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Reviewing the New Vanguard Tax-Exempt Bond Index Fund

A reader writes in, asking:

“I recently learned that Vanguard opened a muni bond index fund for the first time. What are your thoughts on it? Is it a better choice than the existing intermediate tax exempt fund? Is it worth switching?”

Overall, the new Vanguard Tax-Exempt Bond Index Fund appears to be very similar to the existing Vanguard Intermediate-Term Tax-Exempt Fund.

A few points of comparison:

  • The expense ratios are the same (0.12% for Admiral Shares, 0.20% for Investor Shares).
  • The minimum investment for Admiral Shares of the new index fund is $10,000, as compared to $50,000 for Admiral Shares of Vanguard Intermediate-Term Tax-Exempt Fund. However, the non-ETF version of the new index fund currently comes with a 0.25% purchase fee.
  • The new index fund includes a much smaller number of bonds, which makes it appear somewhat less diversified. But this data is as of 10/31/15 when the fund was super new. I would expect this number to grow as the fund attracts more assets.
  • The credit rating distribution within the funds is very similar.
  • The new fund has slightly more interest rate risk, with an average duration of 5.7 years as opposed to 4.8 years for the non-index fund.
  • And as you would expect for a fund with slightly higher risk, it has a slightly higher yield (1.86% as opposed to 1.71% for the non-index fund.)

In other words, the new fund looks like a great offering — very comparable to the existing Intermediate-Term Tax-Exempt Fund. But I do not see anything about the new fund that makes it distinctly better than the existing non-indexed fund. So I would definitely not think it’s necessarily worth switching, especially if doing so would incur undesirable tax consequences. (After all, by definition we’re talking about taxable accounts, otherwise tax-exempt funds wouldn’t be of interest in the first place.)

I think the new fund will be good for anybody who is simply more comfortable with indexed products than with actively managed products. (That said, the Intermediate-Term Tax-Exempt Fund, while technically not an index fund, is still a pretty passive fund with a relatively low degree of portfolio turnover.)

But I think the two most likely uses for the new fund will be:

  • As a tax-loss harvesting partner for the existing fund, and
  • As a low-commission option for people who invest via brokerage firms other than Vanguard (and who would be able to buy a Vanguard ETF at a lower commission than an open-end Vanguard mutual fund).

Why Are Bonds a Useful Diversifier?

A reader writes in, asking:

“I graduated in May and immediately started contributing to the 401k at my new job. Fidelity runs the 401k. I am using the Spartan 500 Fund, the Spartan U.S. Bond Fund, and a small amount in the Total International Equity Fund.

I thought my portfolio was diversified. But the Spartan 500 fund went way down last month and the U.S. Bond fund barely went up at all. I’ve read that ‘bonds zig when stocks zag’ but that doesn’t seem to be working. Do you have any suggestions?”

The problem doesn’t appear to be with the portfolio. A portfolio of those 3 funds would be reasonably well diversified. The problem is that you’re expecting too much from your bond holdings.

Historically in the U.S., bonds have typically had a positive correlation to stocks. (See Figure 2 in this paper from Vanguard.) In addition, the correlation between stocks and bonds varies dramatically over time. (See Figure 1 in this article from Rick Ferri.)

In other words, the reason bonds are a successful diversifier is not that they have negative correlation to stocks and that you can expect bonds to rise reliably when stocks fall. Sometimes it works out that way, and it’s very convenient when it does. But you can’t count on it.

The primary reason that bonds work well as a diversifier is simply that they are less risky than stocks. That is, when stocks are falling, it’s entirely possible that bonds will be falling too. But as long as you’ve stayed away from very high-risk bonds (e.g., junk bonds or bonds with very long durations), it’s very unlikely that your bonds will fall as much as your stocks.

For example, the following chart (made using the Morningstar website), shows the returns of Vanguard Total Stock Market Index Fund (in blue) and Vanguard Total Bond Market Index Fund (in orange) over the last three months.

Screen Shot 2015-09-27 at 8.48.22 AM

As you can see, the stock fund fell quite noticeably around the middle of August. The bond fund didn’t shoot upward when the stock fund fell, but it didn’t decline precipitously either. That’s pretty much what you should be hoping for from a bond fund. It delivers boring, low-risk performance, even when stocks are performing poorly.

If you’re hoping that your bond holdings will reliably offset any stock losses that you experience, thereby allowing your portfolio to climb steadily upward without any bumps, you’re going to be disappointed.

Why Use Actively Managed Bond Funds?

A reader writes in, asking:

“I saw an article on your blog about passive funds beating active ones. But then why do Jack Bogle and Rick Ferri use the actively managed Vanguard funds? For example, wouldn’t a muni ETF be a better option if it beats the active manager 95% of the time? I’m a full time indexer but I don’t understand why these legends use active bond funds. Can the same be said for corporate bond funds?”

The key point about indexing isn’t that there’s anything magical about the indexing itself but rather that it is a very low-cost way to run a diversified mutual fund. Or, to look at it from the other direction, most actively managed funds have a very difficult time overcoming their much higher costs.

In some cases, however, the actively managed funds have costs that are approximately as low as (or sometimes even lower than) the costs of index funds (or ETFs) in the same category. This is especially common with Vanguard’s bond funds. Many of them are not technically index funds, because they do not specifically track an index. But they have low expense ratios because the fund’s investment strategy is still very passive. That is, the fund isn’t trying to do any of the (expensive) things that many actively managed funds do in their attempts to outperform their benchmarks.

For example, Vanguard’s Intermediate-Term Investment-Grade Fund is technically actively managed. But the Vanguard website describes the fund’s investment strategy as follows: “This fund provides diversified exposure to medium- and high-quality investment-grade bonds with an average maturity of five to ten years.” Nothing about trying to pick bonds with unusually high performance. Nothing about trying to predict interest rate movements. It’s basically just, “We’re going to buy a bunch of bonds with investment-grade credit ratings and maturities of 5-10 years.” Very boring and, importantly, inexpensive to implement.

Similarly, in the muni bond category, Vanguard’s funds are technically actively managed. And their expense ratios range from 0.12% (for Admiral shares) to 0.2%. By way of comparison, if you take a look at a list of muni bond ETFs (here or here, for example), you’ll notice than none are less expensive than Admiral shares of Vanguard’s non-index muni funds.

The triumph of index funds is really a triumph of inexpensive funds over expensive funds. When an actively managed fund has very low costs (and there’s no reason to think that the manager is going to do something stupid with your money), such a fund can be a perfectly good option for inclusion in a low-cost, diversified portfolio.

Distribution Yield vs. SEC Yield: Which Is More Useful?

A reader writes in, asking:

“When I look at a bond fund on Vanguard’s website, it provides an ‘SEC Yield’ and ‘Distribution yield.’ What’s the difference between these and which should I be paying attention to?”

A bond fund’s distribution yield is basically the distributions paid over a recent period, annualized, divided by the net asset value of the fund.

Upon initial consideration, that sounds like something that would be helpful to know. It sounds like it would provide a decent estimate of what level of income to expect from the fund.

But it doesn’t. For a few reasons, distribution yield is a nearly meaningless figure — at least from the perspective of the individual investor trying to figure out what to expect from the fund. Specifically:

  • Distribution yield is not especially useful for comparisons between fund companies, because different fund companies do the calculation differently. Vanguard, for instance, looks at the most recent monthly distributions and annualizes that figure, while Fidelity looks at the last 12 months of distributions.
  • Because distribution yield is backward-looking (sometimes up to 12 months), it can be influenced by an interest rate environment that could be quite different from today’s.
  • Distribution yield is focused entirely on distributions (i.e., cash flow), so it doesn’t properly account for amortization of bond premiums or discounts (i.e., non-cash flow factors that affect the actual rate of return earned).
  • Distribution yields can include returns of capital (i.e., distributions that were not really income).

In contrast, SEC yield is much more useful.

  • The calculation of SEC yield is standardized, which means you can compare from one fund company to another.
  • SEC yield does a better job as a forward-looking indicator. (As Vanguard describes it, SEC yield approximates the after-expenses yield an investor would receive in a year, assuming that bonds in the portfolio are held to maturity and all income is reinvested.*)
  • SEC yield focuses on actual income earned rather than cash flow.

*If you want all the nitty-gritty details of the calculation, you can find them beginning on page 35 here under the heading “Yield Quotation.”

Which Interest Rates Affect Bond Prices?

A reader writes in, asking:

“I understand that a bond’s price goes up when interest rates go down and vice versa. Do interest rates usually move together with all rates going up by roughly the same amount? And if not, which interest rate is it that determines bond prices? Federal funds rate? Treasury bond rates? Other??”

Firstly, interest rates do not move in lockstep. For example, if the yield on 1-year Treasuries goes up by 1%, you shouldn’t expect the yield on 10-year Treasuries to necessarily go up by the same amount. It might go up by more than 1%, it might go up by less than 1%, or it might not go up at all.

You can see this by looking at how yield curves change over time. For those who haven’t encountered yield curves before, they are charts that show the yields for bonds of various maturities. For example, the following chart shows the yield curve for Treasury bonds as of the beginning of this year.

YieldCurve

If interest rates rose and fell in lockstep, the yield curve for Treasury bonds would always have this exact same shape — it would simply shift up and down as rates move. But that’s not the case.

The following chart shows the Treasury yield curve as of the first day of business on each of the last 5 years. As you can see, the lines do not share exactly the same shape, because interest rates did not move in lockstep. As it turns out, over those five years, short-term rates moved around much less than longer-term rates.

YieldCurves

And the above chart only looks at Treasury yields. If we were to include yield curves for muni bonds or corporate bonds, we’d see even more diversity.

So Which Rates Affect Your Bonds’ Prices?

Imagine that you’re trying to sell your car. The price you’re going to be able to get for it will depend on what other sellers are charging for cars with the same characteristics (make, model, year, mileage, condition, etc.).

The same thing goes for bonds. If you want to sell a bond, it is the yield on other similar bonds that will determine the price that you’re able to get.

So, for example, if you own a Treasury bond with 5 years remaining until maturity, and interest rates on 5-year Treasuries rise, the market value of your bond will go down. (That is, in order to make your bond as attractive to a buyer as a new, higher-yielding 5-year Treasury would be, you would have to lower the price of your bond until it provides the same yield to the buyer as a new 5-year Treasury would.)

Or, if you hold a portfolio of highly-rated short-term muni bonds, the market value of your bonds will depend on what happens with interest rates for other highly-rated short-term muni bonds.

Tax-Gain Harvesting with Bonds

Tax-loss harvesting is a very common tax strategy in which you sell a holding when its value is less than the amount you paid for it, then reinvest the proceeds from the sale in a similar (though not “substantially identical”) investment. The idea is that you then get to use the capital loss (up to $3,000 per year) to offset ordinary income on your tax return, without having to make any significant change to your portfolio.

Tax-gain harvesting is a somewhat less common strategy, as it’s generally only helpful for people in the 15% tax bracket or below. The idea is to sell a long-term holding for a gain, then reinvest the proceeds in a similar investment. The benefit comes from the fact that, if you’re in the 15% tax bracket or below, you do not have to pay any tax on the long-term capital gain, and now your cost basis in the asset has increased to the asset’s current value, thereby reducing the size of the capital gain that you might have to pay tax on in the future.

There is, however, a form of tax-gain harvesting that can be helpful even to investors who are in a tax bracket higher than 15%. It becomes relevant when you’ve held a bond for more than one year, and it is currently valued at a price higher than what you paid for it (i.e., the price has gone up because interest rates have fallen since you purchased the bond).

The idea is that, rather than holding the bond and continuing to receive payments at the bond’s higher-than-market interest rate, you sell your bond at a premium, then reinvest the proceeds in a bond that:

  • Has a similar credit quality and remaining maturity (so that you’re not changing the risk of your portfolio), yet
  • Is selling at (or very close to) its par value (e.g., because it’s a new bond).

By doing so, you essentially convert a portion of the yield that you would have received as interest into a long-term capital gain, which will be taxed at a lower rate than the interest income would have been. While it does result in having to pay the tax sooner than you otherwise would have had to (which is generally not a good thing), taking advantage of the difference in tax rates often allows you to achieve a higher after-tax return.

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