Is 0.46% more after-tax yield enough to justify muni risk?

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ribonucleic
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Is 0.46% more after-tax yield enough to justify muni risk?

Post by ribonucleic » Thu Feb 22, 2018 11:03 am

The standard advice is to choose tax-exempt bond funds for taxable accounts. I'm not convinced yet.

Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) - SEC yield: 2.91% After (new) top federal tax rate of 37%: 1.83%

Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (VWIUX) - SEC yield: 2.29%. After (no) federal tax: 2.29%

[Assume a state-specific fund is unavailable or deemed insufficiently diversified. Here, the state tax is the same either way.]

An extra 0.46% in after-tax yield isn't nothing. But is it enough to justify the risk (at whatever level you may assess it) of:

- less diversification

- more default risk

- potential loss of tax exemption

As best I can tell from searching the forum, the last possibility is often raised and then dismissed. But given what I perceive as the direction in which financial burdens are increasingly being shifted, I'm not so sanguine.

rkhusky
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by rkhusky » Thu Feb 22, 2018 11:43 am

ribonucleic wrote:
Thu Feb 22, 2018 11:03 am
- less diversification

- more default risk

- potential loss of tax exemption
It is not easy to compare diversification because there is little to no overlap between Total Bond and Intermediate Tax Exempt.

Total Bond contains 35%+ corporate bonds, which have higher default risk than the bonds in Int. TE.

Loss of tax exemption is just speculation. Base your decisions on current law. (In the unlikely event that this did occur, it is very likely that existing bonds would retain their tax exempt status - perhaps becoming more valuable)

The usual advice is to use Tax Exempt in a taxable account if you are in a high tax bracket.

You can always use Total Bond in a tax-advantaged account and a TE fund in taxable, thereby truly increasing diversity.

See: https://www.schwab.com/resource-center/ ... -sense-now

Here is a more recent report in all its gory detail:
https://www.researchpool.com/download/? ... _data=true
Last edited by rkhusky on Thu Feb 22, 2018 12:10 pm, edited 3 times in total.

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welderwannabe
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by welderwannabe » Thu Feb 22, 2018 11:58 am

Im not sure I agree with the premise that munis are more risky than the blend of bonds in BND.

BND is loaded with treasuries which are basically risk free, but it also has a bunch of corporate and MBS.
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

vtMaps
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by vtMaps » Thu Feb 22, 2018 12:18 pm

ribonucleic wrote:
Thu Feb 22, 2018 11:03 am
potential loss of tax exemption
A loss of the tax exemption would require a constitutional amendment. The reason state bonds are tax exempt is that the constitution forbids the federal government to tax the obligations of the states. (and vice versa)

--vtMaps
The optimist proclaims that we live in the best of all possible worlds; and the pessimist fears this is true. --James Branch Cabell

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Noobvestor
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by Noobvestor » Thu Feb 22, 2018 12:30 pm

VBTLX isn't tax efficient and, as others have pointed out, it also carries a mix of risks that are hard to compare directly.

I would compare to VSIAX, intermediate-term Treasuries. Indeed, I had the same question recently, and given the state savings of Treasuries versus the federal savings of tax-exempt, Treasuries seemed like a better deal to me (close yield, safer), so I switched out of VWIUX to VSIAX.

Here's my thread if you want to see how I arrived at that conclusion (with help from Bogleheads!): viewtopic.php?f=1&t=241570
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

rkhusky
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by rkhusky » Thu Feb 22, 2018 1:01 pm

Noobvestor wrote:
Thu Feb 22, 2018 12:30 pm
VBTLX isn't tax efficient and, as others have pointed out, it also carries a mix of risks that are hard to compare directly.

I would compare to VSIAX, intermediate-term Treasuries. Indeed, I had the same question recently, and given the state savings of Treasuries versus the federal savings of tax-exempt, Treasuries seemed like a better deal to me (close yield, safer), so I switched out of VWIUX to VSIAX.

Here's my thread if you want to see how I arrived at that conclusion (with help from Bogleheads!): viewtopic.php?f=1&t=241570
The past returns of Int. Treas. are quite a bit below Int. TE, but I suppose one should use the SEC yield for the comparison, although I wonder how stable is SEC yield. While Treasuries are safer, they are both very safe (kind of like the difference between ER's of 0.04% and 0.06%). I wouldn't pay much for the difference in safety and the decision also depends on your state tax rate. I also wouldn't incur a bunch of taxable cap gains to switch.

lack_ey
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by lack_ey » Thu Feb 22, 2018 1:06 pm

vtMaps wrote:
Thu Feb 22, 2018 12:18 pm
ribonucleic wrote:
Thu Feb 22, 2018 11:03 am
potential loss of tax exemption
A loss of the tax exemption would require a constitutional amendment. The reason state bonds are tax exempt is that the constitution forbids the federal government to tax the obligations of the states. (and vice versa)

--vtMaps
I'm definitely not a lawyer, but it's my understanding that this is false, effectively settled by SCOTUS in South Carolina v. Baker (1988). Intergovernmental tax immunity does not prevent the federal government from taxing interest on state and local bonds. The federal government just doesn't for most state and local bonds for a number of historical, political, and policy-related reasons.

ribonucleic wrote:
Thu Feb 22, 2018 11:03 am
- less diversification

- more default risk

- potential loss of tax exemption
Less diversification is right. More default risk is debatable, and if true relates to the "less diversification." Historically muni default rates are lower than in corporate bonds of similar ratings, and furthermore, the recovery rate has been higher (you get more pennies on the dollar when there's a default on average). But I'll definitely grant that a narrower category sharing certain features could be impacted systemically by some issues—default rates are definitely not independent between issuers. Longer term, everybody knows a lot of municipalities have pension obligations and other challenges; particularly with the issue of underfunded pensions which generally also have unrealistic return assumptions for their portfolios, this is a risk that could well show up in a bad way in the future that would not have shown up in historical figures.

Furthermore, this means that for diversification purposes, muni bonds may not be as good as an equity left tail hedge. If stock returns are terrible, you'd hopefully want your bonds to do okay, yet in this scenario there's definitely not going to be enough money to go around for pensioners, local taxpayers, and muni bondholders. Some combination of people are going to be unhappy.

I think the potential loss of tax exemption is a relatively remote possibility. It's hard to make that kind of change that would completely disrupt a market, anger all the most influential constituents, etc. A potentially bigger issue and one maybe we've just seen is the potential for tax rate changes or some other tweaks that would reduce the value of muni bonds somewhat relative to taxable bonds. On the other hand, if the top tax rates are increased, this would be good for muni bond prices (they would be bid up).

Maybe the biggest issue is that many muni bonds are callable, so you get negative convexity. The negative convexity is primarily why agency MBS (which have basically zero credit risk) have higher yields than Treasury bonds, so that's definitely part of what's priced into the muni bond market as well.

mega317
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by mega317 » Thu Feb 22, 2018 4:19 pm

Noobvestor wrote:
Thu Feb 22, 2018 12:30 pm
VBTLX isn't tax efficient and, as others have pointed out, it also carries a mix of risks that are hard to compare directly.

I would compare to VSIAX, intermediate-term Treasuries. Indeed, I had the same question recently, and given the state savings of Treasuries versus the federal savings of tax-exempt, Treasuries seemed like a better deal to me (close yield, safer), so I switched out of VWIUX to VSIAX.

Here's my thread if you want to see how I arrived at that conclusion (with help from Bogleheads!): viewtopic.php?f=1&t=241570
Agree with this. If you're willing to give up that much yield due to perceived risk of munis (and I don't think that's totally unreasonable) then use treasuries.

venkman
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by venkman » Thu Feb 22, 2018 11:21 pm

There's one other issue to consider with Vanguard's muni bond funds (which I'm still not 100% clear on, but this is what I think is the case):

VWITX has a current SEC yield of 2.20%, but its distribution yield (as of 1/31) is 2.74%. My understanding is that it's a standard practice for muni bonds to be sold at a premium, with an above-market coupon rate. Bondholders get higher tax-free income, but take a capital loss at maturity; presumably it all works out to equal whatever the original stated YTM is. This seems like an obvious free lunch--more tax-free income PLUS you can deduct the capital loss at maturity.

Alas, for individuals who hold these bonds, you have to amortize the capital loss each year and deduct it from the bond income (which you weren't going to pay taxes on anyway). By the time you get your principal back, the capital loss is gone.

But I think (not know, but think) that Vanguard's muni bond funds are structured in such a way that gets around that requirement. So, if you bought into VWITX today, you would expect future distributions to be more than the 2.20% SEC yield, combined with a gradual drop in the NAV of the fund (notwithstanding all the other factors that cause the NAV to move) that would ultimately work out to a yield of 2.20%. Except you could then sell your fund shares and claim the capital loss from selling at the lower NAV. (This apparently only works for funds that accrue dividends daily, which I think includes most Vanguard muni funds, but NOT the new-ish Tax Exempt Index (VTEAX).)

Again, I've tried to verify this, but I'm not an expert; and this is a subject that's pretty esoteric, so it's hard to find definitive answers. If anyone else can confirm or deny any of this, I'd love to hear your thoughts.

Charlieville
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Re: Is 0.46% more after-tax yield enough to justify muni risk?

Post by Charlieville » Thu Feb 22, 2018 11:40 pm

Potential loss of tax deduction? Pleeez. A bunch of retirees supplying credit to large states and cities. How do you think it became tax free in the first place?

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