Tax Exempt Portfolio How to Gain Compound Dividends and Beat the Stock Market

Chip Evans, PH.D & Dziko Thunde

We’ve been studying and trading the stock market, bonds and stock options for over 40 years, and our website www.bluechipoptions.com specializes in educating the stock trader. Part of what we teach is using Fear and Greed and Supply and Demand and how to trade, and more, how to understand yourself.

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This is written in May 2015 and the market has seen the following returns over the past 52 weeks, not including any dividends paid.

We know that strong returns, such as the market has shown this past year, are not consistent, and also work with clients that wish

good returns that do not have tax consequences for selling, such as in non-retirement or 401K folios. Thus, we invest prudently in

all accounts and look for consistent and safe growth, and try to avoid “bubble” stocks.

We buy dividend stocks, the old formula, and look for any stock that has paid 3.5% to 12% dividend for at least 12 years or more,

and we buy them equal weighted average in a folio. We then hold and use a 25% trailing stop loss on our folio, OR we continue to

buy on any downturns, thusly lower our averaged cost while the dividend stays the same. Compounding is the key. Below is an

illustration of a comparison of an investment of $20,000 into a portfolio made up of Vanguard’s VWAHX and VWITX, compounded

for 4 ¼ years. Note, this portfolio shown below is for non-retirement investing and is federally tax exempt. This is where we keep

“safe money”, earning more than in a money market fund, or short term Certificate of Deposit.

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The table below shows what would happen if an investor starts with an initial investment of $20,000 into a portfolio made up of

Vanguards VWAHX and VWITX and then he adds $2,500 to VWAHX every year for 4 years. If we calculate the total yield per $10,000

invested, $20,000 above gives us $2,803.50 per $10,000 invested while $30,000 in table below gives us $2,229.67 per $10,000

invested in the 4 ¼ years.

Equal weighted average is the weighting assigned to each component of the average. For example, an investor wants to invest

$25,000 into a portfolio of five bonds with equal weighted average. This will mean that they will have to invest $5,000 in bond. This

example can be illustrated as follows:

The total investment of $25,000 into 5 bonds averages $5,000, which is equally weighted at 20% to spread the

risk of the investment.

If trading in a 401K, SEP or IRA, the concept of dividend stocks compounding is even more compelling, but not using TAX EXEMPT

folios or Treasuries.

But what if you were paying high income taxes, say the 28% bracket, and had the earning of stocks be far less than the % increase

overall, because of the tax burden.

Here’s what the returns would be for the same indices above, if the same conditions occurred.

We think simple. For some investors, the buy and hold theory of old has failed, as they expect high returns. In reality, a return of 10

to 12% in the stock market is doing great, and only those willing to take much higher risk for what “great returns” often get taxed

down to far less.

For the prudent trader looking for safety, low expense ratio, and “no work” we have created a simple folio of Vanguard bond funds.

You simply buy and hold and reinvest on any downside, or use a trailing stop loss if even more prudent.

Here is what we use, and why.

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Vanguard High-Yield Tax-Exempt VWAHX

The fund focuses on generating income with a stake in mid- and low-quality muni bonds that is heftier than what is found in the

typical intermediate-term muni-bond fund, but still takes on a much lower level of credit risk than the average fund in Morningstar's

high-yield muni category. And with duration of 6.6 years, its interest-rate risk is higher than the muni intermediate median but lower

than the high-yield muni median.

As with any Vanguard fund, the management team led by Mathew M. Kiselak, rides its low-cost advantage and largely avoids riskier

pockets of the municipal market, including tobacco bonds and debt from the troubled Puerto Rico territory. Instead it prefers such

stable cash flow sectors as transportation and health-care bonds. Recently, it has found opportunities in toll road bonds, slightly

increasing exposure there while lightening up on health care where uncertainty regarding state Medicare payments has caused

concerns.

The fund has performed as expected over the long term considering its risk profile. Its 5.6% annualized return since Kiselak began

managing the fund in 2010 through August 2014 beats the muni intermediate category average but lags the high-yield muni average,

which is higher risk.

Vanguard Interm-Term Tx-Ex Inv VWITX

An important factor to bear in mind about these funds is their low fees. Since Vanguard's muni team keeps the fund on an even keel,

its low expenses are a powerful advantage. For instance, the fund's 10-year annualized return before expenses of 4.6% for its

Admiral Share class ranks in the peer group's bottom half, but its net-of-expenses return ranks in the top 15%.

The fund has also provided a smoother ride than most of its peers during the past decade by offering better downside protection.

For example, in 2008, the fund was barely in the red and ranked in the top third of the category while most of its peers had bigger

losses. Manager James D'Arcy took charge of this fund, Vanguard's largest muni fund, in June 2013 after managing the firm's

California muni offerings for a couple of years.

The fund's slim 0.20% expense ratio is its key selling point. This makes it the third cheapest of the intermediate-muni category and

puts it among the cheapest of any muni fund across category or vehicle (along with the rest of Vanguard's lineup). Moreover, those

investing $50,000 or more in the fund's Admiral Share class see the price drop down to 0.12%.

Growth

Growth of $20,000 invested in VWAHX ($10,000) and VWITX ($10,000)

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The chart above shows the growth of a $20,000 portfolio over a 4 ¼ year period.

The chart below shows the performance of the two Vanguard bonds in the portfolio in comparison to Barclay Muni

bonds and other bonds in their category from 2010 to 2014.

The three charts below shows the growth of the two bonds in the portfolio. The first one shows that VWAHX has a

growth rate of 2.67% in a 10-year period while VWITX shows a growth rate of 4.37% in the same period. The second

one shows a growth rate of 6.60% for VWAHX and 3.91% for VWIHX over a period of 5 years. The last chart shows a

VWAHX growth rate of 0.27% in 3 years and VWITX negative growth rate of -1.47%. Remember, growth rate does

not influence the dividend yield.

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Costs and Expenses

These Vanguard funds have very low operating costs. Total cost projections and other fees that an investor can expect to incur are

listed below.

Total Cost Projections

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Tax and Taxation

Interest income that is sheltered from federal taxation and possibly state and local taxes as well, has always been the main

attraction of municipal bonds. However, tax-advantaged bonds generally offer a lower coupon rate than taxable bonds of similar

maturity, such as government bonds.

While interest earned on municipal bonds is generally exempt from federal income tax, exemption of the interest from state income

taxes is not uniform. The investor needs to become familiar with the tax-exemption rules of their own state or the tax-exempt status

of other states’ bonds, if they want to take state and local taxes into consideration.

How to compare yields of bonds that receive different tax treatments

A relatively simple formula can help the investor put the yields on an equal footing.

Marginal Tax Rate

The first factor in the equation is Marginal Tax Rate.

Marginal Tax Rate is the percentage tax rate that one pays on their last dollar of taxable income, it is typically higher than or equal to

average tax rate. If they are in the higher tax brackets and subject to phase-out rules that reduce itemized deductions and personal

exemptions, their real marginal rate may be a percentage or two higher than the stated percentage bracket.

While interest earned on municipal bonds is generally exempt from federal income tax, exemption of the interest from state income

taxes is not uniform. One needs to become familiar with the tax-exemption rules of their own state, particularly the tax-exempt

status of others states’ bonds, if they want to take state and local taxes into consideration.

They have to keep in mind that, although interest income may be exempt from federal, state, and/or local taxes, capital gains and

losses are generally taxable at all levels.

Taxable Equivalent Yields

Assuming that the tax-exempt and fully taxable investment alternatives have similar maturities, then a simple calculation would give

the taxable equivalent yield of the tax-exempt bond:

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When using this formula to obtain the taxable-equivalent yield, one should convert percentages to decimals. For example, if they are

in the 35% marginal federal tax bracket (0.35 in decimal form) and they are considering the purchase of a municipal bond with a

3.33% (0.033 in decimal form) yield that is exempt from federal taxes, their calculation looks like this:

This tells you that in your tax bracket (35%), a municipal bond yield of 3.33% is equivalent to a taxable bond that has a yield of

5.08%.

If you were in the 15% tax bracket, on the other hand, the same formula would result in a tax-equivalent yield of 3.88%. This

changes the picture considerably.

You can use the same formula to determine whether an in-state bond, on which you pay no state tax, would net you more than an

out-of-state bond on which you would have to pay state taxes. For example, if your state tax is 5%, add that amount to your federal

tax (35% in the preceding example) and substitute the resulting number (40%) in the above formula. And you can use it to compare

yields on municipal bond mutual funds and exchange-traded funds with similar maturity taxable funds.

The table below provides the taxable equivalent yields of tax-exempt yields ranging for Federal income tax brackets of 22%, 28%

and 35%.

The logic from Taxable equivalent yield table is that an investor in the 28% tax bracket who invests in taxable bonds for 5 years has

to earn 13.71% to be on a par with the one that invests in tax-exempt bonds for the same period and earns 9.87%.

Tax-Exempt versus Taxable Bonds

An investor has $20,000 and is debating whether he should invest in tax-exempt bonds or a series of EWA (Equal Weight Average)

Treasuries that has a return of roughly 2.50%. Looking at the first section of the table (highlighted in gray) and comparing the total

returns with any of the three tax brackets reveal that the investor is taking more risk for low returns if they choose to invest in EWA

Treasuries.

The Taxable Equivalent Yield table can be used in deciding whether to invest in taxable bonds or tax exempt bonds by calculating

and comparing tax-exempt yields with taxable equivalent yields.

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Risk and Return Ratings of Portfolio Bonds

Blackrock’s MDNLX

BlackRock National Municipal Fund is an open-end fund incorporated in the USA. The Fund seeks a high level of income exempt from

Federal income taxes. The fund invests in municipal bonds in any rating category or unrated municipal bonds. The Fund targets and

invests in municipal bonds that have a maturity of five years or longer.

Note: Risk exists in owning any stock or bond, but higher grade Tax Exempt funds show a lower risk overall because of compounding

and re-investing at lower prices on any downturn. The folio managers to keep the risk level lower always adjust Bond funds of this

caliber.

Performance

Below is a comparison of the performance of MDNLX with our portfolio that is made up of VWAHX AND VWITX over a ten-year

period

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Costs and Fees

There are costs associated with running mutual funds which may include shareholder transaction costs, investment advisory feeds

and marketing and distribution expenses which are incurred by the company and they are passed on to investors various ways. Fees

are low compared to funds in the same category. Below are fees and cost projections for MDNLX.

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These figures show how much an investor would expect to pay in expenses-sales charges and fees assuming a $10,000 investment

that grows by 5 percent per year with redemption at the end of each time period.

Vanguard can be bought through www.folioinvesting.com for a fee of $290 per year for unlimited trades. Thus, one can trade

hundreds of stocks without paying commission but a flat rate of $290.00 per year. Vanguard can also be bought directly from

Vanguard, where there is no fee for buying these funds.

Fidelity owns BlackRock, MDLNX, and they charge 4.25% initial sales fees. This means that if an investment of $10,000 would cost

$475.00 just to invest. They then charge a higher expense ratio than Vanguard at 0.72% versus Vanguard’s lower fee of 0.20%.

Fidelity, however, charges $75.00 to invest in Vanguard. An investor should consider all the fees and expenses levied on the

investment, the lower its value. If Blackrock is bought through Fidelity they waive the upfront load fee of 4.25% and charge no

commission for any further investments.

Summary

Investing in a Treasury is only risky if one wishes it to increase in value in addition to yield. One is still guaranteed the yield

throughout the life of the Treasury Bond.

Our work on Tax Exempt Bonds was done to show three things:

1. These are only valuable investments in a taxable account, not in an IRA, 401K, or retirement account.

2. The risk to a Tax Exempt Portfolio is minimal and for those wishing to hold cash in money market fund, it earns less, and is

not FDIC insured.

3. Compounding is magic with any dividend yielding stock or fund, if the expense ratio is low, and if the trader reinvests even

if the stock/fund drops or increases in price.

Buying stocks that have shown a dividend of over 3 to 4% consistently for 12.5 years or more and many “dog” stocks have

consistently paid out 5 to 6% in dividends for 12.5 to 25 years can use the same methodology, for a prudent retirement portfolio.

Using the same methodology, money can multiply by re-investing all dividends in the stock again even if the stock drops or increases

in price. If the stock drops 25% but continues to pay a 5% or higher dividend the investor is guaranteed, from historical data), to at

least earn the dividend. By not using a stop loss, or using one that is a trailing stop loss of 35% or higher the trader can “buy low” on

the stock, dollar cost average with their other buys and the compounded dividend remains the same, or increases, and the stock is

dollar cost averaged to a lower buy price, thus building a greater overall price increase and yield if the stock goes up.

We see dividends two ways:

1. To pay out to keep investors with the company

2. To “bribe” by offering a dividend or yield to attract new investors. Bribery here is not bad, but simply put, exactly what

companies that pay dividends do; they entice to buy and hold by paying back a “rebate”.

At www.bluechipoptions.com we provide a financial educational trading program and systems for cash derivative options (Dow,

S&P500, S&P100, and others) and for stock options, and stocks, ETF’s, mutual funds and bonds.

To learn more about the authors:

Chip Evans, PH.D. - https://www.linkedin.com/in/evanschip

Dziko Thunde - https://www.linkedin.com/in/dzikothunde