Deciding Between Treasuries and Munis in Taxable

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Noobvestor
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Deciding Between Treasuries and Munis in Taxable

Post by Noobvestor » Tue Feb 13, 2018 8:52 pm

My IPS calls for 50/50 TIPS/Treasuries on the bond side, but with flexibility for optimizing around taxes.* For various reasons, about half my bond allocation is in taxable. Right now, I have Vanguard Intermediate-Term Tax Exempt in taxable and Vanguard Inflation-Protected Securities in tax-deferred space. I'm debating whether I should change from tax-exempt to Vanguard Intermediate-Term Treasuries in taxable.

Federal tax bracket: 24%
State tax bracket: 9%

By my calculations,

Tax Exempt: 2.13% SEC yield => [b]2.97%[/b] EDIT: looks like actually 2.80% tax-equivalent yield (adjusted for fed tax)
Treasuries: 2.46% SEC yield => 2.70% tax-equivalent yield (adjusted for state tax)

Note: I would also have to realize around $2,500 in long-term capital gains to sell the Intermediate-Term Tax Exempt fund.

So basically, the yield is still lower for Treasuries, but the idea behind having them in the portfolio in the first place was downside protection during flights to safety. But for years, tax-exempt was yielding a lot more than Treasuries, so I picked the former. Now that the yields have converged somewhat, I'm wondering if I should go back to the original plan. I know fighting the last war is a bad idea, but in 08/09 TIPS and munis didn't do so well, but Treasuries held their own. Regardless, my sticking point, in short, is that I don't have a written policy for how close the yields should be before I decide one way or the other - your answers could help me craft that part of my IPS.

*(Note: I also have some EE and I Bonds, but for the purposes of this question and simplicity, I'd like to skip over them.)
Last edited by Noobvestor on Tue Feb 13, 2018 9:17 pm, edited 2 times in total.
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Re: Deciding Between Treasuries and Munis in Taxable

Post by weltschmerz » Tue Feb 13, 2018 9:06 pm

It's a no brainer. Treasuries for the win. The yield is good enough, and I want that "flight to safety" if the stock market really falls. For me, as long as the after-tax yield on Treasuries is within 1% of what I could get from CDs or munis, I always go with the Treasuries. Of course, I followed Harry Browne's Permanent Portfolio for quite a while, and I think that has affected my view.

Looking at your numbers, I'm not sure about your tax-equivalent yield for the tax-exempt. If the yield is 2.13%, and you're in the 24% bracket, then the tax-equivalent yield is:

2.13% / (1 - 0.24) = 2.80%

Hey that's even better! Only a 0.1% difference between the tax-exempt and the treasuries!

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Re: Deciding Between Treasuries and Munis in Taxable

Post by Noobvestor » Tue Feb 13, 2018 9:16 pm

weltschmerz wrote:
Tue Feb 13, 2018 9:06 pm
It's a no brainer. Treasuries for the win. The yield is good enough, and I want that "flight to safety" if the stock market really falls. For me, as long as the after-tax yield on Treasuries is within 1% of what I could get from CDs or munis, I always go with the Treasuries. Of course, I followed Harry Browne's Permanent Portfolio for quite a while, and I think that has affected my view.

Looking at your numbers, I'm not sure about your tax-equivalent yield for the tax-exempt. If the yield is 2.13%, and you're in the 24% bracket, then the tax-equivalent yield is:

2.13% / (1 - 0.24) = 2.80%

Hey that's even better! Only a 0.1% difference between the tax-exempt and the treasuries!
I think you're right - I used Vanguard's calculator for that one and it seems to be using 2.23% (a less up-to-date yield). Thank you!

If that's the case, I'm open to other opinions, but with virtually equivalent (.1% or less) after-tax yields this feels like a no-brainer indeed.

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Re: Deciding Between Treasuries and Munis in Taxable

Post by baw703916 » Tue Feb 13, 2018 9:25 pm

Are there any other reasons why having an increased AGI (due to the interest on the Treasuries) might be undesirable? For example, not being able to make a Roth contribution. That's one thing that isn't accounted for in the equivalent yields math.
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Re: Deciding Between Treasuries and Munis in Taxable

Post by weltschmerz » Tue Feb 13, 2018 9:26 pm

Noobvestor wrote:
Tue Feb 13, 2018 9:16 pm
....with virtually equivalent after-tax yields this feels like a no-brainer indeed.
I'm glad you brought this up when you did. I had been considering opening up a position in Intermediate Munis (VWIUX or BMBIX), but after seeing these numbers, I think I'll just stick with the Treasuries. In fact, I am tempted to add to my position with the recent drop in bond prices (Intermediate Treasuries are down about 4.5% since Sept 2017). I have been hiding out in the Treasury Money Market (VUSXX) for far too long...

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Re: Deciding Between Treasuries and Munis in Taxable

Post by Dominic » Tue Feb 13, 2018 9:42 pm

For 10 basis points, take the Treasuries. Municipal bonds are almost always safe, but Treasuries have substantially lower credit risk. That's worth paying a little extra for.

If you were really itching to save those 10 bps, you could probably build your own Treasury latter and not have to pay the fund's expense ratio. I don't think that's worth the time, but it's an option that exists.

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Re: Deciding Between Treasuries and Munis in Taxable

Post by aristotelian » Tue Feb 13, 2018 9:47 pm

I would do Treasuries in the tax deferred account instead of Intermediate Bond, with Muni in taxable. You would effectively replace the corporates and GNMA in the index fund with all intermediate Treasury. Lower expected return but better diversification hedge and more tax efficient.

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Re: Deciding Between Treasuries and Munis in Taxable

Post by grabiner » Tue Feb 13, 2018 9:55 pm

Noobvestor wrote:
Tue Feb 13, 2018 8:52 pm
Federal tax bracket: 24%
State tax bracket: 9%
If you can't get a muni fund for your state, and you don't itemize deductions, that's a tax difference of just 16%; that is, munis yielding 84% as much as Treasuries would have the same after-tax yield. (This is calculated as (1-.24)/(1-.09)=.84.

With those ratios, Treasuries look better; I would expect munis to have less than 84% the yield of Treasuries of comparable risk. (For the bonds to have comparable risk, the munis would need to be shorter-term, since no Treasury bonds have credit or call risk.)
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Re: Deciding Between Treasuries and Munis in Taxable

Post by weltschmerz » Tue Feb 13, 2018 9:56 pm

Dominic wrote:
Tue Feb 13, 2018 9:42 pm
If you were really itching to save those 10 bps, you could probably build your own Treasury latter and not have to pay the fund's expense ratio. I don't think that's worth the time, but it's an option that exists.
I did this for many years, and it is definitely not worth the hassle. Let's say the fund expense ratio is 0.10%. If you did it yourself, you keep the 0.10%, but then you pay taxes on the interest, so you really only save 0.10% * (1 - your tax bracket). Now it's really not worth it!

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Re: Deciding Between Treasuries and Munis in Taxable

Post by stlutz » Tue Feb 13, 2018 11:21 pm

Plus, if you're talking about the Treasury index fund the ER is only .07% :happy

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Re: Deciding Between Treasuries and Munis in Taxable

Post by Soul.in.Progress » Wed Feb 14, 2018 9:39 am

baw703916 wrote:
Tue Feb 13, 2018 9:25 pm
Are there any other reasons why having an increased AGI (due to the interest on the Treasuries) might be undesirable? For example, not being able to make a Roth contribution. That's one thing that isn't accounted for in the equivalent yields math.
I’m wondering about this ^ question raised by baw703916 also. Anyone have insights on this aspect?
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Re: Deciding Between Treasuries and Munis in Taxable

Post by Noobvestor » Wed Feb 14, 2018 1:58 pm

Thank you all so much for your insights and opinions! So glad (as always) to have folks on this forum to help with things like this. I am still thinking about where to set the spread rule (for munis vs. Treasuries in the future), but definitely by .1%, and maybe as high as .5% makes sense.
grabiner wrote:
Tue Feb 13, 2018 9:55 pm
If you can't get a muni fund for your state, and you don't itemize deductions, that's a tax difference of just 16%; that is, munis yielding 84% as much as Treasuries would have the same after-tax yield. (This is calculated as (1-.24)/(1-.09)=.84.

With those ratios, Treasuries look better; I would expect munis to have less than 84% the yield of Treasuries of comparable risk. (For the bonds to have comparable risk, the munis would need to be shorter-term, since no Treasury bonds have credit or call risk.)
I also do have access to a state muni fund, but am a little worried about concentration risk. I'm in CA, and the intermediate-term tax-exempt fund has a 2.12% SEC Yield / (1 - .9 - .24) => 3.16% tax-equivalent yield, by my math. So I don't know - could put some of it there?
baw703916 wrote:
Tue Feb 13, 2018 9:25 pm
Are there any other reasons why having an increased AGI (due to the interest on the Treasuries) might be undesirable? For example, not being able to make a Roth contribution. That's one thing that isn't accounted for in the equivalent yields math.
Good question! It doesn't look like this will boost me into the phase-out range (hard to say for sure due to variable income).
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Re: Deciding Between Treasuries and Munis in Taxable

Post by weltschmerz » Wed Feb 14, 2018 2:31 pm

Noobvestor wrote:
Wed Feb 14, 2018 1:58 pm
I also do have access to a state muni fund, but am a little worried about concentration risk. I'm in CA, and the intermediate-term tax-exempt fund has a 2.12% SEC Yield / (1 - .9 - .24) => 3.16% tax-equivalent yield, by my math. So I don't know - could put some of it there?
Here's the math:
VCADX: 2.12% / (1 - .09 - 0.24) = 3.16% tax-eq yield
VWIUX: 2.24% / (1 - 0.24) = 2.95% tax-eq yield

Since both these funds have almost the same duration, then yes, you will get more yield by going with the CA state-specific fund. But is that 0.21% extra yield worth the extra risk? Most advice I have seen suggests no more than 50% of your muni exposure in your home state. However, if California's finances blow up, are the other states really going to be any safer?

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Re: Deciding Between Treasuries and Munis in Taxable

Post by skime » Wed Feb 14, 2018 2:36 pm

If you are going to do Muni's, stick with AAA in states without credit issues. Stay away from CA, NY, IL, etc.

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Re: Deciding Between Treasuries and Munis in Taxable

Post by 3funder » Wed Feb 14, 2018 3:19 pm

Dominic wrote:
Tue Feb 13, 2018 9:42 pm
For 10 basis points, take the Treasuries. Municipal bonds are almost always safe, but Treasuries have substantially lower credit risk. That's worth paying a little extra for.

If you were really itching to save those 10 bps, you could probably build your own Treasury latter and not have to pay the fund's expense ratio. I don't think that's worth the time, but it's an option that exists.
+1

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Re: Deciding Between Treasuries and Munis in Taxable

Post by Noobvestor » Wed Feb 14, 2018 5:02 pm

3funder wrote:
Wed Feb 14, 2018 3:19 pm
Dominic wrote:
Tue Feb 13, 2018 9:42 pm
For 10 basis points, take the Treasuries. Municipal bonds are almost always safe, but Treasuries have substantially lower credit risk. That's worth paying a little extra for.

If you were really itching to save those 10 bps, you could probably build your own Treasury latter and not have to pay the fund's expense ratio. I don't think that's worth the time, but it's an option that exists.
+1
Solid idea, but I'm too lazy to buy individual bonds (besides Series I and EE). Funds make it easy to rebalance, ignore, etc...
skime wrote:
Wed Feb 14, 2018 2:36 pm
If you are going to do Muni's, stick with AAA in states without credit issues. Stay away from CA, NY, IL, etc.
AAA seems like a high bar. I just checked credit quality for intermediate-term national versus CA state at Vangaurd. Looks like the average rating is pretty similar - mostly AA in both cases, with some AAA and A (and a little bit below). But yeah, CA makes me nervous.
weltschmerz wrote:
Wed Feb 14, 2018 2:31 pm
Since both these funds have almost the same duration, then yes, you will get more yield by going with the CA state-specific fund. But is that 0.21% extra yield worth the extra risk? Most advice I have seen suggests no more than 50% of your muni exposure in your home state. However, if California's finances blow up, are the other states really going to be any safer?
I assume there's some level of state-specific concentration risk to munis, but honestly haven't done much research on it. Either way: at most, I could see splitting Treasuries and CA munis 50/50 in taxable, but I'm leaning toward just Treasuries.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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