Is this the correct choice of tax-exempt bond funds in a taxable account?

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psh
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Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by psh »

Hi, this question is for my portfolio in a taxable account. Objective of this account is retirement savings. I've been a little aggressive in my taxable account since I started 401k quite late (10 yrs after starting my first job). I've already maxed my 401k, Roth IRA and HSA. Excluding my employer's RSUs (which is something I need to diversify but hesitating to do so due to the huge tax bill I'll incur; this is a separate topic though), my portfolio consists of 5 vanguard funds: VTSAX, VIGAX, VTIAX, VWIUX and VCLAX (see descriptions of these below in the Appendix).
12% - VWIUX and VCLAX (equal amounts)
Remaining are stocks - 20% in VTIAX and 12% in VIGAX.
Question is - Is this the correct choice of tax-exempt bond funds? There are so many on Vanguard that it's confusing.
I've 20 yrs to retirement.
Thanks in advance.

Appendix:
VTSAX: https://investor.vanguard.com/mutual-fu ... file/vtsax
VIGAX: https://investor.vanguard.com/mutual-fu ... file/VIGAX
VTIAX: https://investor.vanguard.com/mutual-fu ... file/vtiax
VWIUX: https://investor.vanguard.com/mutual-fu ... file/VWIUX
VCLAX: https://investor.vanguard.com/mutual-fu ... file/VCLAX
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vineviz
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by vineviz »

Are you sure that tax-exempt bonds are actually advantageous for you? I'm pretty sure that even at the top federal (37%) and CA (13.3%) tax brackets, the after-tax yield of Vanguard Long-Term Bond Index Fund Admiral Shares (VBLAX) is higher than the yield of Vanguard California Long-Term Tax-Exempt Fund Admiral Shares (VCLAX).
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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psh
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by psh »

How did you calculate this? I’m in a high tax bracket.
dcabler
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by dcabler »

psh wrote: Fri Jan 21, 2022 4:29 am How did you calculate this? I’m in a high tax bracket.
SEC yield for both funds are available on Morningstar. Multiply the SEC yield for the taxable bond fund by (1-tax bracket%) and then compare to the yield of the muni bond fund.

Cheers.
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vineviz
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by vineviz »

The easiest way to compare the yield of a state muni fund to a taxable fund is to multiply the yield of the taxable fund by (1 - federal tax rate - state tax rate).

A California resident with $500k in income would be in the 35% federal bracket and the 9.3% state bracket. So take the 2.77% yield of VBALX and multiply by (1 - .35 - .093). You get something like 1.54%. That's the after-tax yield of the taxable fund. (Note that for simplicity I'm not accounting for the portion of the income from VBALX that comes from US Treasury bonds, which is 32% of that fund's income that would be exempt from state tax. To be fully accurate you'd need to add that back in, adding about .08% to the after-tax return.)

Compare that 1.54% to the yield of VCLAX, which is about 1.26% currently, and you'll see that you come out slightly ahead with the broader fund.

The relative yields of municipal bonds and taxable bonds can fluctuate, so you might find periods of time when things reverse, but right now I don't see a tax bracket that makes municipals a clear favorite.

EDIT: It's possible that net investment income (NII) of 3.8% might apply to you, which lowers the after-tax yield of VCLAX but still probably not enough to make it less than the yield on VCLAX.
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rkhusky
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by rkhusky »

Make sure your choices are comparable. VCLAX has a duration of 5 years, while VBLAX has a duration of 16 years and 50% in corporate bonds. The duration difference means that VBLAX will drop 3x more than VCLAX when interest rates go up. And depending on how you view the safety of California muni bonds, it seems that the 50% of corporate bonds in VBLAX makes the latter more risky, which is reflected in the higher yield.

Don't judge the choices based on performance only. Also take into account the risk. A closer taxable comparison to VCLAX might be VBILX, which has a duration of 6.6 years and 40% in corporate bonds, which still might be more risky than VCLAX. The equivalent yield for VBILX is 1.05%, which is less than that of VCLAX. Another comparable is Total Bond, which has a duration of 6.9 years, 28% in corporate bonds and 22% in mortgages. Total bond has an equivalent yield of 0.96% which is similar to VWIUX.

Your choices of VWIUX and VCLAX are the standard recommendation for TE funds for CA residents in high tax brackets.

That being said, using all stocks in taxable has advantages. I would only put bonds in taxable if I expected to need cash in the short term (< 5 years) for a down payment or living expense or some other major purchase.

Another thing to consider - avoid having the same funds in taxable that you have in tax-advantaged accounts (for avoiding wash sales when you sell for a loss in taxable).
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vineviz
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by vineviz »

rkhusky wrote: Fri Jan 21, 2022 7:55 am Don't judge the choices based on performance only. Also take into account the risk.
I think a reasonable case could be made that VBLAX might have more default risk than VCLAX, but it's not clear which has more interest rate risk for the OP.

If their investment horizon is 6-7 years then the tax-exempt bonds would have less interest rate risk. If their investment horizon is 12+ years then VBLAX would have less interest rate risk. I was implicitly assuming the later to be more likely than the former, but obviously that could be incorrect.
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rkhusky
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by rkhusky »

vineviz wrote: Fri Jan 21, 2022 10:07 am
rkhusky wrote: Fri Jan 21, 2022 7:55 am Don't judge the choices based on performance only. Also take into account the risk.
I think a reasonable case could be made that VBLAX might have more default risk than VCLAX, but it's not clear which has more interest rate risk for the OP.

If their investment horizon is 6-7 years then the tax-exempt bonds would have less interest rate risk. If their investment horizon is 12+ years then VBLAX would have less interest rate risk. I was implicitly assuming the later to be more likely than the former, but obviously that could be incorrect.
Even if long bonds are appropriate now, one should have a plan for converting those to intermediate bonds in the future. Because you might not want to be 100% long bonds at retirement or at age 80 or at some other point.

There are different ways of doing that- e.g. as you are ramping down stock exposure, you could move that money into intermediate bonds and keep your long bond allocation static.
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psh
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by psh »

Thanks so much to all who responded. I learnt a lot in this process. The investments are for long term. Bond funds are a bit tricky to understand compared to regular bonds.
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vineviz
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by vineviz »

rkhusky wrote: Fri Jan 21, 2022 10:23 am
Even if long bonds are appropriate now, one should have a plan for converting those to intermediate bonds in the future. Because you might not want to be 100% long bonds at retirement or at age 80 or at some other point.
Maybe something like this? A bond duration glide path for retirement investing
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
rkhusky
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by rkhusky »

vineviz wrote: Fri Jan 21, 2022 3:23 pm
rkhusky wrote: Fri Jan 21, 2022 10:23 am
Even if long bonds are appropriate now, one should have a plan for converting those to intermediate bonds in the future. Because you might not want to be 100% long bonds at retirement or at age 80 or at some other point.
Maybe something like this? A bond duration glide path for retirement investing
Exactly.
CletusCaddy
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Re: Is this the correct choice of tax-exempt bond funds in a taxable account?

Post by CletusCaddy »

vineviz wrote: Fri Jan 21, 2022 2:52 am Are you sure that tax-exempt bonds are actually advantageous for you? I'm pretty sure that even at the top federal (37%) and CA (13.3%) tax brackets, the after-tax yield of Vanguard Long-Term Bond Index Fund Admiral Shares (VBLAX) is higher than the yield of Vanguard California Long-Term Tax-Exempt Fund Admiral Shares (VCLAX).
Interesting to note that the comparative yields on these funds have recently flipped.

VCLAX is now at 2.93%
VBLAX is now at 4.03%

VCLAX now beats VBLAX for most high tax bracket investors.
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