Last month I wrote about the curious fact that mutual funds designed to be held in retirement accounts, where their distributions are generally untaxed year-to-year, nonetheless hold federal bonds that are exempt from state income taxation. I suggested that it should be possible to optimize your retirement account holdings by replacing those federal bonds with taxable corporate bonds.
Once I get an idea in my head it’s hard for me to let go of it until I follow it to its end, so I decided to see if there was an easy way to make the swap.
How to think about your federal bond holdings
As I wrote in the previous post, if you own virtually any target retirement date or target risk fund, or a total bond market index fund, you probably own a lot of federal bonds simply because they constitute such a large share of the US bond market: about 43% of Vanguard’s Total Bond Market Index Fund, for instance, is in federal bonds, and about 35% of its income is attributable to federal sources.
What this means is that when you own the Total Bond Market Index Fund, either as a separate mutual fund or ETF or in a packaged target retirement date fund, you’re saying you are willing to accept the interest rate the fund pays, given the volatility of the fund and the safety of the fund.
When you hold the fund in a tax-advantaged account, however, you are also “paying,” in the form of a lower interest rate, for a benefit the fund offers all shareholders, but which you are not using: the exemption from state income taxes of the federal portion of the fund’s income stream.
Logically, there are three ways you can “cash out” the value of the state income tax exemption you’re not using. For these examples, I’ll be using the following funds in case you want to check my math or strike your own balance:
- VTBIX to represent the total bond market;
- VCSH to represent short-term corporate bonds;
- VCIT to represent intermediate-term corporate bonds;
- VCLT to represent long-term corporate bonds;
- and VGSH to represent short-term federal bonds.
Option 1: match yield, minimize duration
“Duration” is a term of art that refers to the sensitivity of the price of a bond (or bond mutual fund) to changes in interest rates. A short-term bond has a lower duration because changes in interest rates don’t have a big impact on its price: since the bond will mature soon, you can reinvest the principle at the new interest rate frequently. A long-term bond has a higher duration since you have to wait a long time to take advantage of higher interest rates, while if interest rates fall you can happily collect your legacy coupons for years to come.
All else being equal, for any given yield, you should prefer your bonds to have a lower duration, thereby reducing their price volatility. As of the time I ran my calculations, you can match the 1.95% SEC yield of VTBIX with a combination of 73% VCSH and 27% VCIT. While offering the same SEC yield, by excluding the long-term bonds present in the total market fund, this corporate bond portfolio has a much shorter duration: 3.57 compared to 6.26.
In this option, you’re exchanging the unused state income tax exemption for a much lower level of price volatility.
Option 2: match duration, maximize yield
Since we specified at the outset that when you own VTBIX you’re implicitly accepting the exposure to changes in interest rates embedded in that fund, another option is to try to match that interest rate exposure while exchanging the state tax exemption for higher-paying corporate bonds.
In principle you could achieve this in almost unlimited ways, but I found a simple equilibrium in a corporate bond portfolio of 12% VCSH, 82% VCIT, and 6% VCLT. This portfolio has a duration of 6.24 (still slightly lower than VTBIX) and an SEC yield of 2.31%, about 18% higher than VTBIX.
Option 3: match Treasuries, optimize something else
At this point you might be scratching your head and saying this whole experiment has gone too far. We started with a minor observation about an unused tax benefit, and now we’re cutting Treasury securities out of our retirement portfolio entirely? And you’re exactly right: remember that Treasuries have not one, but two advantages. The income they generate is generally exempt from state income taxes and they’re completely safe (if held to maturity).
While the corporate bond ETF’s I’ve been using to illustrate these options only hold investment-grade securities, anyone who lived through 2008 knows that the term “investment-grade” can conceal just as much as it reveals. That being the case, you might simply chop your bond holdings into two categories: the federal bonds you hold because they’re ultra-secure and the corporate bonds you hold to optimize some other value, like yield, duration, or credit.
As mentioned, VTBIX holds about 43% of its value in federal securities. If that’s the level of Treasury security you want in your domestic bond portfolio, you can simply allocate 43% of your domestic bond portfolio to a short-term bond ETF like VGSH. With that out of the way, you can set about optimizing your corporate bonds for some other value. Portfolio Visualizer has a nice, free tool that lets you optimize a portfolio for things like Sharpe ratio or risk parity (note: I have nothing to do with Portfolio Visualizer and don’t vouch for any of their tools or results).
As a general rule, bonds are helpful to have even in the most aggressive investment portfolio, not because they’re expected to contribute to total return, but because their imperfect correlation with stocks means they periodically present opportunities to rebalance into higher-expected-return assets. Treasury bonds offer the additional advantage of a federal guarantee of their value (if held to maturity) and exemption from state income taxes.
In tax-advantaged accounts, you may well value the imperfect correlation of investment-grade bonds with stocks, and you may well value the federal backing of Treasury securities, but you should not value the state income tax exemption at all: you’re not paying state taxes on the income either way. That means there should be some margin at which you’re willing to shift away from the default allocation to federal bonds, either in order to reduce your risk even more, to collect additional yield from investment-grade corporate bonds, or to optimize your portfolio across both risk and yield.