SEC vs DIST yield in tax equivalent yield calc

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slingsandarrows
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SEC vs DIST yield in tax equivalent yield calc

Post by slingsandarrows » Wed Dec 09, 2015 1:24 pm

When deciding on taxable vs tax exempt bonds we use the tax equivalent yield formula to determine which total return is greater.

taxable yield = (tax exempt yield)/(1- tax rate)

When this has been discussed before I see people using the SEC yield in the formula. Shouldn't you use the distribution yield in the formula? That is what I actually receive each month. Example.

VWIUX (Vanguard intermediate tax exempt ADM) only federal taxes exempt
SEC yield = 1.79%
DIST yield = 2.94%
tax rate = 28%
Using the DIST yield gives a taxable yield of 4.1%
Using the SEC yield gives a taxable yield of 2.5%

VBTLX (Vanguard total bond market ADM)
SEC yield = 2.36%
DIST yield = 2.52%

Using the DIST yield clearly indicates I should be investing in VWIUX (4.1% vs 2.52%).
Using the SEC yield indicates that both investments are about even.

Am I missing something? If I receive the DIST yield each month (or quarter) shouldn't I use that in the calculation? Thanks.

Quark
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by Quark » Wed Dec 09, 2015 1:39 pm

Simplifying for illustration:

SEC yield is, in essence, yield to maturity. It takes into account that bonds bought at a premium or discount will eventually mature at par, resulting in a loss or gain. Distribution yield doesn't really take this into account.

For example, if you buy a bond for $110 that will mature in one year and pay $100, you should consider that $10 loss when calculating your return.

dbr
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by dbr » Wed Dec 09, 2015 1:44 pm

You should use the income you will receive in the applicable tax year. For the next immediate year that will turn out to be somewhere between the past actual yield (distribution) and the forward looking yield (SEC). For a general calculation for the indefinite future the SEC yield is probably a better predictor.

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ogd
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by ogd » Wed Dec 09, 2015 1:47 pm

Always use the SEC yield when comparing funds. The SEC mandates this number be clearly available for this very purpose. Otherwise, unscrupulous fund managers could tweak the distribution / appreciation knobs that they have for bonds to attract unwary investors; see math in the first reply you received.

However, I question the premise of tax equivalent calculators to begin with. They completely ignore risk, which is always a factor in yields. The market's assessment of the risk of bonds is ever-changing (and you should trust it), which means there's no particular fund that you can say is "about the same" as VWIUX. For example, the Inv Grade Bond fund would beat VWIUX handily, but that doesn't mean that it's the better choice, just like it doesn't mean that it's a better choice than VBTLX. Tax-adjusting does not automatically give you license to compare two funds as if it were apples to apples.

Instead, my approach is this: if your tax bracket is above 25%, use munis, otherwise use taxable funds. For the rest, trust the market to match yield and risk; or in other words trust that the relative yield is a better representation of relative risk than you could ever come up with. The 25% number ("average tax discount of the muni buyer") is empirical and I admit to not having a definitive source for this, but there are simple reasons (and past data) why it has to be considerably higher than 15% and other reasons why it's not all the way up in the max tax brackets.

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by grabiner » Wed Dec 09, 2015 11:06 pm

ogd wrote:Instead, my approach is this: if your tax bracket is above 25%, use munis, otherwise use taxable funds. For the rest, trust the market to match yield and risk; or in other words trust that the relative yield is a better representation of relative risk than you could ever come up with. The 25% number ("average tax discount of the muni buyer") is empirical and I admit to not having a definitive source for this, but there are simple reasons (and past data) why it has to be considerably higher than 15% and other reasons why it's not all the way up in the max tax brackets.


This is my rule of thumb as well. While it isn't useful in choosing funds, it can be useful in comparing risks; if you switch from holding a bond fund with a 3% yield in your 401(k) to holding a muni fund with a 2.25% yield in your taxable account, you haven't changed the risk of your bond portfolio significantly.

Tax-equivalent comparisons are important if there are state tax issues. If you pay 8% MD tax, and you could buy a MD bond fund with 0.40% expenses and a 3.22% yield, then a Vanguard fund of comparable risk would have 0.12% expenses and thus a 3.50% yield. The MD tax on the 3.50% yield is 0.28%. Thus, in this situation, the Vanguard fund saves just as much in expenses as it costs in taxes, so there is no advantage to using the non-Vanguard MD fund. If muni yields rise to 5%, the non-Vanguard fund could be a better deal (although there is a diversification issue; you probably don't want to hold too much of your bond portfolio in Maryland).
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slingsandarrows
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by slingsandarrows » Thu Dec 10, 2015 11:43 am

Thanks for the replies.
Quark:
I did not realize the distribution yield could be manipulated so easily, I've learned something. Hopefully Vanguard is not actively doing this with VWIUX. If you look at past history VWIUX DIST yield always beats the SEC yield.

Ogd:
I understand the apples to oranges problem. I realize VWIUX and VBTLX are not equal comparisons but I chose those two because of their diversification and safety. Even though I agree with you the reality of the situation is this. I want to buy a bond fund in my taxable account. If I use the SEC yield to make my decision as you suggest then I might buy VBTLX, but VWIUX has a long history of distributing tax free about 3% a month which significantly beats VBTLX. Using the SEC yield to decide might be safer and more correct but it will cause me to have less total return.

I will use your "above 25%" argument and stick with munis. Thanks.

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ogd
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by ogd » Thu Dec 10, 2015 6:49 pm

slingsandarrows wrote:I understand the apples to oranges problem. I realize VWIUX and VBTLX are not equal comparisons but I chose those two because of their diversification and safety. Even though I agree with you the reality of the situation is this. I want to buy a bond fund in my taxable account. If I use the SEC yield to make my decision as you suggest then I might buy VBTLX, but VWIUX has a long history of distributing tax free about 3% a month which significantly beats VBTLX. Using the SEC yield to decide might be safer and more correct but it will cause me to have less total return.

It's up to you but understand that most of the difference you see in the dist yields is not a real improvement in real returns. When you have bonds with higher coupons but same yield, you will give up the extra distributions in the form of capital losses or smaller appreciation (the latter occurs presently due to the steep yield curve).

There is in fact a tax advantage to have higher distributions, which is why the muni managers are doing a good thing for their taxable shareholders, and the Total Bond Market managers for theirs (for taxable bonds the advantage is reversed). However, this advantage is small when compared to the coupon/yield effect.

It boils down, once more, to not comparing apples and oranges after tax adjustment. A taxable fund with higher distributions but same SEC yield as TBM would not lead to higher returns. A tax-advantaged fund does, but only slightly. And this is all overwhelmed by the imprecision of comparing TBM and VWIUX as if they were similar in "diversification and safety" in the first place.

takee4
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by takee4 » Sun Oct 29, 2017 8:55 am

Quick question...If I buy a bond fund with a Distribution Yield vs. SEC Yield difference which will create a loss/gain for the bond fund as the bond nears maturity, what is the tax impact? Does the bond fund accretion/amortization of the premium/discount equalize this factor? Or, could I buy a fund with a SEC Yield premium vs. the Distribution Yield (bonds are priced at a discount which will increase towards maturity) and achieve a capital gain vs. taking it all at the higher taxed interest income? Any thoughts?

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by grabiner » Sun Oct 29, 2017 3:29 pm

takee4 wrote:
Sun Oct 29, 2017 8:55 am
Quick question...If I buy a bond fund with a Distribution Yield vs. SEC Yield difference which will create a loss/gain for the bond fund as the bond nears maturity, what is the tax impact? Does the bond fund accretion/amortization of the premium/discount equalize this factor? Or, could I buy a fund with a SEC Yield premium vs. the Distribution Yield (bonds are priced at a discount which will increase towards maturity) and achieve a capital gain vs. taking it all at the higher taxed interest income? Any thoughts?
If you buy a fund which holds a bond at a discount (because rates have risen since the fund bought the bond), your returns will be higher than the distribution yield, as the bond price will rise; your share price will rise as a result. Thus, if you sell the fund, you will have a capital gain to make up for the lost distributions. If the fund sells the bond (replacing it with a new bond which is at par), its share price will stop rising and the distributions will increase. The fund will have a capital loss, but that loss is only deductible against capital gains in the fund; you cannot deduct it directly.

Conversely, if you buy a fund which holds a bond at a premium (because rates have fallen), your returns will be lower than the distribution yield, as the bond price will fall. You can sell the fund yourself to take the capital loss; if you do not sell it, the fund will eventually sell the bond for a capital gain, but that gain increases your capital loss if you sell the fund later.

Thus there is a tax advantage for buying a taxable bond fund with SEC yield higher than the distribution yield (converting ordinary income into capital gains), and a disadvantage for buying a municipal bond fund (converting tax-exempt income into capital gains).
David Grabiner

thomaspinckney3
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by thomaspinckney3 » Sun Oct 29, 2017 4:27 pm

A key point about the SEC Yield is that it subtracts expenses. Another potentially subtle difference is that the SEC Yield on bond funds is calculated based on accrued interested vs the distribution yield which is actual payments. The two may theoretically vary from time to time. Finally the SEC yield assumes income is reinvested over the course of the year. Vanguard does a good job of defining exactly what the SEC yield calculates: https://personal.vanguard.com/us/glossa ... ontent.jsp

So, back to the OP. The main reasons to always pay attention to the SEC Yield on bond funds is that the distribution yield doesn't reflect yield-to-maturity or expenses.

Now, you can still calculate an effective pre-tax rate for tax-exempt funds using the SEC yield and dividing through by 1-TaxRate like you describe.

venkman
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by venkman » Sun Oct 29, 2017 9:56 pm

slingsandarrows wrote:
Thu Dec 10, 2015 11:43 am
Thanks for the replies.
Quark:
I did not realize the distribution yield could be manipulated so easily, I've learned something. Hopefully Vanguard is not actively doing this with VWIUX. If you look at past history VWIUX DIST yield always beats the SEC yield.

Ogd:
I understand the apples to oranges problem. I realize VWIUX and VBTLX are not equal comparisons but I chose those two because of their diversification and safety. Even though I agree with you the reality of the situation is this. I want to buy a bond fund in my taxable account. If I use the SEC yield to make my decision as you suggest then I might buy VBTLX, but VWIUX has a long history of distributing tax free about 3% a month which significantly beats VBTLX. Using the SEC yield to decide might be safer and more correct but it will cause me to have less total return.
I think it's a somewhat standard practice these days for municipal bonds to be sold above par value with a high coupon rate. So, your ultimate yield to maturity works out to be whatever the market rate is, but you don't have to worry about incurring any capital gains that would be taxable. Theoretically, you would expect the NAV of the fund to decline over time, because they're trading higher coupon payments for future capital losses; but I haven't been able to figure out to what degree that's actually happening, because NAV prices are also moving due to general market forces.

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by grabiner » Sun Oct 29, 2017 10:17 pm

venkman wrote:
Sun Oct 29, 2017 9:56 pm
I think it's a somewhat standard practice these days for municipal bonds to be sold above par value with a high coupon rate. So, your ultimate yield to maturity works out to be whatever the market rate is, but you don't have to worry about incurring any capital gains that would be taxable. Theoretically, you would expect the NAV of the fund to decline over time, because they're trading higher coupon payments for future capital losses; but I haven't been able to figure out to what degree that's actually happening, because NAV prices are also moving due to general market forces.
Taxpayers are required to amortize the premium when a bond is bought at initial offering above par value; mutual funds do the same. Otherwise, you could buy one of these bonds, hold it to maturity, and get tax-free income with a guaranteed capital loss. With the amortization of the premium, you report less tax-exempt income than the coupon payment, but have no capital gain or loss if you hold the bond to maturity.
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Re: SEC vs DIST yield in tax equivalent yield calc

Post by venkman » Sun Oct 29, 2017 10:38 pm

grabiner wrote:
Sun Oct 29, 2017 10:17 pm
Taxpayers are required to amortize the premium when a bond is bought at initial offering above par value; mutual funds do the same. Otherwise, you could buy one of these bonds, hold it to maturity, and get tax-free income with a guaranteed capital loss. With the amortization of the premium, you report less tax-exempt income than the coupon payment, but have no capital gain or loss if you hold the bond to maturity.
I figured that would be too much of a free lunch to get away with. :happy

So, how does it work with mutual funds? When they get interest payments from the bonds, do they hold on to some of it, to match the amount they had to amortize, thereby preserving the NAV? I'm still unclear on how the distribution yield can be significantly higher than the SEC yield without some NAV erosion.

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by grabiner » Sun Oct 29, 2017 11:05 pm

venkman wrote:
Sun Oct 29, 2017 10:38 pm
grabiner wrote:
Sun Oct 29, 2017 10:17 pm
Taxpayers are required to amortize the premium when a bond is bought at initial offering above par value; mutual funds do the same. Otherwise, you could buy one of these bonds, hold it to maturity, and get tax-free income with a guaranteed capital loss. With the amortization of the premium, you report less tax-exempt income than the coupon payment, but have no capital gain or loss if you hold the bond to maturity.
I figured that would be too much of a free lunch to get away with. :happy

So, how does it work with mutual funds? When they get interest payments from the bonds, do they hold on to some of it, to match the amount they had to amortize, thereby preserving the NAV? I'm still unclear on how the distribution yield can be significantly higher than the SEC yield without some NAV erosion.
If a mutual fund receives coupon payments of 40 cents per share, but is required to declare 50 cents per tax purposes, the NAV will drop by 10 cents as the premium is amortized. Shareholders who do not reinvest dividends will receive the 50 cents, for a net gain of 40 cents since the NAV dropped by 10 cents. Shareholders who do reinvest dividends will also gain 40 cents, with the 50 cents reinvested in new shares.
David Grabiner

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by venkman » Mon Oct 30, 2017 1:52 am

grabiner wrote:
Sun Oct 29, 2017 11:05 pm
If a mutual fund receives coupon payments of 40 cents per share, but is required to declare 50 cents per tax purposes, the NAV will drop by 10 cents as the premium is amortized. Shareholders who do not reinvest dividends will receive the 50 cents, for a net gain of 40 cents since the NAV dropped by 10 cents. Shareholders who do reinvest dividends will also gain 40 cents, with the 50 cents reinvested in new shares.
Are there any special rules about tax-loss harvesting with a muni bond fund? It seems too good to be true that you could get higher tax-free income up front, and then get a tax break on the NAV decline. If you can't do it with individual bonds, I would think you wouldn't be allowed to get around that by using a fund.

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Re: SEC vs DIST yield in tax equivalent yield calc

Post by grabiner » Mon Oct 30, 2017 5:29 pm

venkman wrote:
Mon Oct 30, 2017 1:52 am
grabiner wrote:
Sun Oct 29, 2017 11:05 pm
If a mutual fund receives coupon payments of 40 cents per share, but is required to declare 50 cents per tax purposes, the NAV will drop by 10 cents as the premium is amortized. Shareholders who do not reinvest dividends will receive the 50 cents, for a net gain of 40 cents since the NAV dropped by 10 cents. Shareholders who do reinvest dividends will also gain 40 cents, with the 50 cents reinvested in new shares.
Are there any special rules about tax-loss harvesting with a muni bond fund? It seems too good to be true that you could get higher tax-free income up front, and then get a tax break on the NAV decline. If you can't do it with individual bonds, I would think you wouldn't be allowed to get around that by using a fund.
There is a special rule, but it doesn't cover this case. The rule applies to ETFs, and only to a few funds such as Tax-Managed Balanced which do not accrue dividends. Most funds accrue dividends daily; if a fund worth $100.00 per share pays a dividend of 31 cents per share on October 31 (representing a 3.65% yield), but you bought the fund on October 30, you only receive 1 cent of the dividend, and thus the share price does not decline. If the fund did not accrue dividends, then by buying on October 30 and selling on October 31, you would receive a 31-cent dividend even though you only earned 1 cent, so the fund's price would need to drop from 100.00 to 99.70.

If a muni fund does not accrue dividends, and the fund distributes tax-exempt income, you must reduce your capital loss on any share held for less than 6 months by the dividends on that share. Thus, in the example above, you would not be allowed to deduct the 30-cent capital loss; if market movements caused the price to fall to 99.65, you could deduct 4 cents of the 35-cent loss.

But this doesn't apply in the longer run, as in the situation above. If you buy a mutual fund or ETF after rates have fallen, you may expect the share price to decline, so you might get a capital loss. (Or you might not; the fund might sell the bonds, or be forced to sell the bonds because they get called, and then the share price would not decline and the yield would rise.)
David Grabiner

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