VTEB vs VGIT 30 day SEC Yield Comparison [Munis in taxable…or not?]

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Horton
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VTEB vs VGIT 30 day SEC Yield Comparison [Munis in taxable…or not?]

Post by Horton »

I recently noticed that the 30 day SEC yields for Vanguard’s intermediate Treasury (VGIT) and muni bond (VTEB) ETFs are about the same. VGIT’s 30 day SEC yield is currently 0.85% with a duration of 5.4 years. VTEB’s yield is currently 0.87% with a duration of 4.6 years. There’s some slight duration differences, but pretty similar. Normally I would expect VTEB to have a higher yield compared to VGIT (spread) since the underlying securities are not as secure as the US Treasury.

That leads to my questions:

1) Is there a tax offset that needs to be considered (e.g., munis are federal tax exempt while Treasuries are not)?
2) What else causes such a narrow spread?
3) Anyone have data on the historical spread?
4) I assume the 30 day yield is still a reasonable approximation for the return of VTEB over the next 5ish years (absent interest rates changes and the “roll return”)?
5) Anything else I am missing?

Edit: see post below for a comparison against the Total Bond Index (BND).
Last edited by Horton on Tue Sep 28, 2021 8:49 am, edited 1 time in total.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by sycamore »

Horton wrote: Mon Sep 27, 2021 3:59 pm 2) What else causes such a narrow spread?
Recent & relatively greater buying of munis compared to Treasuries. Plenty of speculation of why that might be, but I would say even if true it'd only be one cause among many. And the narrow spread could be undone as quickly as it came about.
Horton wrote: Mon Sep 27, 2021 3:59 pm 5) Anything else I am missing?
The duration comparison is not quite apples-to-apples. VGIT hold Treasuries, which are not callable. VTEB holds munis, which can be callable. As I learned in another thread:
grabiner wrote: Sun Sep 26, 2021 1:05 pm The reason for the short duration is that most munis are callable. A muni which matures in 2045 but is callable in 2025 has a 24-year "stated maturity". But since interest rates are much lower now than they were when the bond was issued, the muni is likely to be called, so its price is more similar to that of a bond maturing in 2025. If the muni were certain to be called, it would have a 4-year duration; if the call is likely but not certain, it might have a 6-year duration.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by drk »

Horton wrote: Mon Sep 27, 2021 3:59 pm 1) Is there a tax offset that needs to be considered (e.g., munis are federal tax exempt while Treasuries are not)?
Yes. In the top federal tax bracket, VTEB's tax-equivalent yield is 1.38%.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by UpperNwGuy »

OP, have you learned about tax equivalent yields (TEYs)? Both municipal bonds and treasury bonds have TEYs, so you should run the SEC yields through the TEY formula for your tax bracket before comparing the yields.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by Horton »

drk wrote: Mon Sep 27, 2021 5:11 pm
Horton wrote: Mon Sep 27, 2021 3:59 pm 1) Is there a tax offset that needs to be considered (e.g., munis are federal tax exempt while Treasuries are not)?
Yes. In the top federal tax bracket, VTEB's tax-equivalent yield is 1.38%.
Let’s compare VTEB and BND on a tax-equivalent basis. VTEB’s tax-equivalent yield for the highest tax bracket (37%) is 1.38% versus BND at 1.31%. Go down to a lower tax bracket - let’s say 24% - and VTEB’s tax-equivalent yield is only 1.14%.

The prevailing recommendation here seems to be to use a muni bond fund in taxable, but, at least currently, it’s at best a tie with BND for those in the highest tax bracket and likely lower expected returns for everyone else.

Plus, BND’s average credit quality is better.

What am I missing?
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by UpperNwGuy »

Horton wrote: Mon Sep 27, 2021 9:14 pm The prevailing recommendation here seems to be to use a muni bond fund in taxable, but, at least currently, it’s at best a tie with BND for those in the highest tax bracket and likely lower expected returns for everyone else.
The prevailing recommendation here is to use munis in taxable if you're in the highest tax brackets, and to use taxable bonds in the lower tax brackets. But in all cases the recommendation is to do the math and to compute the tax equivalent yields before making the decision on where to invest.

There is a member of this forum named grabiner who has excellent advice on this topic. I hope he'll chime in.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by tomsense76 »

Horton wrote: Mon Sep 27, 2021 9:14 pm
drk wrote: Mon Sep 27, 2021 5:11 pm
Horton wrote: Mon Sep 27, 2021 3:59 pm 1) Is there a tax offset that needs to be considered (e.g., munis are federal tax exempt while Treasuries are not)?
Yes. In the top federal tax bracket, VTEB's tax-equivalent yield is 1.38%.
Let’s compare VTEB and BND on a tax-equivalent basis. VTEB’s tax-equivalent yield for the highest tax bracket (37%) is 1.38% versus BND at 1.31%. Go down to a lower tax bracket - let’s say 24% - and VTEB’s tax-equivalent yield is only 1.14%.

The prevailing recommendation here seems to be to use a muni bond fund in taxable, but, at least currently, it’s at best a tie with BND for those in the highest tax bracket and likely lower expected returns for everyone else.

Plus, BND’s average credit quality is better.

What am I missing?
One could rework this for other tax brackets, but am going to stick with the highest tax bracket so you can see all of the pieces at play. Others should feel free to check my math.

The other piece of the puzzle that is missing here is if one doesn't hold munis in taxable, what do they hold instead? Typically the answer is equities. For simplicity let's say VTI (but they could make other choices) which has had a dividend yield of ~1.2%.

Ok so if one is holding equities in taxable, what is the tax drag on those? If one is in the highest tax bracket, they are paying 20% on dividends and long-term capital gains. They also will be subject to NIIT, which is an additional 3.8% on top of that. So in total the investor is paying 23.8% on dividends and long-term capital gains. Meaning they are facing a tax drag from dividends of 0.29% (using 1.2% for dividend yield). This will of course be lower for lower tax brackets.

The tax drag above then counts against the yield on BND making it closer to ~1.0%. Though the drag will be less significant for lower tax brackets.

Alternatively one holds stocks in tax-exempt accounts avoiding the 0.29% tax drag and holds munis in taxable. So the difference between VTEB & BND is 0.36% (so much larger than a couple of basis points). The difference will get smaller for lower tax brackets.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by Horton »

tomsense76 wrote: Mon Sep 27, 2021 9:40 pm
The tax drag above then counts against the yield on BND making it closer to ~1.0%. Though the drag will be less significant for lower tax brackets.

Alternatively one holds stocks in tax-exempt accounts avoiding the 0.29% tax drag and holds munis in taxable. So the difference between VTEB & BND is 0.36% (so much larger than a couple of basis points). The difference will get smaller for lower tax brackets.
You are double counting - comparing tax-equivalent yield of VTEB to the after-tax yield of BND.

You either compare the tax-equivalent yields of VTEB vs BND (1.38% vs 1.31%) or you compare after-tax yields (0.87% vs what you quote as ~1.0% but I think is closer to 0.83%).

Again, all the percentages above are for the highest tax bracket. The results are different for lower tax brackets.
Last edited by Horton on Tue Sep 28, 2021 7:56 am, edited 1 time in total.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by Horton »

UpperNwGuy wrote: Mon Sep 27, 2021 9:22 pm The prevailing recommendation here is to use munis in taxable if you're in the highest tax brackets, and to use taxable bonds in the lower tax brackets. But in all cases the recommendation is to do the math and to compute the tax equivalent yields before making the decision on where to invest.
Thanks, that’s helpful. I agree.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by grabiner »

Horton wrote: Mon Sep 27, 2021 9:14 pm
drk wrote: Mon Sep 27, 2021 5:11 pm
Horton wrote: Mon Sep 27, 2021 3:59 pm 1) Is there a tax offset that needs to be considered (e.g., munis are federal tax exempt while Treasuries are not)?
Yes. In the top federal tax bracket, VTEB's tax-equivalent yield is 1.38%.
Let’s compare VTEB and BND on a tax-equivalent basis. VTEB’s tax-equivalent yield for the highest tax bracket (37%) is 1.38% versus BND at 1.31%. Go down to a lower tax bracket - let’s say 24% - and VTEB’s tax-equivalent yield is only 1.14%.

The prevailing recommendation here seems to be to use a muni bond fund in taxable, but, at least currently, it’s at best a tie with BND for those in the highest tax bracket and likely lower expected returns for everyone else.

Plus, BND’s average credit quality is better.
BND has more interest-rate risk, with a duration of 6.8 years versus 4.6 years. Callability of munis does mean that VTEB has more interest-rate risk than indicated by its duration, but so does BND because all GNMAs and some corporate bonds are callable.

Also, I believe the average credit quality at Morningstar is not accurate. VTEB holds 3% unrated bonds, and Morningstar treats all unrated bonds as having the default risk of BB bonds, which I do not believe is correct for those bonds used in the index. (The reason 3% of BBs has such an effect is that Morningstar properly averages default rates, not grades, to determine the average credit quality.)
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by tomsense76 »

Horton wrote: Tue Sep 28, 2021 7:38 am
tomsense76 wrote: Mon Sep 27, 2021 9:40 pm
The tax drag above then counts against the yield on BND making it closer to ~1.0%. Though the drag will be less significant for lower tax brackets.

Alternatively one holds stocks in tax-exempt accounts avoiding the 0.29% tax drag and holds munis in taxable. So the difference between VTEB & BND is 0.36% (so much larger than a couple of basis points). The difference will get smaller for lower tax brackets.
You are double counting - comparing tax-equivalent yield of VTEB to the after-tax yield of BND.

You either compare the tax-equivalent yields of VTEB vs BND (1.38% vs 1.31%) or you compare after-tax yields (0.87% vs what you quote as ~1.0% but I think is closer to 0.83%).

Again, all the percentages above are for the highest tax bracket. The results are different for lower tax brackets.
No what is being computed is the tax drag on stocks in taxable. In both cases pre-tax equivalent yields for bonds were used.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison

Post by retired@50 »

Horton wrote: Tue Sep 28, 2021 7:38 am
tomsense76 wrote: Mon Sep 27, 2021 9:40 pm
The tax drag above then counts against the yield on BND making it closer to ~1.0%. Though the drag will be less significant for lower tax brackets.

Alternatively one holds stocks in tax-exempt accounts avoiding the 0.29% tax drag and holds munis in taxable. So the difference between VTEB & BND is 0.36% (so much larger than a couple of basis points). The difference will get smaller for lower tax brackets.
You are double counting - comparing tax-equivalent yield of VTEB to the after-tax yield of BND.

You either compare the tax-equivalent yields of VTEB vs BND (1.38% vs 1.31%) or you compare after-tax yields (0.87% vs what you quote as ~1.0% but I think is closer to 0.83%).

Again, all the percentages above are for the highest tax bracket. The results are different for lower tax brackets.
I was under the impression it's better to mathematically "knock-down" the taxable (BND) yield based on your particular Federal and State income tax rate rather than "build-up" the tax-exempt bond yield when deciding whether or not to use municipal bonds.

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Re: VTEB vs VGIT 30 day SEC Yield Comparison [Munis in taxable…or not?]

Post by tomsense76 »

Going to try to clarify since it seems like folks are getting confused by what I wrote above. Assuming one holds stocks (VTI) and bonds (BND or VTEB), one needs to make a choice of where to put these.
  1. VTI in 401k + VTEB in taxable
  2. BND in 401k + VTI in taxable
There has already been a thorough computation by others above on BND vs. VTEB. So skipping that.

The question is what is the tax cost to holding stocks in taxable vs. holding them in the 401k and not paying that tax cost. This is what I was answering above.

The tax cost of holding stocks in taxable is quite high for those in a high tax bracket. So it can make sense to hold stocks in one's 401k and bonds in taxable.
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Re: VTEB vs VGIT 30 day SEC Yield Comparison [Munis in taxable…or not?]

Post by grabiner »

tomsense76 wrote: Tue Sep 28, 2021 2:49 pm Going to try to clarify since it seems like folks are getting confused by what I wrote above. Assuming one holds stocks (VTI) and bonds (BND or VTEB), one needs to make a choice of where to put these.
  1. VTI in 401k + VTEB in taxable
  2. BND in 401k + VTI in taxable
There has already been a thorough computation by others above on BND vs. VTEB. So skipping that.

The question is what is the tax cost to holding stocks in taxable vs. holding them in the 401k and not paying that tax cost. This is what I was answering above.

The tax cost of holding stocks in taxable is quite high for those in a high tax bracket. So it can make sense to hold stocks in one's 401k and bonds in taxable.
The reason for this difference is that the 15% tax most investors pay on qualified dividends and long-term gains increases to 18.8% or 23.8% at higher incomes.

Meanwhile, the tax cost of holding bonds in taxable, which is the difference between the yields of munis and taxable bonds of comparable risk, does not depend on your tax bracket. I estimate that this cost is 1/3 of the muni yield or 1/4 of the taxable yield (that is, the break-even tax rate is 25%), which gives an estimate of 0.29% for VTEB, or 0.33% for the slightly riskier BND. Thus I agree with tomsense76 that at current yields, investors in high tax brackets should prefer munis.
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