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Total bonds aren’t the only option for retirees. Moving beyond one-size-fits-all bond funds can help improve income without jumping straight into high-risk strategies.
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VCIT mediates between security and yield. It focuses on intermediate-term, investment-grade corporate bonds, offering high income while keeping risk relatively moderate.
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Taxes can quietly erode your returns. The monthly income is attractive, but keeping VCIT in a taxable account can significantly reduce your after-tax yield.
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This is called habit. Call it decades of conventional wisdom pushed by financial advisors and DIY investors. After all, many retirees default to accumulating bond funds.
It doesn’t really matter if it’s from Vanguard, iShares, State Street, or Invesco. The structure is generally the same. You get a comprehensive portfolio of thousands of US Treasuries, mortgage-backed securities, and investment-grade corporate bonds in short-, intermediate- and long-term maturities, for an average duration.
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This is essentially the fixed income equivalent of total US stock market purchases. And to be fair, that approach works, and it’s affordable too. But it’s not the only way to build a bond allocation.
At a certain point, once you’ve got hundreds or thousands of bonds, the diversification benefit starts to diminish. Especially if your primary goal is income rather than pure capital preservation. That’s where overall bond funds can fall short.
What happens next is that retirement investors jump directly from overall bonds to more risky income sources such as preferred stocks, dividend stocks, or covered call strategies.
But there is a middle ground, and in that place is an overlooked option Vanguard Intermediate Term Corporate Bond ETF (NASDAQ: VCIT). Here’s why retirees shouldn’t ignore this underrated Vanguard Monthly Income Bond ETF.
VCIT is a passive, benchmark-tracking ETF, typical of Vanguard. There is no active bond selection here. The fund aims to track only the Bloomberg US 5-10 year corporate bond index. This means it often targets what is known as the “belly” of the yield curve.
In plain terms, it is a middle ground between short-term and long-term bonds. Short-term bonds have lower yields but lower interest rate risk. Long-term bonds offer higher yields but are more sensitive to rate changes. Intermediate bonds aim to strike a balance between the two. You can think of it as a Goldilocks area.
VCIT currently has an average tenure of approximately six years. This gives it moderate interest rate sensitivity. In a rising rate environment like 2022, it doesn’t fall as much as long-term bond ETFs. But when rates fall, it’s still long enough to benefit from price appreciation.
On the credit side, the portfolio is firmly investment grade. It has more than 2,200 bonds, with about 95% rated A or BBB. These are companies that are considered financially stable with a relatively low probability of default. There is some exposure to AA and AAA-rated issuers, but those are less common because few corporations meet that standard.
So you’re taking on some credit risk but still staying in the high-quality segment of the market. Income is where things get interesting. As of March 31, VCIT offers a 5.06% 30-day SEC yield after accounting for its 0.03% expense ratio. That’s above the 4% threshold that most retirees aim for, at least before taxes.
VCIT doesn’t have many hidden surprises. In exchange for that 5.06% yield, you pick up some sensitivity to both interest rates and corporate credit conditions. But relative to many other bond ETFs, it still leans toward the conservative side. Vanguard rates it a 2 out of 5 on its risk scale.
The biggest problem is taxes. Each monthly distribution from the VCIT is taxed as ordinary income if held in a taxable account. This means it is subject to both federal and state taxes at your marginal rate. This can significantly reduce your payments.
Vanguard estimates that over the past three years, VCIT has delivered a 5.5% annualized total return before tax. After taxes on distributions, that drops to 3.69%. If you also factor in capital gains tax on the sale, it drops to 3.44%.
There is no real solution here. Corporate bond income is inherently tax inefficient. The most practical solution is to place the VCIT in a tax-advantaged account, such as a Roth IRA, where those distributions can be compounded without tax drag.
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