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The Independent Adviser for Vanguard Investors
•
October 2015
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5
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bond funds, like
Intermediate-Term
Investment-Grade
, anyway.
Where Munis Belong
Okay, let’s talk about where your muni
investments most likely should be held—
in a taxable account. This gives us an
opportunity to distinguish between mini-
mizing your tax bill and maximizing your
after-tax dollars. Allow me to cherry-pick
an example using today’s numbers.
Say you have $100,000 to invest in
a short-term bond fund. You could buy
Limited-Term Tax-Exempt
and earn
$980 in tax-exempt income (using the
fund’s SEC yield of 0.98% as a measure
of the income you’ll receive). You’ll
owe no federal taxes on the income
and keep all $980. Or you could buy
Short-Term Investment-Grade
with a
1.88% yield, and earn $1,880 of taxable
income. If you are in the highest tax
bracket of 39.6% (which goes to 43.4%
counting the 3.8% health care surtax),
you’ll owe $816 in taxes, leaving you
with $1,064. By choosing Short-Term
Tax-Exempt, you minimized your tax
bill, but if the goal is maximizing your
after-tax dollars, buying Short-Term
Investment-Grade, although it increased
your taxes due, would have been the
better move.
Note that I did not include the impact
of state or local taxes in that exercise,
in part to keep things simple, but also
because they do not move the needle too
much. Yes, with a national muni bond
fund, the portion of the income paid out
from bonds issued by municipalities in
your state is still tax-exempt at the state
level. But, like I said, the numbers are
pretty small. For instance, 15% or so of
Limited-Term Tax-Exempt’s assets are
in New York bonds—which is the larg-
est weight any state receives in the fund.
If you live in New York, income from
those bonds is exempt from state taxes.
So factoring in state and local taxes
we can. If you look at the composition of the portfolio, particularly in the
top 10, the names have, on average, slightly more downside protection to
them. There’s a little more yield in the portfolio than normal, which has a
buffering effect.
To be clear, I am not actively managing the portfolio out of fear or cau-
tion. But to the extent I feel a little cautious, I can do those things on the
margin. But there’s nothing different about the philosophy. There’s noth-
ing different about the approach.
Speaking of being opportunistic, what were you and your trad-
ers doing for Dividend Growth shareholders during the tumult in
late August?
When you have rapid volatility like that, you don’t really have enough
time to do a lot. You might have an opportunity for about a day. The win-
dow opens very narrowly and shuts very rapidly. So it’s really hard to take
advantage of.
Having said all that, what do we do? We are pretty organized in terms
of trying to take advantage of those environments. I have a list of five
or six names that we are very interested in buying, that have all the
characteristics that we like, and we make the trading desk aware of that.
If [the trading desk] sees opportunities either in terms of liquidity pre-
senting itself or sharp share price changes, [they are] aware that we are
interested in doing something. And we have a dialogue that we maintain
to make sure that we take advantage of that opportunity. I’ll also do that
with existing positons in the portfolio.
You spent a long time covering the energy industry. What do you
think of energy now? Oil is half the price it was a year ago. Are
we at an inflection point?
Right now my view on energy is, at the very best, mixed. There doesn’t
seem to be a lot of evidence to suggest that we are about to inflect. It used
to be that when oil was down meaningfully, you would buy, and when it
was up meaningfully, you’d sell, but it seems to me we have a double-
headed problem here. You have got weakening demand, largely via China.
You have a supply curve that has shifted meaningfully, given shale and
some other non-conventional sources of supply. You’ve got OPEC, which is
still stubbornly producing at a high level. So there’s no real evidence that
price is going to turn anytime soon. Now just feels too early for me.
Let’s turn to financials for a minute. Financials are close to 15% of
the portfolio, the highest level since you started on the fund, and
more than double the weight of your benchmark.
Our exposure to financials is a little bit different than many other
dividend investors—it is largely insurance [companies]. There’s not a lot
of bank exposure. The big banks have these big balance sheets, where
capital is more precious every day, and that has implications for dividend
growth. What we do when looking at financials is we try to avoid big bal-
ance sheets or balance sheets that have long-term liabilities. So we own
property and casualty insurance, insurance broking and asset management.
Things like that. We only own a couple of banks in the portfolio right now.
You can make pretty strong arguments as to why we own both of them.
Competitive Yields on Tax-Exempt Funds
Yield ———Taxable-Equivalent Yields———
Yield
25% 28% 36.8%* 38.8%* 43.4%*
Tax-Ex. MM 0.01% 0.01% 0.01% 0.02% 0.02% 0.02% Adm. Treasury MM 0.01%
Federal MM 0.06%
Prime MM 0.07%
Short-Term Tax-Ex.
0.48% 0.64% 0.67% 0.76% 0.78% 0.85% Ultra-Short-T Bond 0.66%
Ltd.-Term Tax-Ex.
0.98% 1.31% 1.36% 1.55% 1.60% 1.73% Short-Term Treasury 0.62%
Short-Term Federal 0.78%
Short-Term Bond Idx. 1.14%
Short-Term Inv.-Gr. 1.88%
Interm.-Term Tax-Ex. 1.79% 2.39% 2.49% 2.83% 2.92% 3.16% Int.-Term Treasury 1.41%
Total Bond Market 2.13%
Int.-Term Bond Index 2.54%
Int.-Term Inv.-Grade 2.79%
Long-Term Tax-Ex.
2.45% 3.27% 3.40% 3.88% 4.00% 4.33% Long-Term Treasury 2.61%
Tax-Ex. Bond Index 1.82% 2.43% 2.53% 2.88% 2.97% 3.22% Long-Term Bond Idx. 4.02%
High-Yield Tax-Ex.
2.90% 3.87% 4.03% 4.59% 4.74% 5.12% Long-Term Invest.-Gr. 4.07%
*Tax equivalent yields incorporate the 3.8% health care surtax into the 33%, 35% and 39.6% tax rates. Data through 9/30/15.
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