Why a California Retiree Holding BND Is Paying State Tax This Muni ETF Would Skip
California retirees comparing bond ETFs by headline yield alone could be leaving meaningful income on the table, and the culprit hides in plain sight inside a perfectly ordinary tax bill.
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By assets under management (AUM), the Vanguard Total Bond Market ETF (BND) is the biggest bond ETF in the world with $163 billion. I’ve got plenty of good things to say about it. You get a respectable 4.84% 30-day SEC yield with monthly distributions, a rock-bottom 0.03% expense ratio, and a diversified portfolio of more than 11,000 short-, intermediate-, and long-term Treasuries, mortgage-backed securities, and investment-grade corporate bonds.
One area where BND tends to fall short, however, is tax efficiency. Vanguard’s after-tax return data illustrates the potential drag. Over the trailing one-year period, BND returned 3.69% before taxes but just 2.04% after taxes on distributions. That’s something I think retirees can easily gloss over when comparing bond ETFs based solely on their headline yields.
Consider the iShares California Muni Bond ETF (CMF). Its 3.52% 30-day SEC yield looks substantially lower than BND’s 4.84%. But for a California resident investing through a taxable brokerage account, that’s not necessarily the comparison that matters. What you keep after taxes can be more important than what the ETF initially distributes.
Why Aggregate Bond ETFs Can Be Tax Inefficient
Most aggregate bond ETFs hold several types of fixed income, and each can receive different tax treatment. Interest from corporate bonds is generally taxable as ordinary income at the federal level and can also be subject to state income taxes. Treasury interest receives an important break because it’s generally exempt from state and local income taxes, but it remains federally taxable. Mortgage-backed securities add another source of taxable income to an aggregate portfolio.
BND mixes all of these together. That’s useful for diversification, but it doesn’t give a high-income California retiree the cleanest possible tax profile in a taxable account. CMF takes a different approach. It invests in municipal bonds issued primarily by California state and local governments and related entities. Its 3.52% 30-day SEC yield is generally exempt from federal income taxes and, for California residents, California state and local personal income taxes as well.
That second exemption can be particularly valuable in California because the state has one of the highest marginal individual income tax rates in the country. For a retiree in a high federal and California tax bracket, comparing CMF’s 3.52% directly with BND’s 4.84% therefore understates the value of the municipal income.
There is a trade-off. A single-state municipal ETF concentrates its exposure geographically, whereas BND spreads its holdings across the entire U.S. investment-grade bond market. CMF therefore makes the most sense when the California tax advantage is sufficiently valuable to compensate for giving up some geographic diversification.
How Much Could You Actually Earn?
CMF charges a 0.08% expense ratio, and its current 30-day SEC yield is 3.52%. For a California investor in a high tax bracket, however, the more informative number is the tax-equivalent yield. Tax-equivalent yield estimates how much a taxable investment would need to yield for an investor to keep the same amount of income after taxes. In other words, it puts taxable and tax-exempt bonds on something closer to an apples-to-apples basis.
Because CMF is a California-specific municipal fund, iShares calculates its tax-equivalent yield using the highest federal individual income tax rate and highest California individual income tax rate. On that basis, CMF currently has an estimated tax-equivalent yield of 7.68%. That’s a very different proposition from the headline 3.52%.
For a California investor subject to those highest marginal rates, a comparable taxable investment would need to yield approximately 7.68% to leave the same amount of income after the assumed taxes. Getting a taxable bond yield in that neighborhood would typically require accepting considerably more credit risk, potentially into high-yield, or junk, bonds. CMF isn’t taking anything close to that degree of credit risk. Approximately 82% of its portfolio is rated AA, giving investors predominantly high-quality municipal exposure.
Of course, the 7.68% figure doesn’t apply to everyone. Tax-equivalent yield depends on your actual marginal federal and state tax rates. A retiree in a lower bracket would have a lower personal tax-equivalent yield, while someone holding bonds inside an IRA wouldn’t receive the same benefit from choosing federally tax-exempt municipal income in the first place.
But that’s exactly why I’d look beyond the headline SEC yield when choosing bonds for a taxable retirement portfolio. BND remains an excellent low-cost core bond ETF. For the right California retiree, however, CMF’s lower nominal yield could translate into considerably more spendable income after taxes.
Contact [email protected] for any questions or corrections.
Tony Dong is the founder of ETF Portfolio Blueprint. He also serves as Lead ETF Analyst for ETF Central, a partnership between Trackinsight and the NYSE.
Tony’s work focuses on ETF strategy, portfolio construction, and risk management, with an emphasis on making complex investment concepts accessible to everyday investors. His insights and analysis have also appeared in U.S. News & World Report, Kiplinger, MoneySense, and The Motley Fool.
Tony holds a Master of Science degree in enterprise risk management from Columbia University and the Certified ETF Advisor (CETF) designation from The ETF Institute.
