Municipal Bond Fund Showdown: Vanguard Limited Term Tax-Exempt (VMLTX) Vs Vanguard Intermediate Term Tax Exempt (VWITX)
In the past, I have posted my Roth IRA asset allocation for everybody to see. My Roth allocation forms the core of my retirement portfolio (my 401k allocation is roughly the same, using different funds), so I thought it prudent to share. Lately, however, my growing online income coupled with some pretty aggressive cost cutting strategies, my taxable portfolio has become a pretty significant chunk of my net worth.
Since I’m single and have no dependents, I’ve found myself pushed into higher and higher tax brackets the past few years to the point where owning a municipal bond fund in my taxable account rather than a taxable bond fund is a no-brainer. And before you ask, yes, there are several good reasons why I choose not to view my taxable and retirement portfolios as one large portfolio, which I plan to write about some other time. Suffice it to say I’ve determined that a.) I need to own bonds in a taxable account and b.) that bond fund needs to be a muni bond fund. To that end, I narrowed down my municipal bond fund choices to two of my favorites: Vanguard Limited Term Tax-Exempt Bond Fund (VMLTX) and Vanguard Intermediate Term Tax Exempt Bond Fund (VWITX).
My general criteria for considering these two muni bond funds were:
- High credit quality – Bonds are for safety, so no high yield municipal bond funds (tempting though those yields may be).
- Low Costs – The best funds are invariably the lowest-costing ones, and municipal bond funds are no exception to the rule. Obviously, Vanguard fits this requirement nicely. Every Vanguard municipal bond fund sports below-average costs.
- Open-Ended - I would have preferred a Georgia-specific municipal bond fund so as to avoid state income tax in addition to federal income tax; however, those are hard to come buy in open-ended form. There are a few closed-ended options (Nuveen has one), but these tend to be relatively illiquid and often trade at large premiums/discounts to their net asset value.
- Diversified – Let’s face it, Georgia is broke. Atlanta is so broke, they started furloughing essential employees like police officers and Boards of Education across the state have been cutting teacher payrolls as well. Since I in no way believe in my state’s ability to pull itself out of this mess, I don’t want to own a pile of Georgia debt.
- Average Effective Duration Under 6 Years – Only short- and intermediate-term bond funds were in consideration.
- Vanguard – Hey, I really like Vanguard. It may be I’m leaving money on the table by not considering anybody else, but I doubt it. And even so, I doubt the difference would be worth the extra effort required to do the due diligence required. Vanguard may not be the best, but it is more than good enough.
Municipal Bond Fund Showdown!
All of the following stats come from Morningstar and are accessible with a free account
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Limited Term Tax-Exempt (VMLTX)
- Expense Ratio: 0.20%
- Yield: 2.47%
- Average Duration: 2.6 years
- Avg Credit Quality: AA
- 10 year performance: 4.03%/yr
The Limited Term Tax-Exempt fund is the tax-free equivalent of the short-term bond index fund, a fund I would highly recommend to most investors. There’s nothing special or flashy here. Over the last 10 years, the fund has exhibited average volatility and slightly above-average returns (although nothing to get excited about). This is a widows-and-orphans bond fund, and while it may not outpace inflation by any significant amount, it isn’t likely to lose out to inflation over the long term, either. This fund was my initial choice.
Intermediate Term Tax-Exempt (VWITX)
- Expense Ratio: 0.20%
- Yield: 3.72%
- Average Duration: 5.6 years
- Avg Credit Quality: AA
- 10 year performance: 5.20%/yr
The Intermediate Term Tax-Exempt fund is not as similar to its taxable brethren as is the Limited Term fund. Its average duration of 5.6 years is almost a full year shorter than its taxable equivalent. Still, at twice the duration (and presumably twice the volatility) of the Limited Term fund, the Intermediate Term municipal bond fund has a lot to prove if I’m to choose it over the limited-term fund. Fortunately, the intermediate fund has generated returns that have more than compensated for the slight additional credit risk it has taken on.
More important than what the Intermediate Term Tax-Exempt fund is is what is isn’t. Vanguard has a reputation for keeping an eye on portfolio risk, and while most other bond shops were out chasing yields in the last bull market, Vanguard stuck to their strategy. The fund sports an AA average credit rating and has never delved into the lower end of the credit rating spectrum, even when most of its peers were doing so.
Since these funds share the same expense ratio and credit quality ratings, the only real difference of consequence is the average duration. How much risk did I want to take? The Intermediate Term fund has been just over twice as risky over the long term, which seems like a lot. But in absolute terms, a 5.45% standard deviation is nothing to get worked up about. Hence, I chose the Intermediate Term Tax-Exempt fund as my taxable account’s municipal bond fund. Which would you have chosen?
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I’m puzzled why you don’t have issues that pay tax qualified dividends in your taxable account and use non-muni bonds in your qualified accounts but that’s beyond this post.
You note the 10-year returns are “…nothing to get excited about…”. Surely you realize they will be lower over the next 10 years given that yields are so low today and are likely to rise sharply as local governments compete with the U.S. government for funds. We are in a period where global markets are shaky and people are piling into U.S. debt. When this ends in the next couple of years bonds will take a beating.
With a duration of 2.6 years, just a 1% rise in yields will mean a negative return with a fund yield of 2.47%.
I plan to write about why I keep my taxable and retirement portfolios separate in the future. As for low yields, it may well be that muni bonds will have negative returns over the next decade. But what is the alternative?
Good article. What do you think about these 3 Vanguard funds -
VNYTX – Vanguard New York Long-Term Tax-Exempt Fund Investor Shares
VWSTX – Vanguard Short-Term Tax-Exempt Fund Investor Shares (VWSTX)
(0041)
VTMFX – Vanguard Tax-Managed Balanced Fund (VTMFX)
I live in NY and am in a high tax bracket so was thinking of getting VNYTX.
I would be wary of putting most of my bond money in any one state. That said, I don’t know NY’s finances. Perhaps it’s better off than Georgia. The short-term fund is excellent, but it’s super-low duration so the yield is low as well. I don’t really recommend balanced funds in taxable accounts. What if you want to own foreign stocks? You’d be forced to buy another fund, which would defeat the purpose.
Great thanks a lot Kyle for your feedback.
Thanks.
Vikram
I’m puzzled why you don’t have issues that pay tax qualified dividends in your taxable account and use non-muni bonds in your qualified accounts but that’s beyond this post.
You note the 10-year returns are “…nothing to get excited about…”. Surely you realize they will be lower over the next 10 years given that yields are so low today and are likely to rise sharply as local governments compete with the U.S. government for funds. We are in a period where global markets are shaky and people are piling into U.S. debt. When this ends in the next couple of years bonds will take a beating.
With a duration of 2.6 years, just a 1% rise in yields will mean a negative return with a fund yield of 2.47%.
Thank you for the analysis; it is just what I needed to make a decision between these two funds, even though I ended making the opposite decision. I looked at your profile, and found that you are 20-something in age, while I am a 70-something. You see evaluate munis as part of a long-term investment plan, while I am just looking for a place to park the RMD’s that I don’t need for current spending but may need in the next few years. So VMLTX seems best for me, but I needed your analysis to make that clear. So thanks again.
Margaret, for your situation I agree that the Limited Term fund is probably more appropriate. There’s no point in taking any more risk than you absolutely need to. And if your RMD’s really start to pile up because you end up needing less than you anticipated, you can always choose to funnel some of that cash into something more aggressive in the future.