Why Vanguard advisers don't always push today's best-paying asset

When triple-A rated communities such as Chester and Montgomery Counties borrow money — and less-solvent local and state governments, too — investors who buy their bonds typically enjoy federal, state, and local tax exemptions on bond income.

You'd think the tax breaks would give these governments an advantage, letting them sell debt extra cheap, compared with taxable bonds — because muni yields plus tax benefits should tend to equal taxable yields, for borrowers with comparable risk, says Alan Schankel, managing director and municipal bond strategist at Janney Montgomery Scott in Philadelphia.

But that's not what always happens with the bond funds that many investors use to buy into the market. To the contrary: Vanguard Group's Long-Term Tax Exempt municipal bond fund has typically posted higher yields than its Total Bond Market Index funds, or even U.S. Treasury-based funds, since the last big financial markets crisis in the late 2000s, according to monthly SEC yield data. Bond people argue about why this is — the slow real estate recovery in many areas, Detroit's bankruptcy, Puerto Rico's default, state pension deficits, federal highway funding gaps — but towns and states have had to pay more to borrow, and that has boosted muni yields.

And yet, Vanguard is cautious about herding customers into muni-bond portfolios. Indeed, the Malvern-based fund giant, which last year took in a billion dollars a day and boosted managed assets above $5 trillion, last month took the occasion of the Trump tax cuts to issue new instructions to the reps who run its largely automated Personal Advisor Services (PAS) fee accounts, guiding more savings into taxable bond funds, instead of munis. More on PAS — Vanguard's "hybrid robo-adviser" that "creates Amazon-like fear among competitors" — from the Inquirer's Erin Arvedlund here.

It's not just about which pays more, Vanguard argued: "Since municipal bonds represent a relatively small and less-diversified sector of the larger bond market, investors should require clear and compelling tax savings when substituting munis for taxable bonds," according to an internal memo last month from Vanguard's Investment Strategy Group (ISG) to its PAS reps, who manage partly automated advisory accounts for Vanguard investors that pay a fee for the service.

And the new tax law, Vanguard added, has made taxable bonds the right choice for more investors. Even if muni fund yields, for now, remain higher than similar-rated taxable bond funds.

In the past, reviewing the spreads between taxable bonds and tax-free munis over a period of more than 25 years, Vanguard recommended that investors taxed at the old 28 percent marginal tax bracket, and above, buy some muni funds instead of taxable-bond funds. The tax exemption, for these investors would at least compensate for the fact that munis in the past tended to yield lower returns.

But "after analyzing the new tax brackets, ISG's most recent guidance indicates a threshold of 32 percent as being the appropriate 'breakpoint' for municipal bond purchase going forward," according to the memo. So, new and "rebal" (rebalancing) investors earning as little as $91,000 (for single investors) up to as much as $305,000 for couples will now be directed toward taxable bond portfolios.

Why so certain? "Long-term trends indicate that taxable bonds have had historically higher yields," Emily M. Farrell, head of U.S. business public relations at Vanguard, told me. "While it is true that muni bonds can yield more than taxable bonds at certain points of time, we have long cautioned investors against making tactical shifts, particularly when we expect markets to revert back to the long-term trend."

Bonds, like stocks, should eventually regress to the old mean, the argument goes. Wait around, and you should be glad you stuck with the trend.

Should — and can — Vanguard's largely automated advisory service be flexible enough to note that munis are currently yielding more than equivalent high-quality taxable bonds — especially in states like New York and California, where high tax rates, and recent federal limits on state-and-local income tax deductions, hit some investors extra hard?

Of course Vanguard "is absolutely correct that tax-equivalent yields are important comparisons," Wiener added. But de-emphasizing munis despite years of higher returns makes it's easy for investors to wonder whether the long-term strategy fits the investor's needs as well as the adviser's: "This policy goes to the heart of why you can't just assume the robo advisers are really working on your behalf. Sometimes their policies are designed to make it efficient to run the system" whether or not it maximizes investor profits.

Guidelines or no, it would be wrong to think a Vanguard advisory client is locked in to one approach, Vanguard says. "A key element of Personal Advisor [Services] is ongoing engagement with a human adviser," who could agree a particular client might be better off with munis, Vanguard spokeswoman Farrell told me in an email. "These types of portfolio decisions are made in consultation with the client, and customized in deference to individual preferences, unique tax situations, and/or concerns about capital gains/losses."

Other private advisers — who, like Wiener, compete against automated services such as  Vanguard's — agreed that there are considerations besides yield to keep in mind, even at the low rates currently paid by creditworthy bond issuers.

"Certainly, we are in an opportunity where munis provide risk and returns that outstrip, for example, a U.S. Treasury" bond portfolio, said Terry J. Siman, who heads the Philadelphia office of $22 billion-asset, California-based United Capital. "But, honestly, the delta [interest-rate spread] that we are talking about is nominal. It's not all that meaningful in an overall portfolio. The notion that robo-advisory clients are being cookie-cuttered — while true — that's what people should expect from an automated service," along with low fees. "That's a fair trade."

In the end, bond preferences are also a question of strategy; for example, more-volatile taxable bonds are in vogue among advisers when prices are rising, says Matt Fabian, partner at Connecticut-based Money Market Analytics. "Are you looking to provide total return — coupon income plus capital gains — or just after-tax income? Most brokers these days prefer the latter, since the price direction of, really, everything has become so uncertain."