaults.



The discussion with my advisor has been educational (but I have gotten far more from this thread!), and he is not going to like my response but I agree.

Thanks again.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Wed Mar 22, 2017 10:03 am

Personally I wouldn't ask the advisor anything, but just use the Vanguard fund.

However, if you want to discuss it with your advisor, I've already elaborated at length on the bond characteristics you want to use to compare a bond fund to a bond ladder (average YTM or SEC yield, average duration, average credit quality, costs), but also keep in mind that there's no way you'll get the same diversification with your bond ladder. If one of your 10-20 bonds (for example) defaults, it will have a much larger impact than if one of the fund's 6,355 bonds defaults.



The discussion with my advisor has been educational (but I have gotten far more from this thread!), and he is not going to like my response but I agree.


My advisor's response; they see a flattening yield curve and a ladder will be more nimble and provide more flexibility to adjust duration and target strategic maturities along the yield curve. In a scenario like this, having a bond fund like VWIUX that targets a duration of ~5 years, can’t engage in a barbell strategy to take advantage of a flattening yield curve.

Curious to hear if others with greater understanding than mine would agree/disagree and what magnitude of benefit can be realized and whats the risk?

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by ogd » Wed Mar 22, 2017 11:46 am

underwood wrote:My advisor's response; they see a flattening yield curve and a ladder will be more nimble and provide more flexibility to adjust duration and target strategic maturities along the yield curve. In a scenario like this, having a bond fund like VWIUX that targets a duration of ~5 years, can’t engage in a barbell strategy to take advantage of a flattening yield curve.

Curious to hear if others with greater understanding than mine would agree/disagree and what magnitude of benefit can be realized and whats the risk?

Don't let the jargon deceive you. He sounds smart but millions of investor get ripped off by advisors promising "nimbleness" and "strategic flexibility" for fees that erase even the purported benefit let alone the actual.

The basic facts remain: 1) that if your advisor was so good at deciding which maturities are the better deals, he'd be running a multi-billion dollar fund not your portfolio, 2) that his fees will hurt you with certainty, while the help comes with as a rather uncertain possiblity, 3) that "nimbleness" and "flexibility" are greatly diminish in this illiquid market (munis at a small scale). Whereas a large institution like Vanguard can trade much more effectively if they do decide to implement a sophisticated maturity curve of some sort.

Also, it's plain untrue that "targeting a duration" can't allow a "barbell strategy". I can synthesize a duration of 5 years from 20 year bonds and 1 year bonds, and to some degree I do with CDs and savings account on the short end. What the fund pretty much can't do is target a substantially different duration (it would be a breach of its contract with you when you bought it -- you didn't sign up for such surprises). You can do that instead by switching funds. But like I mentioned, other than responding to personal circumstances, I think investors (or advisors) are in no position to judge which maturities are most rewarding today.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by Kevin M » Wed Mar 22, 2017 1:42 pm

underwood wrote:My advisor's response; they see a flattening yield curve and a ladder will be more nimble and provide more flexibility to adjust duration and target strategic maturities along the yield curve.

What do you think the Vanguard fund managers are doing? Read the annual reports and you'll see that this is exactly the type of thing they try to do as well. I've looked at changes in some of Vanguard's bond fund holdings in the past, and it's obvious that the fund managers are targeting points on the yield curve that they think are the most advantageous. This is part of the active management component of this fund and ones like it. Sometimes they get it right, and sometimes they don't. It will be the same for your advisor, but your costs will be higher and you'll get much less diversification.

In a scenario like this, having a bond fund like VWIUX that targets a duration of ~5 years, can’t engage in a barbell strategy to take advantage of a flattening yield curve.

Sure they can. The target duration may be about 5 years, but as of 2/28/2017 they held about 41% in 20-30 year maturities, and about 20% in maturities of 3 years or less. So unless you think your advisor has a better yield curve crystal ball than the Vanguard fund managers, just use the fund.

Curious to hear if others with greater understanding than mine would agree/disagree and what magnitude of benefit can be realized and whats the risk?

The risk is that the advisor's crystal ball is as cloudy as anyone else's, and the yield curve moves against the bet. Vanguard fund managers are making what they consider to be judicious yield curve bets, but they're probably not going to make a big bet on a yield curve prediction that is way out of line with the market's bets. To the extent your advisor deviates from the market's bets (which results in the current yield curves), you stand to gain or lose proportionally.

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Re: VWIUX SEC vs Distribution yield [Vanguard Int-Term Tax-Exempt]

Post by underwood » Wed Mar 22, 2017 6:27 pm

In a scenario like this, having a bond fund like VWIUX that targets a duration of ~5 years, can’t engage in a barbell strategy to take advantage of a flattening yield curve.

Sure they can. The target duration may be about 5 years, but as of 2/28/2017 they held about 41% in 20-30 year maturities, and about 20% in maturities of 3 years or less. So unless you think your advisor has a better yield curve crystal ball than the Vanguard fund managers, just use the fund.


Excellent point and to the extent the VWIUX manager is trying to do better than the benchmark I would expect them to use all the legitimate tools available. I give my advisor high marks for their tenacity, they keep trying to convince me...

Thanks Kevin for the continued education.

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