VMMXX vs BND: do I understand correctly?

[BarbWire]

More tutoring, please ...

I am exploring the addition of bond funds to my taxable account when I re-balance next month. (My tax deferred accounts are already maxed out in bonds). But I'm clueless about bond mechanics, so I'm trying to wrap my head around how the risk/reward pencils out, at a very high level. To that end, I've concocted a "story problem" worked example below to try to figure out what would happen if I kept cash in Vanguard's money market fund versus putting the same amount in, say, BND.

I'd appreciate it if someone could read my example below and tell me where I'm going off the rails. I know there are tons of complexities that I'm ignoring; I'm just trying to get the big picture. Monthly dividend rates were taken from Vanguard's website; the 12 month rate series for VMMXX is eye-opening. For simplicity, dividends are not re-invested.

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[FONT=&quot]Suppose I purchased $500K of VMMXX in late Nov 2019, and took dividends for the next twelve months. At the end of 12 months I would have received gross dividends of $3,352.06, or net of 24% tax, $2,547.50. So after tax, I’d have $502,547.50 (after tax dividends + capital), cash in hand.[/FONT]

[FONT=&quot]Suppose instead I purchased $500K of BND at $83.79 per share, or 5,769 shares. Taking monthly per share dividends over the same 12 month period, I’d have gross dividends of $11,900.41 or after 24% tax,$9,044.31 net. So, just on dividends, BND seems the choice for reducing my equity exposure.[/FONT]

[FONT=&quot]But to compare apples -to – apples, I’d need to sell the BND shares (held for at least a year, of course), now at $88.26, which would net $526,673.83. That’s a capital gain of $26,673.83, which less 15% yields $22,672.75 . So in this scenario, after 24% dividend and 15% capital gains taxes, I’d have $531,717.06 (= $522,672.75 + $9,044.31) cash in hand.
[/FONT]
[FONT=&quot]Of course, if the bond price had fallen rather than risen, selling at $79.32 would produce $473,326.17 – or a capital loss of $ 26,673.83. Assuming for simplicity that the dividends paid had been the same as above, I’d exit the year with $482,370.48 (= $473,326.17 + $9,044.31) cash in hand (and a capital loss to play with).[/FONT]

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[FONT=&quot]So, writ large, do I understand the mechanics and risk/rewards of a money market fund vs a bond fund correctly?[/FONT]

[FONT=&quot]As always, thanks to everyone who takes the time and effort to educate me![/FONT]

 

[PaunchyPirate]

BarbWire, I won't try to validate your math. It may or may not be correct. But I'm in your situation and I'll share what I do. I also have my tax deferred accounts maxed out in bonds. My desired allocation calls for more bonds. I have about $275,000 in VBTLX in my taxable brokerage account. VBTLX is the mutual fund version of BND. At one time, I kept about $100,000 in VMMXX in the same taxable account as well. I differentiated the 2 choices as this: VBTLX (my bonds) were part of my investments. VMMXX (money market) was part of my savings plan (emergency savings, near-term spending savings, etc.). I have since moved out of VMMXX entirely and moved that money into an Ally high interest savings account. It's not really high interest anymore, but it pays more than VMMXX does.

I'm retired with my entire income from dividends and any cap gains I get or choose to make. It's not a high tax bracket income, so I don't worry about the taxes due by having VBTLX/BND in my taxable account.

 

[pb4uski]

I didn't check the numbers, but they seem credible. BND pays higher interest but in exchange you are exposed to interest rate gains or losses... since rates have declined over the course of 2020 BND has had interest rate gains.

BND has a duration of 6.7 years, meaning that if rates increase 1% then it is likely that the value of BND will decline by 6.7% all else being equal... assuming no further interest rate changes it would take 6.7 years for the extra yield to offset the decline in value.

VMMXX (or actually VMRXX) is essentially treading water, but with no interest rate risk and BND is income-producing but has interest rate risk.

What is your time horizon for this money?

Pick your poison.... wisely.

 

[BarbWire]

@PaunchyPirate -- thanks. This is a very similar position, so your example is very useful.

I didn't check the numbers, but they seem credible. BND pays higher interest but in exchange you are exposed to interest rate gains or losses... since rates have declined over the course of 2020 BND has had interest rate gains.

BND has a duration of 6.7 years, meaning that if rates increase 1% then it is likely that the value of BND will decline by 6.7% all else being equal... assuming no further interest rate changes it would take 6.7 years for the extra yield to offset the decline in value.

VMMXX (or actually VMRXX) is essentially treading water, but with no interest rate risk and BND is income-producing but has interest rate risk.

What is your time horizon for this money?

Pick your poison.... wisely.

"Wisely" is too much for me to hope for. "Not bone-headed" is my current goal! My math is good (too many years crunching corporate spread sheets) -- it's my logic that I'd like checked.

And, thanks -- I had ignored interest-rate risk. That makes sense as a differentiator from equities. Something more to read about.


My inclination is to keep my non-equity portion in three roughly equal funds: a MMF, and two bond funds. I'm not especially concerned with keeping up with inflation.

Time horizon? I don't know. Might be one (or two or five) year if I find a house to buy and decide to sell bond funds rather than equities (which will depend on my AA at the time). Or it could be very long horizon as I slowly shift my AA away from equities. Probably some of both.

Does this make my bond holdings "Ballast?" I'm mostly concerned with keeping a portion of my portfolio as not-too-wobbly if (and when) equities tank. But the thought of the "safest' option of keeping 50% of my assets in cash in a MMF is just too painful.

 

[mrfeh]

First question you need to ask yourself: if you have to sell your bond fund (ie. to buy a house), would it be acceptable to find that the investment was a net loser compared to when you bought it?

Look at the last 10 years performance: https://www.morningstar.com/etfs/xnas/bnd/performance

It is a pretty smooth trajectory upward, but for a given shorter period of time, it could lose value, even after including dividends.

 

[BarbWire]

Thank you, all. I now have a slightly better understanding of how bonds work as "ballast" in a portfolio (as opposed to something one holds expressly for capital appreciation and/or current income generation).

So much still to learn about bonds and portfolio construction, beyond simple AA! In fact, I hadn't heard of "ballast" until reading a thread here last week, but the idea makes enormous sense. Now the real trick is finding things to read that aren't at the boglehead level!

Again, thanks.

 

[audreyh1]

Here you can read about the Efficient Frontier of using an asset allocation how ratios of different assets classes can work together to reduce volatility yet still capture much of the gain. The Online Asset Allocator

 

[BarbWire]

Thank you!