Which Vanguard California Muni fund?

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bluquark
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Which Vanguard California Muni fund?

Post by bluquark » Tue Dec 11, 2018 8:52 pm

I'm trying to decide whether to use VCLAX ("Long-Term California tax exempt") or VCADX ("Intermediate-Term California tax exempt"). I see they have the following properties:

VCLAX: Average maturity 17.1 years, average duration 7.3 years
VCADX: Average maturity 9.1 years, average duration 5.5 years

I read in a few places that "duration" is the only one that matters and stated maturity is basically just an irrelevant factoid. So aren't these two funds extremely similar, with only a 30% difference in duration, basically making the "long-term" name of VCLAX a misnomer? I'm confused why Vanguard even bothered to offer two different funds in this niche category and I'm wondering if I'm missing any important difference.
70/30 portfolio | Equity: global market weight | Bonds: 20% long-term munis - 10% LEMB

Steadfast
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Re: Which Vanguard California Muni fund?

Post by Steadfast » Wed Dec 12, 2018 4:38 pm

I don't think you're missing anything important. The durations of these funds will vary a bit from time to time, and right now, they're a bit closer.

The general advice here is to hold intermediate-term bond funds, which nicely balance interest rate (duration) risk and return. If you look at yield curves these days, you're not being compensated very well for taking increased duration risk. 2.92% 30 day yield on VCLAX vs 2.49% for VCADX.

30% longer duration for 0.43% more yield, doesn't sound like a screaming bargain to me, with interest rates where they are.

We use VCADX as our core bond holding.
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Re: Which Vanguard California Muni fund?

Post by bluquark » Wed Dec 12, 2018 4:53 pm

Steadfast wrote:
Wed Dec 12, 2018 4:38 pm
I don't think you're missing anything important. The durations of these funds will vary a bit from time to time, and right now, they're a bit closer.

The general advice here is to hold intermediate-term bond funds, which nicely balance interest rate (duration) risk and return. If you look at yield curves these days, you're not being compensated very well for taking increased duration risk. 2.92% 30 day yield on VCLAX vs 2.49% for VCADX.
Thanks for the reply. Well, another way of phrasing it is that it’s a 17% yield increase for 30% higher duration. Given that duration risk has a potential upside as well, it doesn’t seem totally negligible.

I guess the underlying thing I’m confused about is how much I can trust the duration to stick to a target over time. Ideally I’d specify an average target duration in my IPS and then hold the funds to meet it. But seeing this abnormally low duration for so-called “long-term bonds” makes me question if this is up in the air and not reasonable to target — for example because munis might not be issuing enough long-term bonds in particular market conditions.

The 7 years duration per se is not that scary to me. But if I choose VCLAX as a “slightly juiced-up intermediate muni”, is it possible it will evolve into a true long-term muni fund and make me take more risk than I thought I was taking?
70/30 portfolio | Equity: global market weight | Bonds: 20% long-term munis - 10% LEMB

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Re: Which Vanguard California Muni fund?

Post by Cyclesafe » Wed Dec 12, 2018 5:03 pm

One consideration is that many munis are callable. When interest rates came down, I expect bonds with higher coupons - especially longer term bonds - were called.
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Re: Which Vanguard California Muni fund?

Post by Steadfast » Thu Dec 13, 2018 1:50 pm

bluquark wrote:
Wed Dec 12, 2018 4:53 pm
Steadfast wrote:
Wed Dec 12, 2018 4:38 pm
I don't think you're missing anything important. The durations of these funds will vary a bit from time to time, and right now, they're a bit closer.

The general advice here is to hold intermediate-term bond funds, which nicely balance interest rate (duration) risk and return. If you look at yield curves these days, you're not being compensated very well for taking increased duration risk. 2.92% 30 day yield on VCLAX vs 2.49% for VCADX.
Thanks for the reply. Well, another way of phrasing it is that it’s a 17% yield increase for 30% higher duration. Given that duration risk has a potential upside as well, it doesn’t seem totally negligible.

I guess the underlying thing I’m confused about is how much I can trust the duration to stick to a target over time. Ideally I’d specify an average target duration in my IPS and then hold the funds to meet it. But seeing this abnormally low duration for so-called “long-term bonds” makes me question if this is up in the air and not reasonable to target — for example because munis might not be issuing enough long-term bonds in particular market conditions.

The 7 years duration per se is not that scary to me. But if I choose VCLAX as a “slightly juiced-up intermediate muni”, is it possible it will evolve into a true long-term muni fund and make me take more risk than I thought I was taking?
I think it's possible that the long term fund could extend its current average duration. I would read the prospectus to figure out what their strategy and constraints are. I just use the intermediate fund and don't worry about maximizing yield. I guess you could use both funds in whatever proportion you deem appropriate.
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Re: Which Vanguard California Muni fund?

Post by grabiner » Thu Dec 13, 2018 9:44 pm

bluquark wrote:
Tue Dec 11, 2018 8:52 pm
I'm trying to decide whether to use VCLAX ("Long-Term California tax exempt") or VCADX ("Intermediate-Term California tax exempt"). I see they have the following properties:

VCLAX: Average maturity 17.1 years, average duration 7.3 years
VCADX: Average maturity 9.1 years, average duration 5.5 years

I read in a few places that "duration" is the only one that matters and stated maturity is basically just an irrelevant factoid.
This is not quite the case with municipal bonds, because most munis are callable. Increasing rates decrease the probability of calls, and thus increase the duration. Thus, the fund with a 7.3-year duration might lose 0.73% if rates rise by 0.1%, but 8.3% rather than 7.3% if rates rise by 1% because the duration averaged 8.3 during the rate rise and is 9.3 at the end. It is slightly riskier than the duration indicates.

This phenomenon is known as negative convexity. It works against you in both directions, as durations decrease when rates fall and increase when they rise. Investors don't like it, and thus demand higher yields on bonds with negative convexity. This accounts for the higher yield on long-term munis, and also on GNMAs, which have a similar effect because homeowners will refinance mortgages when rates fall.
Wiki David Grabiner

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Re: Which Vanguard California Muni fund?

Post by palanzo » Thu May 21, 2020 2:50 pm

grabiner wrote:
Thu Dec 13, 2018 9:44 pm
bluquark wrote:
Tue Dec 11, 2018 8:52 pm
I'm trying to decide whether to use VCLAX ("Long-Term California tax exempt") or VCADX ("Intermediate-Term California tax exempt"). I see they have the following properties:

VCLAX: Average maturity 17.1 years, average duration 7.3 years
VCADX: Average maturity 9.1 years, average duration 5.5 years

I read in a few places that "duration" is the only one that matters and stated maturity is basically just an irrelevant factoid.
This is not quite the case with municipal bonds, because most munis are callable. Increasing rates decrease the probability of calls, and thus increase the duration. Thus, the fund with a 7.3-year duration might lose 0.73% if rates rise by 0.1%, but 8.3% rather than 7.3% if rates rise by 1% because the duration averaged 8.3 during the rate rise and is 9.3 at the end. It is slightly riskier than the duration indicates.

This phenomenon is known as negative convexity. It works against you in both directions, as durations decrease when rates fall and increase when they rise. Investors don't like it, and thus demand higher yields on bonds with negative convexity. This accounts for the higher yield on long-term munis, and also on GNMAs, which have a similar effect because homeowners will refinance mortgages when rates fall.
The situation now is:

VCADX: 4.9 years 9.4 years 1.56%
VCLAX: 6.7 years 16.5 years 1.98%

Do you think that the additional duration and greater negative convexity is worth the 0.42% in yield for VCLAX?

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grabiner
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Re: Which Vanguard California Muni fund?

Post by grabiner » Thu May 21, 2020 5:55 pm

palanzo wrote:
Thu May 21, 2020 2:50 pm
grabiner wrote:
Thu Dec 13, 2018 9:44 pm
bluquark wrote:
Tue Dec 11, 2018 8:52 pm
I'm trying to decide whether to use VCLAX ("Long-Term California tax exempt") or VCADX ("Intermediate-Term California tax exempt"). I see they have the following properties:

VCLAX: Average maturity 17.1 years, average duration 7.3 years
VCADX: Average maturity 9.1 years, average duration 5.5 years

I read in a few places that "duration" is the only one that matters and stated maturity is basically just an irrelevant factoid.
This is not quite the case with municipal bonds, because most munis are callable. Increasing rates decrease the probability of calls, and thus increase the duration. Thus, the fund with a 7.3-year duration might lose 0.73% if rates rise by 0.1%, but 8.3% rather than 7.3% if rates rise by 1% because the duration averaged 8.3 during the rate rise and is 9.3 at the end. It is slightly riskier than the duration indicates.

This phenomenon is known as negative convexity. It works against you in both directions, as durations decrease when rates fall and increase when they rise. Investors don't like it, and thus demand higher yields on bonds with negative convexity. This accounts for the higher yield on long-term munis, and also on GNMAs, which have a similar effect because homeowners will refinance mortgages when rates fall.
The situation now is:

VCADX: 4.9 years 9.4 years 1.56%
VCLAX: 6.7 years 16.5 years 1.98%

Do you think that the additional duration and greater negative convexity is worth the 0.42% in yield for VCLAX?
Yes if you have a long time horizon. In an efficient bond market, traders will buy and sell bonds at yields which compensate for the risk. But that is compensation for the average trader; not everyone wants long-term bonds. If you have a long time horizon, long-term munis are fine for you.

Another reason to use the long-term fund is to combine with Vanguard Limited-Term Tax-Exempt to get an overall intermediate-term duration, with more than half your interest exempt from CA tax but only half your bonds in CA. This is a common recommendation if you have a lot of munis and want to reduce the single-state risk. (You get slightly less reward for extending the duration of non-CA munis, since CA takes part of that yield difference.)

But you can see the effect; interest rates have dropped since 2018, but the duration of the CA muni funds shortened, so you did not quite get the full benefit.
Wiki David Grabiner

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