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