Tax-Exempt vs. Taxable Bond Yields: Have Your Cake and Eat It, Too?

by Michael on Feb 10, 2014 · 2 comments

Image of a Tax Free Button

This is a bit random, but I was recently looking at our bond holdings and noticed something that I thought was worth mentioning…

As it turns out, our tax-exempt municipal bonds are currently paying more than our taxable bonds. The absolute difference is slight, but it’s still somewhat unexpected.

For background, municipal bonds generally enjoy favorable tax treatment, which results in a higher tax-equivalent yield than fully taxable bonds. Given this, they are typically expected to offer lower yields.

In our case, I’ve noticed that Admiral shares of Vanguard’s Intermediate-Term Tax-Exempt Fund (VWIUX; it’s VWITX for Investor shares) have an SEC yield of 2.26%. In contrast, Admiral shares of Vanguard’s Total Bond Market Index Fund (VBTLX; it’s VBMFX for Investor shares) are yielding 2.20%.

Related: Take a peek inside our investment portfolio.

Digging deeper, you’ll find that both funds have an average duration of 5.5 years. This means that they should react similarly to interest rate changes. Recall that when interest rates change by a certain percent, you can expect a bond’s value to move in the other direction by that same percent times the duration.

Anyway, like I said above, the absolute difference is slight. The effect does, however, increase when you start doing the math. For example, the earnings from a federally tax-exempt bond paying 1.65% would be worth just as much to an investor in 25% tax bracket as those from a taxable bond paying the current 2.20%.

Conversely, the current 2.26% being paid by tax-exempt bonds is actually worth 3.01% to that same investor in the 25% tax bracket. So what gives? This apparent pricing anomaly must be driven by other factors, such as concerns over the stability of the municipal bond market or something along those lines.

Now, you tell me… Which would you buy? In a taxable account, tax-exempt bonds (currently) appear to win hands down, especially when considering that both options have the same duration. But are there other, non-mathematical considerations that would influence your opinion? If so, what are they?

1 Kurt @ Money Counselor February 10, 2014 at 10:39 am

Michael, I know you don’t have to worry about this too much if you invest in a fund like the Vanguard tax exempt fund you mention, but what’s your view on the overall creditworthiness of municipal bonds these days? Would you recommend the average investor stay away from buying individual municipal bonds?

2 Michael February 10, 2014 at 12:10 pm

Kurt: I think that question is probably too broad. Some issuers may be facing problems but others likely are not. When viewed in the context of a broadly diversified mutual fund, however, I’m not particularly concerned.

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