Allan Sloan FORTUNE
The Deal by Allan Sloan Full coverage
Last Updated: March 10, 2008: 7:58 AM EDT
Email | Print    Type Size  -  +

Math favors tax-free funds - for now

It shouldn't work this way, but it's true: Tax-exempt mutual funds are today yielding more than Treasury funds. Is it time to swap your portfolio?

By Allan Sloan, senior editor at large

(Fortune) -- It's amazing what you can find if you pay attention to detail. For instance, you would discover, as I did, that you can get a higher yield on a tax-exempt money market mutual fund than on a taxable Treasury fund.

Logic would suggest that this would never happen, because income on Treasury securities is subject to federal income tax, while income from tax-free securities is...duh...tax-free. Hence in normal times, tax-exempt money funds yield only about 65% to 70% as much as Treasury funds do.

But in late February and early March, Treasury fund yields began to fall below those of national tax-exempt funds - those that own securities from issuers in many states rather than from just one.

As of late last week, according to data from iMoneyNet, a money fund information firm, the average multi-state tax-exempt fund was yielding 125% of the average Treasury fund: 2.50% to 2.00%. The after-tax difference is even higher - much higher, in fact. This is despite the fact that income from Treasury funds is generally exempt from state and local income taxes, while most income from multi-state tax-exempt funds is subject to them. (In case you're wondering, that's because state and local taxes usually apply to income from tax-exempt securities issued outside the state in which you live.)

Here's the math. We'll assume you're in the 33% federal bracket, and your state and local taxes total 6%. The bottom line: You net 2.35% (that's 94% of 2.50%) on the tax-free fund, some 75% more than the 1.34% (67% of 2.00%) that you net on the Treasury fund. The numbers still work out nicely even if you're in lower brackets.

Why are tax-frees paying more than Treasury funds? I'm glad you asked. It's a reflection of the fear gripping financial markets. Large investors are fleeing to safe-haven Treasurys, which has driven up Treasury prices and has thus decreased their yield. (Yield, as you may recall from Investing 101, is a security's income divided by its price.) Meanwhile, fear and financial market freeze-ups have driven down the prices of tax-exempt securities. Hence, their yields have risen.

I stumbled on this inversion phenomenon during a bout of insomnia early Friday morning, because I decided that looking at my portfolio was less unhealthy than raiding the refrigerator. I was surprised to see my Vanguard tax-exempt money market fund yielding considerably more than my Vanguard Treasury money fund. (Most recent numbers: 3.22% to 2.78%.) I promptly transferred most of my Treasury fund balance to the tax-exempt fund.

BUT NOW, A WARNING.

There is some risk in doing this, because problematic securities keep popping up in parts of the tax-exempt universe. Don't transfer into a tax-exempt fund that owns anything even vaguely risky.

Given my tax bracket and the yield difference, I consider the tiny risk well worth taking. I've still got a majority of my investable assets in stocks, but given my age (63) and the fact that I've been a net seller of stocks since mid-2007, my money fund income matters to me.

Tax-exempt money fund yields were briefly above Treasury yields a few years ago, when yields on short-term Treasury securities were abnormally low because of Federal Reserve Board rate-cut moves. But after a while, things reverted to normal, with Treasury yields exceeding tax-exempt ones.

Christopher Alwine, Vanguard's head of municipal portfolio management, doesn't expect tax-exempt yields to stay above Treasury yields indefinitely this time, either. "We should expect to see volatility (in the tax exempt-Treasury yield ratio) over the next three to six months," he said, "then things will return to their normal condition."

If I were a big enough fish, I'd be out trolling for individual high-quality tax-exempt bonds, some of which seem to offer exceptional values. But buying these securities at a reasonable price - and buying enough different issues to diversify my holdings - seems beyond the reach of a small fry investor like me. So for now, I'll settle for swapping my Treasury money fund shares for tax-frees.

And I'll be paying more attention to money market fund yields than I usually do. This isn't a big-bucks kind of thing. But in a difficult and tricky market like this one, I can use all the breaks I can get. To top of page

Company Price Change % Change
Apple Inc 102.47 0.34 0.33%
Bank of America Corp... 16.06 -0.14 -0.87%
Facebook Inc 73.96 -0.67 -0.89%
Yahoo! Inc 38.36 0.18 0.47%
Pfizer Inc 29.50 0.02 0.05%
Data as of 11:45am ET
Index Last Change % Change
Dow 17,066.79 -55.22 -0.32%
Nasdaq 4,559.13 -10.49 -0.23%
S&P 500 1,995.91 -4.21 -0.21%
Treasuries 2.34 -0.02 -1.06%
Data as of 12:00pm ET
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.