I must admit that I'm a little bit confused with the placement of funds for taxable vs. non-taxable accounts, in particular for those investors seeking income. For example, I've always been told that most bond funds, especially high yield, are appropriate for tax deferred accounts. However, if you are someone who wants to collect the income for bills, expenses, etc., why would you do that? I understand that muni bond funds are appropriate for taxable accounts, but it doesn't seem to be prudent to devote all taxable assets to muni bond funds, especially if you want to stay diversified. So, my questions are: do you devote taxable money to bond funds other than munis? Do you worry about the taxes that will be paid for the income? Do you try to gain income in taxable accounts by buying high dividend ETFs or other investments for qualified dividends?
P.S. - What sort of funds or investments do you use for taxable accounts to gain income?
Comments
BBB may be "investment grade" but there's a reason why it's not called A-. There's a significant jump in risk between letters. Intermediate term because long bonds don't offer enough of an increase in yield to be worth the risk - especially in a low (and likely rising) interest rate environment. Short term bonds simply pay too little.
So one winds up with funds like Fidelity Investment Grade Bond (FBNDX). SEC yield a tad under 3%. (I use SEC yield because it incorporates both the coupon payments and the decline, if any, in principal; that's something you need to watch for in a longer term investment.)
Compare that with a strategy of combining a MMA (1%) with broadly diversified equity funds. The latter should return a couple of percent above bonds (expecting 5%-6% over time is not unreasonable). This approach comes with more volatility, which is why one uses the MMA for cash - this needs to be much larger than the proverbial emergency fund. Over time, as the equity market does well, one sells shares and moves to cash. When the equity market swoons, one draws from the MMA.
Plusses are an expected higher average rate of return than a bond portfolio, and lower taxes (the dividends and cap gains from the equity funds will be taxed less than the bond fund alternative). Just as you wrote. Minuses are that this requires closer monitoring and a tolerance for greater volatility on paper.
You can throw in some munis to give more stability and another source of income in case you're queasy about selling lots of equity at one time (when the market is up, to replenish the MMA).
As interest rates go up, one might make more use of bond funds for income, but I don't see them helping much right now. (Multisector, junk, etc. are different - but one invests in them much as one invests in equity - for total return and diversification - and this is why they wind up in nontaxable accounts.)
In short, one can make a barbell out of the "three bucket" strategy, discarding the middle bucket as dead weight.
a. I would not select an investment for purchase due to its tax-efficiency, regardless of its investment merit. If you find munis (for example only) a good value here, then, I suppose they can be considered a possibility. But even in that example, if pricing gets too rich, I'd consider selling them - paying the tax on my gain -- and finding a new, better asset to own. If/when all risk-assets seem expensive, I tend to de-risk my portfolio and wait for Mr. Market to hand me an opportunity.
Vehicles which have as their objective tax avoidance (muni funds would be the obvious example), are definitionally NOT managed for total (pre-tax) return. They are generally obliged to hold tax-advantageous securities, even if those securities are priced to deliver NON-advantageous total returns. Buy tax-advantaged securities when they are cheap, but don't hold them regardless of price.
b. Yields on MOST vehicles (excluding perhaps CEFs, and BDCs) are low enough that I really don't find the tax to be a concern.
c. I generally hold individual stocks ONLY in taxable accounts, not because their divds are favorably taxed vs. bond coupons, but because they are more volatile and when a stock drops, I want the ability to aggressively tax-harvest. Tax-harvesting is seldom discussed as a part of tax-efficiency, but it can have a big impact if practiced with discipline during market declines. Never let a stock correction go to waste.
But I also hold a chunk of plain-vanilla bond OEFs in my taxable accounts. - Funds which throw off a real return (cash distys), which tend to be total-return driven, and which tend to not be too volatile. --- These vehicles can serve as sources of funds/buying power of more volatile assets when stocks sell off.
I guess my philosophy when it comes to taxes & investment is the old saw: "don't let the tax tail, wag the investment dog". Obviously, each person's tax situation is unique. In my case, I'm in the 25% Fed tax rate, residing in a state with NO state income tax. If I lived in CA, NY, NJ, or MA, I might be more tax-aware...
Just my opinion. Good luck.
Regards,
Ted
http://abcnews.go.com/Business/story?id=88395&page=1
Another familiar face in the same neighborhood was Vanguard Intermediate Term Bond (VBILX). If I'm going to go with a bond index fund, I prefer intermediate over full market, because the latter ones are stuck with short term bonds (yielding nothing), and long term bonds (adding risk). Sometimes those bonds make sense in a fund, but IMHO not mechanically. VBILX has somewhat better total return, but with slightly increased volatility.
Which gets us to your question about total return funds. These are funds that are managed to take advantage of changes in the bond market - some sectors may be offering better value, or it may make sense to increase/decrease maturity (yield curves do not shift evenly, but the amount of change in rates depends on maturity and type of bonds). MWTRX does an excellent job at capturing this. But this is an aggressive strategy. It gives up current yield in order to capture appreciation by trading up and down yield curves (hence "total" return). Not as steady an income source, though a good fund like this one can do better in total performance (or worse, if it errs). @Junkster can likely give a better commentary.
MBS bonds bring up a whole different set of issues. They typically offer a somewhat better yield than "regular" bonds, because they are not well behaved in markets where rates are changing rapidly. That's largely because they typically have calls built in - if you buy a home with a mortgage, and rates drop, you'll refinance (call the bond). So the bond holder doesn't benefit from the falling rates (and rising bond prices). On the other hand, if rates rise, you'll extend the life of the mortgage, taking advantage of the lender.
Gundlach is superb in managing these risks with derivatives. His funds still have risks. M* does not rate his funds; it's not just because they don't get along, but because they do not understand what he is doing. You can bet on the manager, or decide not to invest in what you don't understand.
In a sense, bonds and bond funds are very straightforward - there's no magic. If you want better performance, you take commensurately more risk. Risk comes in various flavors - credit/default risk, interest rate risk, sector risk, call risk, etc. I named FBNDX because it's a pretty vanilla fund without much risk in any dimension. Just what one might want as a "steady Edy" type of cash cow for income. Take incrementally more risk and the yield may grow more lumpy, the returns may come in the form of appreciation (you may need to sell shares to realize the income), and you're more likely to have the occasional "whoops" moment.
I use a few different bond funds, mostly in my IRAs, for diversification and total return. So I'm not averse to using funds all along the risk axis. They just have different uses. Right now, I don't see bond funds as being great for generating current income - for paying bills.
FWIW, a couple of other somewhat familiar and cheap funds I see in the same vicinity are PYCBX (unfortunately, $100K min) and William Blair Bond (WBBNX with a 12b-1 fee, or WBFIX with a TF to get at a brokerage with a reasonable minimum).
MWTRX is general intermediate bond fund which holds corp, govt, and mortgage debt.
DBLTX is strictly mortgages. As for figuring it out -- the manager "barbells" the portfolio - holding agency mortgages, and non-agency mortgages. (the former are generally guaranteed by Uncle; the latter are not -- so THOSE will have credit risk). The former (agencies), typical of quality bonds move inversely in price to interest rates. The latter (NON-agencies) tend to respond positively to an improving economy (which reduces likelihood of defaults). By owning both, the manager offsets the risks of one vs. the other. He also "tilts" the allocation to where he finds relative value. Meanwhile, he collects coupons from both sides of the barbell along the way.
As for the average rating, I'm no expert, but seem to recall hearing several years ago, that while the mortgage bundler pays S&P and Moodys for an INITIAL rating, no one is paying the rating-agencies for a "current" opinion/rating. So a bundle of mortgages rated BB at time of issuance (say a year 2006 vintage) would still carry the original rating, even if mortgages within the particular security are still paying. This is in contrast to corporate-issuances, which generally continue to pay S&P/Moody's for ongoing coverage/opinions.
Basically, for MWTRX and DBTLX both, you are relying on the expertise of active managers. My own personal opinion: those are good bets to make.