Author Topic: High Yield Bond Fund as Emergency and transfer account  (Read 1107 times)

Tigger2

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High Yield Bond Fund as Emergency and transfer account
« on: January 18, 2019, 08:22:42 PM »
I have been using Vangaurds High Yield Tax Exempt Bond Fund VWALX as my emergency and transfer account.  I put all my excess money into it and then each month have automatic transfers to mutual funds.  I like the monthly dividend that is exempt of federal taxes.  Is there any thing wrong with this.  If so whats a better plan.

MustacheAndaHalf

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #1 on: January 18, 2019, 08:46:41 PM »
Take a peek at what happened in 2008 to high yield bonds.  If I recall correctly, they lost more than -33% of their value.  High yield bonds are not safe investments.  These bonds have the highest risk of default, which is why they're also called "junk bonds".

Conventionally an emergency fund is not part of your investments.  It might be in a high yield savings account, or a money market fund.

jacoavluha

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #2 on: January 19, 2019, 07:39:39 AM »
Agree w above. Also frequent trading policy will typically restrict any Buy or Exchange into the fund within 30 days after a Sell. For frequent moves in and out money market much better. Also as share price fluctuates youíre generating lots of small capital gains and losses transactions and could generate wash sales. Vanguard will track this so not a huge deal. But avoided with money market that maintains a $1.00 share price.

But for me biggest thing is risk. Prefer an E fund to be safer.

Andy R

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #3 on: January 19, 2019, 08:33:03 AM »
I also agree. The point of bonds is a relatively risk-free asset class, so don't see the point of junk bonds at all.

MrSpendy

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #4 on: January 19, 2019, 08:44:26 AM »
Setting aside the credit risk for a minute, the biggest problem with using this fund as an e-fund is the giant duration mismatch between the funds and their purpose.

According to the fundís website, the average maturity of the underlying bonds is 17 years. So you are lending to dicey municipal borrowers for 17 years for funds that you might need in 17 days. Over 40% of this fundís bonds mature in more than 20 years.

An additional issue is that the bonds have a maturity of 17 years, but an average duration of 7 years. That tells me that a lot of the bonds are callable, meaning that the issuers can pay back the bonds earlier than maturity. This means that you will generally get hurt by rising rates, but not really benefit from declining rates (because the issuers will call the high cost bonds early). You can see this because the average coupon is 4.7% and the average yield is 3.8%. If the yield is lower than the coupon that is because the bonds trade above par. If you own a bond that is callable at some point in the future and it is above par, it will get called if rates stay the same or decline.

But if rates(or credit spreads) rise significantly, then that bond will drop below par and wonít get called, so the bond goes from trading like a five year bond (because it was trading to the short call) to a 25 year bond as it instead trades  to maturity. In other words, your duration risk increases at precisely the wrong time.

You can think of this as similar to a30 year mortgage. When you borrow with a mortgage you can prepay anytime without penalty, so you benefit when rates fall (via refinancing), but if rates rise you enjoy the low cost mortgage. This fund basically lends long term to less than creditworthy municipalities who can prepay if they become better credits or if it benefits them, but can extend (wait til maturity) if it benefits them. The shit credit municipalities hold the options and the lenders (this fund) is short the option.

In short, this may be appropriate for a high tax bracket person who understands the credit, duration, and call risk, but is highly unsuitable for a short term time horizon emergency fund.

There is no free lunch in the bond market!

The better  plan would be VWSUX to drastically lower duration and credit risk or just stick to money markets, t-bills etc and forget about reaching for tax advantaged  yield with the e-fund. Unless you have a truly massive e-fund, the incremental yield for the risk probably isnít a lot of money anyways

« Last Edit: January 19, 2019, 09:00:48 AM by MrSpendy »

Indexer

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #5 on: January 19, 2019, 09:28:09 AM »
While I agree with everyone else that you shouldn't use a high yield bond fund as an emergency fund, I will admit that the fund in question is very conservative compared to most high yield bond funds.

It was down about 10% in 2008, not 30%+.

For an emergency fund I would stick to money markets and short term bonds. If you want to stay tax free I would look at Vanguard Municipal Money Market Fund (VMSXX) yielding 1.35% and Vanguard Limited-Term Tax-Exempt Fund Investor Shares (VMLTX) at 1.99%.

You could even do a split.

MrSpendy

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #6 on: January 19, 2019, 11:06:01 AM »
While I agree with everyone else that you shouldn't use a high yield bond fund as an emergency fund, I will admit that the fund in question is very conservative compared to most high yield bond funds.

It was down about 10% in 2008, not 30%+.

For an emergency fund I would stick to money markets and short term bonds. If you want to stay tax free I would look at Vanguard Municipal Money Market Fund (VMSXX) yielding 1.35% and Vanguard Limited-Term Tax-Exempt Fund Investor Shares (VMLTX) at 1.99%.

You could even do a split.

On a ratings/ credit quality basis this fund does appear to be of significantly higher quality/ lower risk than the corporate high yield market. But it does have significantly more duration risk than corporate high yield which could suck if rates rise and municipal credit quality deteriorate at the same time .

 Itís a bit too much of a market prediction for most peopleís taste but I for one have a very negative view of the long term prospects of fringe municipal borrowers. I think Puerto Rico is just the beginning and Illinois, Connecticut, New Jersey, are coming next. Thatís perhaps overly alarmist, but just pointing out that muniís may not be as safe as they have been in the past and this is a he type of fund that would suffer if thatís the case.

EDIT: Illinois is about 10% of the fund (the highest concentration), New Jersey is about 6%. I wouldn't lend for 17-30+ years to those festering piles of insolvency and dysfunction to make 3.4% tax free.
https://www.mercatus.org/statefiscalrankings/newjersey
https://www.mercatus.org/statefiscalrankings/illinois
« Last Edit: January 19, 2019, 05:01:51 PM by MrSpendy »

Radagast

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #7 on: January 19, 2019, 10:34:05 PM »
I'm OK with it. I used it like that for a year, then sold it to meet an expense. Now I am chasing signup bonuses, but VWAHX is on my short list for the future. It is not "risk free", look at I-bonds, other short term treasury bonds, and FDIC for that.

In the past 20 years it had similar risk to an intermediate term corporate investment grade bond fund, but a little less correlated with the stock market. Not (very) scary or junky. It's price is higher relative to those other options now than when I bought it. Its tax adjusted yield used to be competitive with VGIT down to the 10% tax bracket, now it makes more sense for 22% and higher.

But keep in mind
There is no free lunch in the bond market!
which is why I don't believe in emergency funds. I want lunch. So VWAHX makes sense to me.

MustacheAndaHalf

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #8 on: January 20, 2019, 05:21:06 AM »
the fund in question is very conservative compared to most high yield bond funds.
It was down about 10% in 2008, not 30%+.
Interesting!  I missed that it was a tax-exempt junk bond fund, which means it invested in municipal bonds.  I agree the fund mentioned by OP only had a max drawdown of -11.5% (which is spread across 2007-2008).

For corporate junk bonds, portfolio visualizer shows a maximum drawdown of -29% (June 2007 - Nov 2008).  Compare that to the total bond market, which had a maximum drop of -4% during that same crisis.

MrSpendy

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #9 on: January 20, 2019, 08:42:28 AM »
I don't want to obnoxiously repeat points already made, but I just think this fund is a poor risk/reward.

Let's start with the reward:
The SEC yield of this bad boy is 3.4%, so that's our best estimate of what one would make over the duration of the fund if all goes smoothly.

At various tax rates this is a TEY of:

0%:    3.4%   20 basis points above the bond index, 100 bps above t-bills
24%:  4.5%    in between
32%:  5.0%    in between
37%:  5.4%    220 basis points above the bond index, about 300 bps above t-bills

So the reward is between 100-300 bps above the risk free rate for a hold period of the duration of the fund (this is of course an inexact approximation).

Now the risks:

Boat Loads of interest rate risks (weighted average maturity of 18 years).

Relatedly, loads of negative convexity. On account of the apparent gap between maturity and duration (the duration is a lot lower than one would expect given the maturity profile of the fund), this will be a long term bond fund when you don't want it to be and a an indermediate term fund when you don't want it to be.

The above points are indisputable and mathematical. The fund has a lot more downside to a rate move up than upside to a rate move down (that's what negative convexity is).

The more subjective is that why would one lend to New Jersey and Illinois to make 100-300 bps above t-bills. That's like lending to your indebted alcoholic uncle for nothing. Is that really adequate compensation? Look at Puerto Rico. General Obligations were constitutionally sacrosanct but that didn't stop Trump from calling for their wipeout, the government trying to declare the bonds invalid (see the post 2012 issueance argument about the 8% of 2035), etc. Bondholders of indebted governments are not those governments' priority, regardless of the rule of law. Pensioners and teachers unions are far more powerful and easy to empathize with then some "greedy institutional investors" or "wealthy yield pig retail holders of junk muni credit". The GO's have traded from 100 to 20 to 60. Other stuff like the island's utility have taken bigger haircuts.

This could be dismissed as overly pessimistic or a political argument, but I think it should be clear the bet that one is making when one is investing in this fund. One is saying "I want to make 1-3% more than the risk free rate to lend to loss making governments who cant pass a budget that are increasingly indebted and losing population. I expect these government to treat me well if/when SHTF". municipal governments can't print money like the federal one can. And they go bankrupt. and when they try to raise more money people just leave. Unlike the federal government, most people don't leave the US to avoid high property taxes or deteriorating services, but people do leave Detroit, Newark, and Chicago). Now there are plenty of healthy government issuers in this fund, but there's enough in there to make one a little scared.

I think in all likelihood, you won't impair your capital investing in this fund. You'll probably make AGG +/-  2 or 3% in a given year, but there are real risks, and not a ton of huge reward. When you take risks in equities and stuff goes well you make a lot of money. With this you'll make just a little bit more than the risk free alternative.

I am happy to be accused of being overly bearish or thinking i'm smarter than the bond market, but why concentrate one's capital in this narrow sliver of the bond market? This is like investing in Vanguard Energy or Tech instead of VTSAX. Long term bonds of lower credit quality municipal issuers is a small part of the market.

I think looking at the last crisis and thinking that represents a downside scenario is overly backward looking. The next crisis may not look like the last one and it may be driven by these type of bonds. One market prognosticator who called subprime (Meredith Whitney) said that muni defaults would be the next crisis. She's been wrong for 10 years! But maybe she was just early..I don't know, but I just want you to know the bet you're making. 

To be clear, the historical default rates of muni bonds is extremely low, suggesting that one will indeed realize that 1-3% above t-bills. But history isn't always necessarily the best guide.

EDIT:
This is more eloquent than my ramblings:
https://www.schwab.com/resource-center/insights/content/are-high-yield-municipal-bonds-high-yield-or-junk


EDIT II (responding to the below posts so as to not unnecessarily bump the thread)

That is all correct (but not as big an issue as implied), but itís prospectus requires VWAHX to invest more than 80% in investment grade municipal bonds.

That does indeed change my view of the credit risk, less so the duration risk.

I think we have provided enough info for the OP and anyone else to make an informed decision. In the paragraphs of my bloviating one can find the potential reasons for not doing it, and in your posts, one can find the reasons why one will probably be okay investing as such.




« Last Edit: January 21, 2019, 11:04:08 AM by MrSpendy »

Radagast

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Re: High Yield Bond Fund as Emergency and transfer account
« Reply #10 on: January 20, 2019, 04:12:50 PM »
That is all correct (but not as big an issue as implied), but itís prospectus requires VWAHX to invest more than 80% in investment grade municipal bonds. Usually it is about 85% investment grade with the rest split between known junk and unrated. So automatically more than 80% of criticism about generic junk munis is off base.

You can determine its effective duration by looking up the effective duration. Morning Star rates it in the middle box, with moderate interest rate risk and moderate credit risk.

It is an old fund so you can backtest it through both the rising rate and inflation crisis in 1978-1981 and the credit crisis of 2006-2009. I did and it wasnít that scary in either case. My biggest issue is that it has done freakishly well the past 20 years which might make people complacent. Also it does seem a little expensive compared to alternatives right now, though obviously I donít know what the price should be.