When triple-A rated local and state governments borrow money — and less-solvent ones, too — investors who buy their bonds typically enjoy federal, state and local tax exemptions on bond income.
You'd think the tax breaks would give these governments an advantage, letting them sell debt extra cheap, compared with taxable bonds — because muni yields plus tax benefits should tend to equal taxable yields for borrowers with comparable risk, says Alan Schankel, a municipal bond strategist in Philadelphia.
But that's not what always happens in bond funds. To the contrary: Vanguard Group's Long-Term Tax Exempt municipal bond fund has typically posted higher yields than its Total Bond Market Index funds, or even U.S. Treasury-based funds, ever since the last big financial markets crisis in the late 2000s, according to monthly SEC yield data. Towns and states have had to pay more to borrow, and that has boosted muni yields.
And yet Vanguard is cautious about herding customers into muni-bond portfolios. Indeed, the Malvern, Pa.-based fund giant, which last year boosted its managed assets above $5 trillion, last month took the occasion of the Trump tax cuts to issue new instructions to the reps who run its largely automated Personal Advisor Services (PAS) fee accounts, guiding more savings into taxable bond funds instead of munis.
It's not just about which pays more, Vanguard argued: "Since municipal bonds represent a relatively small and less-diversified sector of the larger bond market, investors should require clear and compelling tax savings when substituting munis for taxable bonds," according to an internal memo last month.
And the new tax law, Vanguard added, has made taxable bonds the right choice for more investors — even if muni fund yields, for now, remain higher than similar-rated taxable bond funds.
In the past, reviewing the spreads between taxable bonds and tax-free munis over a period of more than 25 years, Vanguard recommended that investors taxed at the old 28 percent marginal tax bracket, and above, buy some muni funds instead of taxable-bond funds. But its Investment Strategy Group (ISG) now suggests "a threshold of 32 percent as being the appropriate 'breakpoint' for municipal bond purchase going forward," according to the memo.
Why so certain? "Long-term trends indicate that taxable bonds have had historically higher yields," said Emily Farrell, a Vanguard spokeswoman.