Should You Abandon Tax-Exempt Bond Fund?

As you know, the majority of securities held in a Tax-Exempt Bond fund are municipal bonds issued by state and local governments. For instance, at least 75% of the securities held by Vanguard Intermediate Tax-Exempt Bond Fund (VWITX) are municipal bonds. High unemployment, loss of tourism, collapse of oil and gas markets, and declining property value due to the COVID-19 Pandemic broke many states’ budgets. According to an NPR article detailing this change, 46 states’ revenue dropped compared with the same period last year. In my state, Texas, the revenue dropped 29% from March to May compared to last year mainly due to collapse in oil and gas markets. With state revenue falling due to the Pandemic, should you abandon the Tax-Exempt Bond fund?

Why Invest in a Tax-Exempt Bond Fund?

Most investors’ asset allocation includes bond and/or bond funds based on their risk tolerance. Many investors, particularly the ones in a high income tax bracket, invest in tax-exempt bond funds in their taxable account, because the income from Tax-Exempt bond funds is exempt from federal personal income taxes. For instance, the Vanguard Intermediate-Term Tax-Exempt fund (VWITX) current yield is 1.08% as of August 1, 2020. So if you are in the 35% federal tax bracket, 1.08% is equivalent to a yield of 1.66% (1.08% / (1-0.35)) in a taxable bond fund. Similarly, if you are in the 24% federal tax bracket, 1.08% is equivalent to a yield of 1.42% (1.08% / (1-0.24)) in a taxable bond fund.

Looking Under the “Hood” of Tax-Exempt Bond Fund

Let’s dig a little deeper by examining Vanguard Intermediate Term Tax-Exempt Bond Fund (VWITX).

According to the Vanguard Municipal Bond Funds Annual Report, 61.8% of VWITX fund allocation is distributed in the municipal bonds issued by the following ten states. In the table below, along with fund allocation by state, I have listed March to May tax revenue compared to last year for each state as reported in this NPR report.

StateFund Allocation (VWITX)March to May Tax Revenue Compared to Last Year
New York14.6%-37%
New Jersey3.3%-37%

As you can see from the table above, tax revenues from March to May 2020 dropped significantly compared to last year for all the states in the top ten allocation in the fund. Although essential services such as utilities (water, electricity) may not have a negative revenue impact on municipalities, there is lots of uncertainty in other sectors. For instance, tax revenues from property taxes, sports arenas, convention centers, and shopping complexes may not return to pre-Pandemic levels even after we emerge from this health crisis. This drop in tax revenue may be long lasting.

Should You Abandon the Tax Exempt Fund?

You should definitely look under the “hood” of your tax-exempt bond or bond funds. In particular, I would avoid lower credit-rating and long duration tax exempt bonds or bond funds. In my opinion, investing in funds with more than 90% of investment in high quality credit-rating municipal bonds from A to AAA like Vanguard Intermediate Tax-Exempt Fund (VWITX) is less worrisome. According to this New York Times article, “highly rated municipal bond issuers typically have enough cash set aside to cover at least a year’s worth of their obligations to their investors.”

During the 2007-2008 financial crisis Vanguard Intermediate Tax-Exempt Fund (VWITX) dropped 8% while S&P 500 lost more than 50% of its value from its peak on October 9, 2007 to bottom on March 9, 2009. During the recent March 2020 sell-off, VWITX dropped 11% while S&P 500 lost more than 30%. So high quality tax-exempt bond funds definitely provide some downside protection during a crisis. Hence, this may be one of the reasons not to abandon the high quality tax-exempt bond fund.

Finally, one cautionary note. If all your bond allocation is in Tax Exempt bond funds, consider splitting between Tax Exempt Bond Funds and US Treasuries to reduce risk.

How is your state revenue doing since March 2020 compared to last year? How much of your bond allocation in a taxable account is in a tax-exempt bond fund?


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