Whether tax-free or taxable, my general take on bonds and bond funds remains consistent. First, I expect that returns will be muted in the years ahead, given the starting yields we’re buying bonds at today. Also, I remain leery of long-maturity bonds, given their extra sensitivity to rising interest rates. And finally, despite these caveats, bonds still have a role to play in a balanced portfolio.
But before I start discussing which bond funds you should go with, let’s do a quick review.
What Is a Municipal Bond?
While the U.S. government and businesses issue bonds for a wide range of purposes, states and local governments (cities and towns) have their own funding needs for both small- and large-scale projects. For example, they might need to repair roads, expand a sewage plant or build a new school. To raise money, these “municipalities” issue bonds called municipal bonds.
How do the municipalities pay interest and ultimately pay back the money owed on their bonds? Some muni bonds, called general obligation (GO) bonds, are backed by the taxing power of the state or city — some of the sales and property taxes you pay go to paying bondholders. Other muni bonds, called revenue bonds, are backed by user fees — i.e., the income generated by the project that the borrowings are used for will help to pay off the debt, such as toll roads, subway systems or water and sewer plants.
Municipal bonds also are called tax-exempt bonds because the income they generate is not taxed by the federal government. And if you buy a municipal bond issued by the state where you live, that income is not taxed at the state level, either. It is this tax-free or tax-exempt income that sets municipal bonds apart from corporate, mortgage-backed or Treasury bonds.
Given the vast number of states and municipalities in the U.S., it’s not surprising that the municipal market is very fragmented, with more than 45,000 different bonds available — compared to, say, the 8,000 or so found in the Barclays U.S. Aggregate Bond Index, which is the index mimicked by the Vanguard Total Bond Market Fund (VBMFX). As you might expect, there are many flavors of and nuances to municipal bonds, so my description, while not comprehensive, covers the majority of plain-vanilla municipal bonds and certainly covers the vast majority of bonds held in Vanguard’s tax-exempt bond funds.
Tax-Free or Taxable?
Investors buying bonds or bond funds in a taxable account need to consider the impact of taxes on the income those investments produce. The easiest way to compare tax-free and taxable bond yields is to calculate a taxable-equivalent yield, which for a tax-free fund is the taxable yield you’d have to earn before taxes to equal the tax-free yield.
Here’s how you can calculate it:
- Convert your federal tax bracket into a decimal (e.g., 25% = 0.25).
- Subtract that from 1.00 (e.g., 1.00 – 0.25 = 0.75).
- Divide the tax-free fund’s yield by the answer to step 2. (E.g., if the tax-free fund’s yield is 1.50%, then 1.50% ÷ 0.75 = 2.00%.)
And voilà! You have your tax-equivalent yield.
Of course, if math isn’t your thing, or you just prefer an at-a-glance reference, I provide estimates of the tax-equivalent yields in each federal tax bracket for all of Vanguard’s tax-exempt funds every month in The Independent Adviser for Vanguard Investors.
Though you must assess your personal situation to decide whether to invest in a tax-free or taxable muni bond fund, I have a few recommendations to give you an idea of what Vanguard is offering.
Buy: Vanguard Intermediate-Term Tax-Exempt Fund
Intermediate-term bond funds often give fixed-income investors the biggest bang for their bucks while taking moderate risk. The Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) has stacked up well against its intermediate-term taxable brethren, delivering an average of 80% of the returns of Vanguard’s taxable intermediate funds over rolling one-, three- and five-year periods. And with a higher taxable-equivalent yield than the Vanguard Intermediate-Term Investment-Grade Fund (VFICX) but a shorter duration, this remains an attractive option.
Intermediate-Term Tax-Exempt also holds its own against the Vanguard Long-Term Tax-Exempt Fund (VWLTX). On average, over rolling five-year periods, this fund actually outperformed its longer-maturity, tax-exempt sibling with less risk.
Given this history of balancing risk and reward, it is no surprise that Intermediate-Term Tax-Exempt has been a go-to fund for investors. But for Vanguard it was becoming too popular and too big. In an effort to stem inflows to the fund in February, Vanguard closed the fund to new accounts opened by financial advisers and institutions, though it remains wide-open to retail investors.
With duration in the middle of its historical range, at 5.2 years, the fund is not going to get hammered when rates rise. A quick jump in yields might hurt returns over the short haul. But this can be a good compromise for investors who want higher levels of current income and are willing to take a modicum of risk with their principal.
Hold: Vanguard High-Yield Tax-Exempt Fund
Vanguard High-Yield Tax-Exempt (VWAHX) is not a “junk bond” fund — less than 10% of its portfolio is in below-investment grade bonds. In that light, the fund isn’t really comparable to the Vanguard High-Yield Corporate Fund (VWEHX), where more than 90% of the portfolio is “junk.” This still is a high-yielding fund, though. The difference between this fund and its tax-exempt siblings is that High-Yield Tax-Exempt holds about 80% of its portfolio in A-rated bonds, while a fund like Long-Term Tax-Exempt, for instance, has more than 90% of its portfolio there.
If you really like that tax-free cash and can stomach the volatility, this is the fund for you. But please don’t overdo it. The bonds producing those higher yields also produce bigger losses when interest rates change direction.
Buy: Vanguard California Intermediate-Term Fund
There’s only one state-specific tax-exempt fund I recommend for purchase at Vanguard, and that’s the Vanguard California Intermediate-Term Fund (VCAIX). Similar to Intermediate-Term Tax-Exempt, this fund invests in a sweet spot of the bond market that has historically provided a nice balance between risk and return.
Editor Dan Wiener publishes The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.