By Dr. Jim Dahle, WCI Founder

As an investor in a high tax bracket, I generally use municipal bonds when I am investing in nominal bonds in my taxable account. Municipal bonds are federal and sometimes also state tax-free. Likewise, when I have a need to hold cash (such as upcoming quarterly estimated tax payments or other short-term savings), I usually find that the best place to hold that cash is a municipal money market fund (MMF).

Over the years, however, there have been times when it made sense to use a taxable money market fund or even a savings account instead, and the only way for me to know was to check yields periodically (and do the math).

## Municipal Yield Math

The math is straightforward, of course. If the yield of the taxable MMF × (1-my federal tax bracket) > the yield of the municipal MMF, then I would choose the taxable MMF. If not, then I would choose the municipal MMF. After a while, you can mostly do it in your head. When the taxable yield is at least 50% higher than the municipal yield, you use taxable. It usually isn't higher, though, so most of the time I use the municipal MMF.

## High Municipal Volatility

Back in January 2023, I noticed this volatility was particularly high. Coincidentally, it happened right as we ran a blog post about money market funds. A reader called me out about it:

“I was trying to sort this out while working nights in the ED last night. I think I’m missing something; when you refer to the muni fund, you mean VMSXX? Vanguard shows a much lower yield (1.7%) and higher expense ratio for that fund. Even accounting for the 37% tax bracket, VMRXX would have a higher return?”

It turned out that the yield on my suggested investment in the post had dropped from 3.7% to 1.7% in just a few days.

My only response was:

“You’re not missing anything. The yield literally changed dramatically overnight. I see it now as 1.70% too. So now once more, it makes sense for you and I to move the money back to the Federal Money Market Fund (4.29%), because 4.29% × (1-37%) = 2.7% and 2.7% > 1.7%. Not my fault but very interesting stuff has been going on with very short-term muni bonds (the ones in MMFs) lately. Not sure why that is, as I’ve never seen that spread move so much so quickly as the last six months.”

But given this extreme yield volatility, I became curious and decided to try to find a better answer as to why and how those yields could be cut in half in just a day or two. I learned a lot about an investment I've been using for years.

The Nuts and Bolts of Investing

## The Priority of a Money Market Fund

MMF managers have different priorities than the manager of a syndication where your money is locked up for 5-10 years. That syndicator is trying to maximize your return. That's not the case for an MMF manager. Their priorities are:

1. Not breaking the buck (i.e. never losing principal)
2. Liquidity (being able to give back everybody's money very quickly if they want it)
3. Yield

That yield (which is typically the entire return for this investment) is a distant third priority. People don't invest in money market funds because they're trying to maximize their return. For them, the return OF their principal is far more important than the return ON their principal.

## What Do Municipal Money Market Funds Actually Own?

I always thought that municipal MMFs just owned muni bonds at the very end of their life (i.e. bonds with a maturity of less than one year). However, when you look under the hood, you will discover that the primary holding of a municipal MMF is an instrument called a VRDN, a Variable Rate Demand Note. That's also known as a VRDO, Variable Rate Demand Obligation. VRDNs are tax-exempt securities issued by municipalities to secure long-term financing (20-30 years) but at short-term interest rates. The yield on these instruments resets every 1-7 days, so they trade as municipal money market fund securities with a duration of zero.

Few individuals own these instruments (they have a \$100,000 minimum), but muni MMFs are full of them. My favored holding, the Vanguard Municipal MMF (VMSXX), has 879 instruments with an average duration of nine days. As near as I can tell, 96% of its money is in VRDNs. The rest of it is in municipal bonds of up to a one-year duration or just sitting in cash to make redemptions. The bottom line is that the yield on MMFs changes dramatically because of the supply and demand for these VRDNs.

The Mathematics of Investing: Talk Nerdy to Me

## Taxable MMF vs. Municipal MMF Yield Volatility

If you've never experienced this personally, the following charts (taken from some Bogleheads forum threads over the years) may come as somewhat of a surprise to you.

The green and blue lines are taxable MMFs. Look how steady their yields are. These yields are highly correlated to the interest rate set by the Fed—the Federal Funds Rate which determines the rate at which banks lend money to each other overnight. As that rate goes up, the taxable MMF yields rise and vice versa. By comparison, the orange and red lines (municipal MMFs yields) look like a drunken sailor careening around a moving ship. Sometimes the municipal yields are even HIGHER than the taxable yields—which, at first appearance, makes zero logical sense since the municipal MMFs have a huge tax advantage for most investors. This next chart is more typical:

This one is more complicated, but just look at the dark line (taxable MMF yield) and the brown line (muni MMF yield) below it. The muni yield is usually lower than the taxable yield but dramatically more volatile. Here's a more recent graph showing the same thing.

And we can even shrink it down to just a few volatile weeks before this post was first written. This chart was made by an investor using his own tax bracket to determine his taxable equivalent yields. It allowed him to see that, if only for a few days in this time frame, the muni MMF was the right fund for him.

And don't kid yourself that nobody is actually watching these yields. Note that these funds report a “seven-day equivalent yield,” so there is a lag of up to one week on reporting of the yield in the fund. But the cash that flows into and out of these funds is highly affected by this reported seven-day equivalent yield. Take a look at the rightmost column of this chart of daily cash flows for the Vanguard MMF.

From October 28, 2022, until November 8, money was going into the fund. Then, from November 9 to December 16, money was coming out. From December 19 to January 13, money was going in again. From January 17 to January 25, it was going back out. While it's hard to tell what was the chicken and what was the egg (is demand lowering yield or is low yield lowering demand?), it is clear that there is a lot of money shuffling back and forth here relatively systematically.

## Why Are Muni MMF Yields So Volatile?

So, if taxable MMFs march in lockstep with Fed actions, why do municipal MMFs really only take Fed activity as a suggestion? Again, the basic rule of economics: supply and demand. The Schwab MMF team put out a paper a year ago that explains a lot of it.

There are three interesting things on this chart. The first is the impressive but very brief spike in yields as the pandemic began that had nothing to do with Fed activity. The second is the rapid drop in yields and long flatlining in correlation with the Fed cutting short-term interest rates to zero in response to the pandemic. But the real lesson was that the yields were so volatile prior to that. Schwab blames supply and demand. These forces act both in long-term cycles (fewer of these investments are available at times, and the amount of money in muni MMFs is obviously highly variable) and in day-to-day fluctuations (muni bond funds/ETFs, separately managed muni bond accounts, and individual investors like you and I sometimes bounce in and out of them chasing yields). When rates get really high, taxable MMFs and their usual investors even get in on the action by buying VRDNs.

If you look at the fluctuations over the long term, you start to see a seasonality to them. Muni MMF rates are low in January and July and high in April and May. The January/July ebbs are due to a disproportionately high amount of muni bonds being issued with January 1 and July 1 interest payments. Those interest payments go into a muni MMF until they can be reinvested, lowering yields in early January and early July. In April, high tax bracket investors have their tax payments (April quarterly estimated payments, payments due with the tax return, and often the entire state income tax payment) sitting in muni MMFs, building up as April 15 approaches. Then, they're all withdrawn on the same day. When that money is pulled out and sent to the Treasury, there is a sudden huge drop in demand for VRDNs and muni MMFs, spiking yields.

Changes in tax policy (such as changes to the tax brackets) can also cause sudden shifts in demand and supply for municipal securities of all types.

## The Bottom Line

If you want to make sure you are earning the best after-tax yields on your cash, you will need to compare yields, do the math, and possibly move money in response to them relatively frequently—perhaps as often as 5-10 times per year. January, April, and July are particular times to pay attention. Expect to move out of the muni MMF in December/early January, March/early April, and June/early July and back in to the muni MMF in February, May, and August.

Alternatively, if simplicity is your goal and it is worth giving up some yield, you can just use a taxable MMF or even split the difference and not bother checking. Any good MMF or high-yield savings account beats what most people are doing with their cash.

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What do you think? Do you use municipal MMFs? Is this added complexity to your investing life worth it? Why or why not? Comment below!