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Welcome to MONEY for the Rest of Us, this is a personal finance show on money. How it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 540. It's titled Beyond Munis. New ETFs for tax efficient Bond Investing. I recently received an email from a Plus member who is early retired. They have about 2/3 of their assets in tax deferred vehicles such as IRAs and 401 s and 1/3 in taxable accounts. Their taxable accounts, at least as of early this year, was 100% in stocks. But their goal is to shift more of the taxable accounts to bonds while also keeping it tax efficient. Now, in earlier episodes such as our bond Masterclass that I'll link to in this episode, we talked about the logical solution if you want tax efficient bond investing. Own municipal bonds. Municipal bonds are bonds issued by states and municipalities. They're exempt in most cases from federal taxes and potentially state taxes. If you own municipals from your home state. One benefit of municipal bonds is their default rates have been extremely low, much lower than investment grade corporate bonds or clearly non investment grade corporate bonds. Now we're talking about investment grade municipal bonds because there are also non investment grade municipal bonds that have higher default rates. We're not discussing those today, but if we look at the cumulative five year default rate for municipal bonds, overall 0.18%, that's very, very low. There are two types of municipal bonds. There are general obligation bonds that are backstopped by the full faith and credit of the issuing government. And there are revenue bonds that are backed by fees from public service enterprises like utilities, toll roads, airports. One reason that municipal bond default rates are so low is that these municipalities, these government entities, they have the power to tax and to raise fees and so that gives them the ability to service the debt. There's also oftentimes reserve funds and other mechanism to make sure that these municipal bonds serviced first that the interest and principal payments are made and default rates are very low. An example of a way to invest in municipal bonds is the Vanguard tax exempt bond ETF ticker is VTEB. Its SEC yield is 3.5%. Now we have to keep in mind that we're not paying federal income tax on these municipal bonds or that ETF like you would if you owned a taxable bond fund like the Vanguard Total Bond Market ETF bnd. So what we can do with a municipal bond is compare it or a municipal bond ETF is to convert it to its tax equivalent yield. And we do that by taking the yield and dividing by one minus the highest marginal tax rate of that investor. So if the investor is in a 35% marginal income tax bracket, we can take that 3.5% yield divided by 1 minus 35%, that equals 65%. So essentially we're taking 3.5% divided by 0.65 and that gets us a tax equivalent yield of 5.4%. That, that's attractive. That's more than you can get right now with BND which has a pre tax yield of just over 4%. But not everybody's in the 35% tax bracket. What if you're in the 22% tax bracket, the highest marginal tax rate for many retirees. And so if we divide that 3.5% SEC yield by 1 minus 22%, that gets us 4.5% tax equivalent yield, which is a little closer to overall bonds such as the Bloomberg Aggregate bond index or ETFs that track that. Now the duration or interest rate sensitivity of VTEB is 7.3 years, which is fairly long. If interest rates go up 1%, this ETF's price could fall by 7.3%. A comparable ETF with the similar duration would be the iShares 7 to 10 year Treasury Bond ETF IEF. It has a duration of 7.04 years and its SEC yield is 3.1% 9%. We already saw the tax equivalent yield for VTEB for someone in that 35% tax bracket is 5.4%. So that's better than comparable Treasury ETFs. And if the investor is in a 22% marginal income tax bracket, it was 4.5%, which is still higher than the 3.9% on a similar duration ETF. But not everyone wants to take that type of interest rate risk. What if you want to invest in shorter term municipal bonds such as the JP Morgan Ultra Short Municipal Income ETF ticker is JMST. It has a duration of 0.7 years, its SEC yield is 2.6% and its tax equivalent yield at a 35% tax bracket is 4%. And that's a 22% tax bracket. It's 3%. So not as attractive on a tax equivalent basis. In fact, a 3% tax equivalent yield for that investor in a 22% marginal tax bracket, that's less than you can get in cash. And so that investor would be better off investing just in a traditional money market fund or short term treasury etf. And they would have a higher yield even after paying taxes than they would investing in a shorter term municipal. And that's the thing with muni bond investing. Sometimes yields on muni bonds are so low that it doesn't make sense to invest in them even if you're at that higher tax bracket. At other times, the yield on munis is much higher and it makes sense even at lower marginal income tax rates.
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Before we continue, let me pause and.
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Mentioned in today's episode. Claude AI David One way to avoid the interest rate sensitivity issue of Munis is what many of our PLUS members do is they buy individual municipal bonds and hold them to maturity and they lock in the yield that they get at the time that they bought the particular bond. Now that takes work. You have to diversify. But the fact that default rates are so low we can get some comfort level for buying a general obligation bond. You live in California and buy a California state bond or it's it's certainly doable. It's easier to do than trying to select individual non investment grade corporate bonds or even corporate bonds because of the much lower default rate for municipal bonds. But what other options are out there if you're in a lower marginal income tax bracket? Are there other options that are tax efficient but aren't munis? And there are. There's The Alpha Architect 1 to 3 month Bond ETF B O X X I covered this on our plus membership site for our Premium members about a year and a half ago in plus episode 470 and at the time this was this ETF was a year old $1.7 billion in assets. This member listened to that plus episode and got comfortable with it and has now invested or started investing in this ETF box early this year. The ETF now has 8.3 billion billion in assets and it makes up 8% of this member's taxable portfolio. The expense ratio is 0.2%. What about this ETF is so tax efficient it's not investing in municipal bonds. The ticker box is a hint as to its strategy. It's using options, a Box option strategy. And what it's doing, it's trying to generate the economic equivalent of investing investing in shorter term Treasuries but doing so using options. So it's not actually generating interest income that an investor has to pay tax on. Instead it's generating all of its return through unrealized gains. And then the investor, when they sell the ETF or need to liquidate portion of it will pay a capital gains tax and if they own it for over a year they would pay long term capital gains and that often is at a lower rate than their marginal income tax rate. Now the Box option strategy is little too complicated to describe. In this episode I'll link to a presentation by Alpha Architect. But essentially it's a combination of buying call options that benefit when the price goes up, selling call options, buying put options, selling put options, and doing it in such a way that no matter what happens, you're guaranteed a particular return. And these options essentially have embedded into their pricing due to the time value of money, the yield on shorter term Treasuries, the risk free rate. But it's coming through this option strategy. And because there's an ETF if there's a gain in a particular option, they can use the ETF share creation and redemption process through authorized participants and transfer over those options embedded gains to an authorized participants as part of this share creation and redemption process and basically pass on the gain to them. And that that's something all ETFs benefit from. Which is why ETFs are more tax efficient than a traditional mutual fund because of the way that shares are created and redeemed. Now what's interesting about Box is their strategy has changed from when they launched this a couple years. They still had the box strategy using options, but separately they would do an option strategy on an individual stock as Another way to generate gains and losses and pass those gains on to authorized participants and then use the losses to offset the gain on their main box strategy. They don't do that anymore. Because here's the thing about this strategy. It's, it's, it's not illegal but there's some gray area when it comes to taxes. There's some tax rules such as Internal Revenue revenue service code 1258. There's something called a conversion transaction. And what it means is if your return essentially is equivalent to earning interest due to the time value of money such as box that potentially that should be taxed as ordinary income. Now IRS hasn't come down on this etf. It got rid of the sort of that straddle position with the individual stock also potentially kind of a tax regulatory headache. But it's been a number of years now and the IRS has not said that you can't do this. But effectively it's like having a short term treasury bond ETF but you're not getting it in the form of interest income. It's coming up as a unrealized capital gain back in August 2024. And one of the risks of this strategy is there can be surprise distribution. Lo and behold, Box paid a capital gains distribution even though that was not the intent and it was because at the time they were using S&P 500 options instead of options on ETFs. They've since switched. That is the only distribution capital gain distribution. They paid and it was sort of inadvertent. Maybe we can call it a mistake, they haven't done it since. But when we step and look at the performance of this etf, it has met its objective. If we compare it to The Spider Bloomberg 1 to 3 month T Bill ETF it's earned slightly more. So in 2023 Alpha Architect box earned 5.04%. The Spider Bloomberg 1 to 3 month T bill ETF earned 4.94%. So basically 10 basis points difference it's slightly underperformed by 3 basis points in 2024 and at year to date in 2025 it's outperformed by 8. BAS strategy works. It's a way to earn short term treasury bond yields without having to pay ordinary income tax rate as long as the IRS doesn't clamp down on it. Now there's also counterparty risk because these are options. But the it's really the options are backed by the options clearing Corporation. It's the same risk that you see with anytime you do options. So this isn't an intriguing strategy and one of the reasons that I'm interested in it. Not only to answer member questions, but we have been working on our model portfolio examples for plus membership and considering should we offer a tax efficient bond portfolio which could include something like boxx as a more tax efficient option? Now they're still taxes, they're deferred. It's just that it comes in the form of capital gains versus ordinary income. Before we continue, let me pause and share some words from this week's sponsors. Deleteme makes it easy, quick and safe to remove your personal data online at a time when surveillance and data breaches are common enough to make everyone vulnerable. With Deleteme you get personalized privacy report. 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So take control of your data and keep your private life private by signing up for Delete Me now at a special discount for our listeners. Get 20% off your delete me plan when you go to JoinDeleteMe.com David20 and use promo code David20 at checkout. The only way to get 20% off is to go to JoinDeleteMe.com david20 and enter code David20 at checkout. That's JoinDeleteMe.com David20 code David20 what other options are there within kind of this this Strategy box has 8 billion in assets. Now a brand new ETF with 25 million is the FM compounder US aggregate bond ETF ticker is CPAG. Its expense ratio is 31 basis points. In some ways its strategy is is much simpler. Still has some IRS risk like Box, but in their case what they're doing is they're owning an underlying bond ETF such as AG by iShares that tracks the Bloomberg Aggregate Bond index. And then right before that ETF is going to pay a dividend, it sells the ETF and buys something substantially similar that isn't going to pay a dividend. And then once the dividend is paid then it will sell the alternative ETF and go back into the original one, thus avoiding the income distribution or even capital gain distribution of the ETF it's holding. Now when I first saw this, like what, you can't do that because of the wash sale rule that as individual investors we can't necessarily sell a holding in this case to recognize a loss and then buy something substantially similar. There's this, it's part of tax loss harvesting. But a registered investment company, the wash sale doesn't apply. So they, they can do this, they can sell one ETF and buy another one. And the idea is to again avoid the distribution. And because an ETF that invests in bonds is collecting interest income from the underlying bonds, the net asset value is going up and then it has to pay out that income in distributions. And so effectively this strategy, all the returns ends up just coming in the form of the price appreciation, an unrealized gain. And then the, the ETF holder can choose when to sell to recognize the gain. Now this is brand new, so it's still early, but in theory it should work just fine. It still has some of the same regulatory risk from the taxes. Is this a conversion transaction or what's sometimes known as economic substance doctrine that if you really earn some interest in some way, you can't relabel it, which is basically what both of these ETFs are doing. The return is due to interest even though it's not collecting it. It's implied interest due to the time value of money. But the IRS has, as I said, hasn't ruled against that. But this ETF is tracking the broader bond market. So a little longer term and we'll have a often have a higher yield to maturity than cash. Not so much today, but it is, it's a, it's an effective strategy in theory. We'll see. And that's the thing with these newer ETFs. We don't know what the IRS will rule and will it require payment of back taxes or who knows. But they're, they're novel and intriguing and I think reasonable alternatives to owning municipal bonds. If you're looking for alternatives, box B O X X obviously has a longer term history, but it's much more cash yield focused. Whereas CPAG is focused on more intermediate term bonds. Seeking to track the US aggregate bond market Compounder in the series they also have similar strategy but focused on non investment grade US bonds. It's the FM compounder high yield ETF cphy. It's also brand new, so there's some options out there now this member asked about two additional ETFs, the NEOs enhanced Income Aggregate Bond ETF and the neos Enhanced Income 1-3-3-T Bill ETF. The ticker for that latter is CSHI. For the former, the NEOS Enhanced Income Aggregate Bond ETF, the ticker is BNDI. In both cases they're owning an underlying bond ETF. And again, this member was looking for more tax efficient options. BNDI and CSHI are not tax efficient options because they own an underlying bond ETF and they own it constantly. They're not selling it right before a distribution like CPAG is doing, they're just owning it. But in addition, they are entering into some option strategy to generate a little bit of income. They're selling puts on the S&P 500 and they do a position where they sell a put, they generate a premium, then they buy a put at a little lower price so they don't get hit if the S and P falls significantly. But there is a window there where they have exposure to the S&P 500 if it falls a certain amount and they, they can adjust that. But this is again, this is not tax efficient in the sense of trying to generate a, a structure a bond portfolio in a tax efficient way. This is more of a yield enhancer, trying to earn a higher return than the underlying index by using an option strategy. Whenever I see something like that, I start to see red flags because of my institutional investing experience having invested in strategies like this. And it looks good until there's a potentially an extreme event. And clearly Both of these ETFs, they've been around for over three years. And the aggregate bond version, BNDI has earned about 90 basis points annualized more than the iShares U.S. aggregate bond ETF due to this option strategy because they haven't had any type of extreme event where the ETF has been exposed to severe downside in the S&P 500. But it's there, it's right there in the prospectus. It says the fund could also suffer losses related to its derivatives position as a result of unanticipated market movements. In other words, a big sell off in the stock market. And this is supposed to be the bond investment. And that's where I have a hard time sort of mixing the two within one etf notwithstanding, it's, it's actually outperformed the index, but it's doing it through this option strategy. And, and with options income that's generated, it has some favorable tax treatment in that it's 60% long term capital gains and 40% short term income or 40% taxed as ordinary income tax rate which are the same as short term capital gains tax rate. So Nothing against those two ETFs but they're not a version where we're seeking greater tax efficiency as sort of supplements or replacements or complements to municipal bonds. My approach to fixed income and how I've invested personally, it's how our model portfolios have been set up is to focus on yield first and if we're not getting paid to take interest rate risk to set up a portfolio that's not dependent on predicting the direction of interest rates but to generate a higher yield. Often that's done through taking some credit exposure in a modest way to recognize where we're getting the most yield on bonds relative to the price risk due to changes of interest rates. And by and large much of that's been in sort of these cash like vehicles the last few years as the Federal Reserve has raised its policy rate but as that policy rates drops down then the yield on something like box is going to be lower than it has been. And so it's always sort of weighing which way to go. We've been running these model portfolios on money for the rest of us plus for almost 10 years will be 10 years this coming March. We were running balanced portfolios but we're in the process this week and we've already done it but we will put them on the site is we've broken out separately our fixed income portfolio and making it a separate portfolio and then we were looking at. One reason I wanted to do this episode is do I want to do we want to do a tax efficient one but the money for the rest of US fixed income portfolio has returned 5% over the past year. It's outperformed the Ishares Korios aggregate Bondi tip by about a percent over the three year it's done 5.4% outperforming by about a half a percent the aggregate and then over the five year period it's returned 1.3% annualized and has outperformed the aggregate by around 1.7%. And it isn't magic, it's just had a higher yield to maturity and hasn't taken as much interest rate risk. I'm interested how these alternatives could be used as complements to our model fixed income portfolio and maybe we just put those as additional options because many are looking for inspiration for their tax deferred accounts. But I do believe if we're looking for more tax efficient fixed income ETFs and we don't want to invest in municipal bonds now recognizing the risks, the IRS regulatory risk as long as we understand that that The Alpha Architect 1 to 3 month box ETF Boxx and the FM compounder US aggregate bond ETF CPAG are valid alternatives and it's why Box has been so successful and potentially the FM Compound ES Aggregate Bond ETF will be equally successful. We don't know, but we'll see. It's fascinating the number of options out there in fixed income. Now we discussed this a few months ago in episode 523 the entire bond market, the ability to trade individual bonds is more efficient due to ETFs and many institutions are using ETFs and they're building products in the fixed income space that hold the underlying ETFs but have sort of these enhancements to it and that and that's great for us individual investors because these are things that we can access, but the key is to understand them and understand what the risks are, the investing risk, the interest rate risk, the regulatory risk, and then make prudent decisions based on that. But I'm glad that there's more opportunities. That Then is episode 5:40 thanks for listening.
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Everything I have shared with you in this episode has been for general education. I've not considered your specific risk situation. We have not provided investment advice. This is simply general education on money investing in the economy. Have a great week. SA.