Portfolio construction
Taxable bonds can have a role in tax-aware portfolios
December 01, 2022
When constructing a taxable portfolio, investment advisors often recommend using municipal bonds to help keep taxes to a minimum. Yet while munis are tax-exempt, they can bring added credit risk. Instead, taxable bonds should be part of the portfolio for many investors, increasing diversification and the potential for generating after-tax wealth, according to new Vanguard research.
Allocations driven by tax brackets
The Vanguard team describes an enhancement of the Vanguard Asset Allocation Model (VAAM) that allows for systematic consideration of taxes as part of the portfolio construction process. “The tax-aware portfolios enable the best of both worlds—diversification and tax efficiency,” the paper’s authors write.
Tax brackets figure into the process in two important ways.
First, interest on taxable bonds is subject to ordinary federal income tax rates, which for 2022 are as high as 37% (for incomes over $647,850 for married couples filing jointly). Hence the tendency to shift to municipal bonds for the fixed income portion of a portfolio.
Second, tax brackets determine whether other types of investment income—such as qualified dividends for equities and long-term capital gains from annual portfolio rebalancing—are taxed at rates of 0%, 15%, or 20%, rendering the tax advantages of munis less meaningful in some cases. Less reliance on munis in turn reduces credit risk relative to the broad bond market.1
Taxes on bond interest, qualified dividends, and portfolio rebalancing
Notes: Dividends can be “qualified” for special tax treatment. (Those that aren’t are called “nonqualified.”) Most payments from the common stock of U.S. corporations are qualified as long as the investment is held for more than 60 days. Stocks of foreign companies traded through American Depositary Receipts (ADRs) or on U.S. markets may also be qualified. For dividends passed through by a fund to be qualified, the fund must first meet the more-than-60-days requirement for the individual securities paying the dividends. Additionally, the owner of the fund must own the fund shares for more than 60 days. Annual rebalancing can trigger the selling of assets that have appreciated and the paying of capital gains taxes.
Sources: Vanguard and the IRS, based on 2022 tax rates.
Finding an optimal allocation
Taxes are far from the only consideration. An investor’s goals and preferences are at the heart of Vanguard’s portfolio construction framework. The VAAM assesses risk and return trade-offs of various portfolio combinations based on user-provided inputs such as risk preference, investment horizon, and specific asset classes.
The tax-aware enhancement to VAAM can be customized to adjust for such factors as whether investors will draw all, some, or none of their income from the portfolio or whether they intend to liquidate their portfolios at the end of the given period.
For the calculation, expected total returns are broken into price and income returns. Tax rates are applied to expected stock dividends, bond interest, and rebalancing-related capital gains. The enhanced VAAM also tracks each asset’s weighted average cost basis through time to allow for the offsetting of gains and losses each year as the portfolio is rebalanced back to its target allocation.
The tax-aware VAAM determines the allocation of municipal bonds as a percentage of the total bond allocation and makes adjustments based on the investor’s tax bracket. For example, based on 10-year asset class forecasts as of June 30, 2022, VAAM would recommend 88% in munis for an investor in the 37% tax bracket (see figure below). The model assumes taxes of 20% each on dividend income and capital gains.
By contrast, using the same forecasts, munis would represent 79% of the total bond allocation for an investor in the 12% bracket. The model assumes dividend income and capital gains would each be taxed at 0%.
Municipal bond percentage of total bond allocation for various tax rate combinations
Notes: Portfolios are constructed based on 10-year Vanguard Capital Markets Model asset class forecasts, as of June 30, 2022.
Source: Vanguard.
A better reflection of trade-offs
By accounting for taxes on equity dividends, bond interest, and capital gains due to rebalancing, as well as current market conditions such as equity valuations and bond yields, the new approach gives the VAAM more flexibility to address an array of client scenarios in a tax-efficient portfolio.
“Using this methodology, investors can construct portfolios that better reflect the after-tax trade-offs between stocks and bonds and between taxable and municipal bonds,” the authors write.
To learn more, read A systematic approach to constructing tax-aware portfolios.
1 Credit risk is the chance that a bond issuer will fail to pay interest or principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Related links:
- Vanguard’s portfolio construction framework (32-page PDF, issued July 2022)
- Vanguard’s principles for investing success (40-page PDF, issued June 2020)
- The Vanguard suite of proprietary models
Notes:
All investments, including a portfolio’s current and future holdings, are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model® (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions, and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or to the results obtained by its use and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal adviser about your individual situation.
Contributors:
Yan Zilbering
Victor Zhu
Vanguard Information and Insights
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