Tax equivalent yield munis vs. other bond funds

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idoc2020
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Tax equivalent yield munis vs. other bond funds

Post by idoc2020 »

I evaluated VWINX (Wellesley fund) and VCADX (CA interm muni fund) on Portfoliovisualizer. I own them both in a taxable account and I use them as fairly (not entirely) safe and reliable funds. In other words, these are the funds which allow me to sleep better at night. Also, I realize that there is an argument to be made that VWINX is somewhat tax inefficient when kept in a taxable account. I went as far back as 1996, and as expected, VWINX far outperformed VCADX on CAGR (8.5% vs. 4.75%). This is expected since the Wellesley fund is 35% equity and the CA muni fund is 100% muni bonds.
Obviously Wellesley had a much bumpier ride with greater drawdowns, volatility, bad years etc but its returns were much better. However, when I run the CA muni fund through a Tax Equivalent Yield calculator, it shows that for my federal (36%)and state (12%) income brackets, the tax equivalent yield was identical to Wellesley's 8.5% CAGR. This analysis does not take into account that Wellesley's final return will go down after taxes are paid (not sure by how much). My inclination with future "sleep well" investments would be to use VCADX as long as I am in the highest tax brackets. Does this make sense?
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Re: Tax equivalent yield munis vs. other bond funds

Post by muffins14 »

Something is off in your calculations if you are finding that a muni bond fund has a tax equivalent yield of 8.5%.

The CAGR is not the same as yield
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Re: Muni bonds in taxable

Post by idoc2020 »

[This post, and reply, have now been moved to the standalone thread on same topic- Moderator Misenplace]
grabiner wrote: Wed Apr 07, 2021 7:06 pm
ilan1h wrote: Wed Apr 07, 2021 1:18 pm
grabiner wrote: My normal recommendation for CA investors with a lot in munis is to split 50/50 between Vanguard CA Long-Term Tax-Exempt and Vanguard Limited-Term Tax-Exempt. This gives an overall intermediate-term duration, with only half the bonds in CA, but more than half the bond interest exempt from CA tax.
Thanks Grabiner:
Is this very different than owning 50% of the intermed munis in CA and the other 50% national? I already own these two and am trying not to complicate things too much.
The difference is a small tax cost. If you hold equal amounts in national and CA intermediate-term muni funds, you will pay CA tax on half your muni interest. If you hold equal amounts in national short-term and CA long-term funds, you may have the same overall yield, but will pay CA tax on less than half the interest (currently only 1/4, since the yield on CA Long-Term Tax-Exempt is about three times the yield on Limited-Term Tax Exempt, although the ratio will be closer to 1/2 if rates rise).
Thanks Grabiner. Can I defer to your obvious expertise in such matters and expand the question a little? I have a large sum that I want to invest in a taxable account and I prefer a "sleep well" kind of investment. Currently, I use the CA muni fund and Wellesley to sleep well. I have looked at both of these in Portfolio visualizer going back to 1996. Obviously Wellesley has a far better CAGR (8.5% vs 4.75%). However, when I run the muni fund through a Tax equiv yield calculator I see that 4.75% has a TEY of 8.5%. This seems to imply that the muni fund was a much better way to go since it was an extremely smooth, low risk ride and wound up with the same CAGR. I'm also not taking into account the fact that Wellesley had to pay taxes (which I'm not able to calculate). I'm inclined now to plough whatever "sleep well" money that I have into munis as opposed to Wellesley. Makes sense?
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Re: Muni bonds in taxable

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ilan1h wrote: Sun Apr 11, 2021 3:29 pm Can I defer to your obvious expertise in such matters and expand the question a little? I have a large sum that I want to invest in a taxable account and I prefer a "sleep well" kind of investment. Currently, I use the CA muni fund and Wellesley to sleep well. I have looked at both of these in Portfolio visualizer going back to 1996. Obviously Wellesley has a far better CAGR (8.5% vs 4.75%). However, when I run the muni fund through a Tax equiv yield calculator I see that 4.75% has a TEY of 8.5%. This seems to imply that the muni fund was a much better way to go since it was an extremely smooth, low risk ride and wound up with the same CAGR. I'm also not taking into account the fact that Wellesley had to pay taxes (which I'm not able to calculate). I'm inclined now to plough whatever "sleep well" money that I have into munis as opposed to Wellesley. Makes sense?
Tax-equivalent yield is not based on total return, particularly for a fund which holds stocks; you don't pay tax at your full tax rate on the stocks every year. (Even on a bond fund, the tax cost is paid on the current yield, not the historical return which may include capital gains and losses.)

That said, Wellesley is a poor fund for a taxable account. It holds high-yielding bonds, which lead to large non-qualified dividends, and its stock turnover creates capital gains. It's a fine "sleep well" fund because it is relatively low-risk, but only in an IRA. A taxable investment in a high tax bracket with similar risk to Wellesley would need to be two funds, about 35% in a US stock index and 65% in a muni fund.
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Re: Muni bonds in taxable

Post by idoc2020 »

grabiner wrote: Sun Apr 11, 2021 4:23 pm
ilan1h wrote: Sun Apr 11, 2021 3:29 pm Can I defer to your obvious expertise in such matters and expand the question a little? I have a large sum that I want to invest in a taxable account and I prefer a "sleep well" kind of investment. Currently, I use the CA muni fund and Wellesley to sleep well. I have looked at both of these in Portfolio visualizer going back to 1996. Obviously Wellesley has a far better CAGR (8.5% vs 4.75%). However, when I run the muni fund through a Tax equiv yield calculator I see that 4.75% has a TEY of 8.5%. This seems to imply that the muni fund was a much better way to go since it was an extremely smooth, low risk ride and wound up with the same CAGR. I'm also not taking into account the fact that Wellesley had to pay taxes (which I'm not able to calculate). I'm inclined now to plough whatever "sleep well" money that I have into munis as opposed to Wellesley. Makes sense?
Tax-equivalent yield is not based on total return, particularly for a fund which holds stocks; you don't pay tax at your full tax rate on the stocks every year. (Even on a bond fund, the tax cost is paid on the current yield, not the historical return which may include capital gains and losses.)

That said, Wellesley is a poor fund for a taxable account. It holds high-yielding bonds, which lead to large non-qualified dividends, and its stock turnover creates capital gains. It's a fine "sleep well" fund because it is relatively low-risk, but only in an IRA. A taxable investment in a high tax bracket with similar risk to Wellesley would need to be two funds, about 35% in a US stock index and 65% in a muni fund.
Perhaps I should have stated it another way. Let's assume that from 1996 to 2021 the muni fund grew from $10,000 to $34,000, and that a fully taxed equity fund grew from $10,000 to $80,000. With the muni fund there is $24K going directly into your pocket (I'm simplifying somewhat). How much of the $70K from the taxable fund will find it's way into your pocket after taxes? This is the type of calculation that I am having trouble figuring out with the various sources that I use. Of course, I realize that there are many variables but let's just say "middle of the road tax efficiency" ie: inbetween SP500 index and a REIT index. In other words, after 25 years how much money in each case winds up in your pocket?
Last edited by idoc2020 on Sun Apr 11, 2021 7:22 pm, edited 1 time in total.
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Re: Tax equivalent yield munis vs. other bond funds

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muffins14 wrote: Sun Apr 11, 2021 3:28 pm Something is off in your calculations if you are finding that a muni bond fund has a tax equivalent yield of 8.5%.

The CAGR is not the same as yield
Sorry, I will clarify my question in Grabiners post above. Technically I am using the wrong term but still trying to equate two different directions of investment after all tax considerations are taken into account.
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Re: Muni bonds in taxable

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ilan1h wrote: Sun Apr 11, 2021 7:05 pm
grabiner wrote: Sun Apr 11, 2021 4:23 pm Tax-equivalent yield is not based on total return, particularly for a fund which holds stocks; you don't pay tax at your full tax rate on the stocks every year. (Even on a bond fund, the tax cost is paid on the current yield, not the historical return which may include capital gains and losses.)

That said, Wellesley is a poor fund for a taxable account. It holds high-yielding bonds, which lead to large non-qualified dividends, and its stock turnover creates capital gains. It's a fine "sleep well" fund because it is relatively low-risk, but only in an IRA. A taxable investment in a high tax bracket with similar risk to Wellesley would need to be two funds, about 35% in a US stock index and 65% in a muni fund.
Perhaps I should have stated it another way. Let's assume that from 1996 to 2021 the muni fund grew from $10,000 to $34,000, and that a fully taxed equity fund grew from $10,000 to $80,000. With the muni fund there is $24K going directly into your pocket (I'm simplifying somewhat). How much of the $70K from the taxable fund will find it's way into your pocket after taxes? This is the type of calculation that I am having trouble figuring out with the various sources that I use. Of course, I realize that there are many variables but let's just say "middle of the road tax efficiency" ie: inbetween SP500 index and a REIT index. In other words, after 25 years how much money in each case winds up in your pocket?
Vanguard publishes after-tax returns, but those returns assume the highest federal tax bracket and no state tax, which may not match your situation. Since the 2001 inception of Wellesley Admiral shares, the pre-tax return on Admiral shares was 7.1%, and the return after taxes was 5.49%. So a reasonable estimate is that you would lose about 2% per year in a high federal and CA tax bracket, or 1.5% in a moderate bracket, by holding Wellesley in a taxable account rather than a tax-deferred account. (You can get a better estimate by looking at the historical distributions and adjusting for your own tax rate.)

While you get 100% of the return of a muni fund, you have a hidden tax cost, since munis yield less than the taxable bonds you would hold instead if you held your bonds in a tax-deferred account. My estimate is that this tax cost is 1/3 of the muni yield, so that munis and taxable bonds of comparable risk have the same after-tax yield at a 25% tax rate. So for the 1.32% yield of Vanguard CA Long-Term Tax-Exempt, you would be losing about 0.44% to the hidden tax cost.

And for a taxable stock index, with a yield around 2%, you would lose 0.49% annually to taxes if you pay 15% federal and 9.3% CA tax, or 0.72% if you pay the maximum 23.8% federal and 12.3% CA state tax.

Now, you can look at historical returns, and find that Wellesley would, or would not, have outperformed, but past performance is not an indication of future results. I did check on Portfolio Visualizer, comparing Wellesley to 35% Total Stock Market and 65% CA Long-Term Tax-Exempt:

https://www.portfoliovisualizer.com/bac ... tion3_2=65

The risk of the two portfolios is about the same, and the return difference of 0.72% is less than the tax difference.

So this is the problem with Wellesley in a taxable account. I don't know what it will return, but this discussion suggests that Wellesley will lose 1% more to taxes than a tax-efficient portfolio of comparable risk does in a moderate bracket, and 1.5% more in a high bracket. I don't expect Wellesley's active management to cover that large a difference. In an IRA, Wellesley's expenses are 0.1% higher than the lowest-cost index portfolio, which makes it a more reasonable choice.
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Re: Tax equivalent yield munis vs. other bond funds

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Thanks Grabiner. That was extremely useful. If I am understanding your point correctly, the combo that you selected had a CAGR that was .72% less than Wellesley, but Wellesley would have lost at least 2%/yr to taxes whereas the combo lost only 0.7%/yr (due to the stock index.) So basically I was losing about 1.3% CAGR per year by investing Wellesley in a taxable account. This is not an inconsequential amount and I will have to reconsider what I'm doing. Overall, I would have to say that by sheer dumb luck I've done better than I deserve using CA muni funds. From an abundance of caution I invested an obscene amount of my taxable funds into these munis over the last 20 years. Given the remarkably safe nature of these funds I've done way better than I ever expected. I have other index funds that have taken me on a roller coaster ride over the same period of time and yet did not do that much better. Overall, very pleased with munis.
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Re: Tax equivalent yield munis vs. other bond funds

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ilan1h wrote: Fri Apr 16, 2021 12:44 am Thanks Grabiner. That was extremely useful. If I am understanding your point correctly, the combo that you selected had a CAGR that was .72% less than Wellesley, but Wellesley would have lost at least 2%/yr to taxes whereas the combo lost only 0.7%/yr (due to the stock index.)
The combo is only 35% stock. The muni fund has an after-tax return equal to its pre-tax return, while the stock fund loses 0.72% in the top brackets. Thus the total portfolio loses only 0.25% annually to taxes. (The muni fund does have a hidden tax cost, but that is already included in the portfolio returns; a similar portfolio with a taxable bond fund of equal risk would have higher pre-tax returns but lower after-tax returns in a high tax bracket.)
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Re: Tax equivalent yield munis vs. other bond funds

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grabiner wrote: Fri Apr 16, 2021 6:10 pm
ilan1h wrote: Fri Apr 16, 2021 12:44 am Thanks Grabiner. That was extremely useful. If I am understanding your point correctly, the combo that you selected had a CAGR that was .72% less than Wellesley, but Wellesley would have lost at least 2%/yr to taxes whereas the combo lost only 0.7%/yr (due to the stock index.)
The combo is only 35% stock. The muni fund has an after-tax return equal to its pre-tax return, while the stock fund loses 0.72% in the top brackets. Thus the total portfolio loses only 0.25% annually to taxes. (The muni fund does have a hidden tax cost, but that is already included in the portfolio returns; a similar portfolio with a taxable bond fund of equal risk would have higher pre-tax returns but lower after-tax returns in a high tax bracket.)
Thanks for that clarification. Not to belabor the point but are you also taking into account the ultimate sale of these different funds? So when you say that Wellesley loses 2% per year to taxes and the combo plan loses 0.25% per year to taxes, this does not take into account what I am ultimately left with once I sell these funds. For example, Vanguard lists the 10 yr returns after all distributions, taxes and sale. It is 4.51% for the muni, 5.56% for Wellesley, 11.44% for stock fund. This would imply a 6.93% return after all taxes on the combo compared to a 5.56% on Wellesley. I could not find the numbers beyond 10 yrs on the Vanguard website.
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Re: Tax equivalent yield munis vs. other bond funds

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ilan1h wrote: Fri Apr 16, 2021 7:28 pm
grabiner wrote: Fri Apr 16, 2021 6:10 pm
ilan1h wrote: Fri Apr 16, 2021 12:44 am Thanks Grabiner. That was extremely useful. If I am understanding your point correctly, the combo that you selected had a CAGR that was .72% less than Wellesley, but Wellesley would have lost at least 2%/yr to taxes whereas the combo lost only 0.7%/yr (due to the stock index.)
The combo is only 35% stock. The muni fund has an after-tax return equal to its pre-tax return, while the stock fund loses 0.72% in the top brackets. Thus the total portfolio loses only 0.25% annually to taxes. (The muni fund does have a hidden tax cost, but that is already included in the portfolio returns; a similar portfolio with a taxable bond fund of equal risk would have higher pre-tax returns but lower after-tax returns in a high tax bracket.)
Thanks for that clarification. Not to belabor the point but are you also taking into account the ultimate sale of these different funds? So when you say that Wellesley loses 2% per year to taxes and the combo plan loses 0.25% per year to taxes, this does not take into account what I am ultimately left with once I sell these funds. For example, Vanguard lists the 10 yr returns after all distributions, taxes and sale. It is 4.51% for the muni, 5.56% for Wellesley, 11.44% for stock fund. This would imply a 6.93% return after all taxes on the combo compared to a 5.56% on Wellesley. I could not find the numbers beyond 10 yrs on the Vanguard website.
You will sell the same amount of stock whether you use Wellesley or a muni fund and stock index (assuming equal stock returns, and rebalancing). The capital gain on selling stocks in Wellesley will be slightly less, because Wellesley's active management leads to some of those stocks being sold for capital gains while you held it, thus increasing your basis when you reinvest the capital gain.
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