The Tax Bind of Bond Funds

Should I worry about tax efficiency when it comes to my bond funds?

QUESTION: I was ready to invest in a total bond-market index fund until I read that it's only 70% tax-efficient. Is that enough of a reason to avoid this fund? What total bond-market funds are more tax worthy?

ANSWER:

Fund tracker Morningstar calculates tax efficiency by looking at the percentage of returns kept by mutual-fund shareholders in taxable accounts over, say, a three-year period. So your 70% tax-efficient index fund means investors held on to 70% of the return and paid 30% of those gains in taxes. And of course, the less you pay in taxes, the more you earn.

In the case of this particular fund, though, you're probably setting the tax-efficiency bar too high. That's because a broad-based bond fund gathers most of its return in the form of income from bonds, known as yield, rather than from price appreciation. And when it comes to interest on bonds, "there's nothing you can really do from a tax-efficiency standpoint to make that not be taxable income," says Joel Dickson, the Vanguard Group's tax-efficiency expert. (Funds that make most of their return from price appreciation, by contrast, can do a few things to minimize the tax hit, such as harvesting losses to offset gains, or keeping portfolio turnover to a minimum.)

So while it's true that this fund's 70% efficiency compares unfavorably to the 90.32% average for a tax-managed domestic equity fund, you should really benchmark your fund against its category. In this case, compare it with other taxable intermediate-term bond funds like those that track the Lehman Brothers Aggregate Bond index, which for the most part is made up of government, mortgage-backed and corporate bonds. The group averages a far worse 50.49% three-year tax efficiency, according to Morningstar. So your fund's 70% rate looks darn appealing.

Keep in mind, however, that tax efficiency focuses on past results -- how efficient a fund was -- and won't necessarily forecast a fund's ongoing performance. "Many funds that have had poor tax efficiency over the last three years might turn out to be very tax-efficient over the next three years," says Michael Chasnoff, a certified financial planner with Cincinnatti-based ACS Financial Advisors. "They may have paid out all their capital gains."

Many investors learned an expensive cap-gains lesson last year when mutual funds distributed a punishing $345 billion, way up from 1999's $238 billion in capital gains, according to the Investment Company Institute. (When a fund distributes capital gains that result from its manager's sale of appreciated securities, those gains are taxable to investors even if they haven't sold any shares.)

Chasnoff urges investors to do their homework by looking at a manager's history of cap-gains distributions over the past few years, by checking turnover (a measure of how a fund's holdings have changed), and by scouring fund materials, such as the prospectus, for references to a tax-sensitive investment strategy.

Once you cross over into municipal-bond funds, the rules change. Most gains from such funds are exempt from federal, and sometimes even state taxes. With this group, you should keep your tax-efficiency expectations high since such bonds typically yield less than their corporate brethren and make up some of the difference in after-tax returns. Look for three-year tax efficiency close to the average of 98.41% for municipal national intermediate-term bond funds.

So if you're interested in minimizing taxes with a bond fund, a muni fund may be a good choice, says Dickson, who recommends them for investors in the 31% tax bracket or higher. Or, you could place the total bond-market index fund in a tax-deferred account to protect yourself from annual tax payments. Either way, you've got the right message, Dickson says: "If you can control items that are under your control -- namely costs and taxes -- you have a leg up over the long run."

For more on taxes and mutual funds, see "The Taxing Side of Mutual Funds" in SmartMoney University.