Tax-Exempt Funds Yield a Surprise

It's amazing what you can find when you pay attention to detail. For instance, you might 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 30 to 35 percent less than 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 25 percent more than the average Treasury fund: 2.50 percent to 2.00 percent. 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.)

Why are tax-frees paying more than Treasurys? I'm glad you asked. It's a reflection of the fear gripping financial markets. Large investors are fleeing to safe-haven Treasurys, driving up their prices and thus decreasing 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. Instead of raiding the refrigerator, I went for the less-unhealthy option of looking at my portfolio. 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 percent and 2.78 percent, respectively.) 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 cuts. But after a while, things reverted to normal, with Treasury yields exceeding tax-exempt ones.

Christopher W. 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.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com.