Bond fund returns and asset location explainer

Your first point caught my attention. Bonds don't appreciate. Bond funds might appreciate or depreciate.

To me there's a significant difference investing in bonds vs. bond funds. With bonds you more or less know you will get your initial investment back if you hold for the duration of the bond, and you know the rate you are getting for that whole time. With a bond fund you generally have neither of those (although there are some options such as fixed maturity bond funds that behave more like individual bonds).

For me, bonds are only another bucket, and I only have short-term treasuries in that bucket. I have four years of income in high yield cash, and one year of income in short-term treasuries, a mix of inflation and non-inflation adjusted. That's enough to allow me to sleep at night without ever caring what the market is doing. I know in the worst case market scenario I can go five years without ever having to sell a stock fund. I only use the bonds to get a little more yield than the high yield savings, and I stick to short-term so I don't have to worry as much about where interest rates are going.

I'd take a hard look at mid to long-term bonds and how and when they've tanked. I use bonds similar to cash, so I don't have to sell stocks at a bad time. That's why I stick to short-term treasuries. I don't want corporate bonds or long-term treasuries that could drop a lot at the same time as stocks, in certain scenarios.

This is not advice, just an example of how I'm using bonds to meet my needs.

Yes, your understanding of bond yield and asset location is correct. Bonds throw off ordinary income which is taxed just like wages and bank interest—at marginal tax rates. If you hold bonds in your taxable account, you'll pay tax on that income each year at marginal tax rates. To defer paying this tax, you can hold large cash positions in a tax-deferred account where you only ever pay tax when money is distributed out of the account.

I mention large cash positions because worrying about paying a small amount of tax is letting the tax tail wag the dog. Don't worry about holding $20K in cash in a brokerage account ($176 tax at 4% yield and 22% tax bracket), but if you intend to hold $200K in cash ($1,760 tax at 4% yield and 22% tax bracket), then you may want to start thinking about tax avoidance strategies like moving that cash into a tax-deferred account.

Some nuances. The dividends thrown off by US securities are fully taxed at the federal level but are exempt from SALT in most states. As an example, I hold some of my brokerage account cash in money-market fund FDLXX because 97% of its holdings are US government securities and so what dividends it throws off are 97% exempt from tax in my state. Also, as Westie mentioned, in most cases, municipal bonds aren't taxed at either the federal or state level.

The discussion Westie referenced that describes how to execute an asset swap is here. TLDR is below or here's a short video from Justin at Risk Parity Chronicles that walks through the steps.

The way an asset swap works between a tax-deferred account and a taxable account is you sell shares of something in the taxable account—let's say $5K worth of VTI—and withdraw that $5K to spend. Now in your tax-deferred account, you use the cash that's there to buy $5K worth of VTI. You've accessed the $5K cash you need to spend without changing your overall asset allocation across the portfolio.

To compare a TIPS fund with an individual bond to see which has the better yield, you can compare the TIPS' real yield with the bond's nominal yield. ICPI reports a real yield of 2.83%. An I-Bond for example currently has a nominal yield of 4.26%.

I agree with Joe—if you're concerned about maximizing yield on cash, you're holding too much cash and should have a rethink. Here are some great resources to learn more if you're interested.

• ChooseFI Episode 194: The Role of Bonds in a Portfolio
• Risk Parity Radio Episode 292: TIPS, Dogs and Data
• Tax Planning To and Through Early Retirement by @Cody Garrett, CFP®and "FI Tax Guy" Sean Mullaney. I have this book and it's excellent.

For long term cash reserves (which you should have relatively few of in your total portfolio) I'm currently looking into muni bond funds for tax optimization.

But also yes, say you need $50k of cash-like assets. You can put $50k in bonds in your 401k and $50k in stocks in your taxable brokerage, to preserve your overall allocation but in tax efficient spaces. If you need to access say $10k in cash, you sell $10k of stock in your brokerage, sell $10k of bonds in your 401k, and buy $10k of stock in your 401k. @BostonFI had a great way of explaining this in another thread I made about muni bonds.

Note though that your brokerage account must be big enough to do this. If your stocks go down in value when you need the cash, you might not have enough available to access.

Holding enough cash that a 1-2% better returns means you are holding too much cash.

Cash should be emergency fund and anything you’ll spend in 1-2 yrs. Brokerage money market is typically the easiest and close enough. If you’re in a real high tax bracket or state tax then look into muni or boxx. But don’t go chasing returns on cash.

If looking to balance volatility look into risk parity approach even if in accumulation.

lastly there are many kinds of bonds. Check out the choose FI episode on types of bonds with Frank Vazquez to learn.