How To Collect High Yields… And Beat The Tax Man
Have you ever been stuck in traffic, anxiously waiting for the next exit to take so you can find another way to your destination? I’ll admit, I’ve always been impatient waiting in traffic. I’ll drive miles out of my way, take every back road I know, just to avoid it…
But one day I found myself stuck in traffic and noticed a peculiar sign. It said something about the construction that was going on — the very thing that was hampering my commute. It said it was being funded by a local bond.
This was back when I was in high school, so bonds were an unfamiliar thing. But when I began my investment career, I soon realized that I could actually invest in the very bonds that were funding my headache of a commute. I was ecstatic. After all, if you can’t beat ’em, might as well make money off them…
You see, these types of bonds have a name — general obligation bonds — a type of municipal bond (or “muni” for short). These bonds are used for everything from funding road construction to building schools, bridges, water infrastructure and other public buildings.
As I became more familiar with municipal bonds, I quickly became a fan. In fact, in my experience, muni-bonds are one of the safest ways for investors to earn income in today’s market — while also beating the tax man. (More on that in a moment.)
What Are Muni Bonds? And How To Invest
Now before I go any further, I need to address something. You may have seen headlines over the past few years about cities like Detroit or Stockton, California having to file for bankruptcy. And you might think that since the finances of some local and state governments have been tight since the Great Recession or the Covid-19 pandemic, the prospect of investing in muni-bonds may not be for you.
Don’t let that scare you. After all, if things get tight with finances, then the local government can simply raise taxes to help cover payments. It’s only in rare cases like Detroit, where the politicians used their last cards (even the ones tucked up their own corrupt sleeves) and bankruptcy became the only option.
The reality is that all investment-grade municipal bonds (those ranging in grade from “A” to “AAA”) have a default rate of only 0.017% over the past 40 years, according to Forbes. That makes muni-bonds one of the safest income investments around.
And to further mitigate risk, one of the best ways to own muni-bonds is through an investment known as a closed-end fund.
This is important. Unlike its more well-known sibling, the mutual fund, a closed-end fund only sells a fixed number of shares, and those shares trade openly on an exchange. And there are several well-run closed-end funds that own portfolios of muni-bonds. So in the event a city defaults on its bond payments (or worse, has to file for bankruptcy), it has a minimal impact on the overall portfolio.
What’s more, sometimes the shares of closed-end funds trade for more or for less than the underlying assets in the fund, also known as the fund’s net asset value (NAV). When you can buy a closed-end fund selling at a discount to its NAV, this is the easiest and clearest way to become a value investor. (Websites like Morningstar.com provide this information for you.)
For example, if a closed-end fund is selling for $8 a share, but the fund has a NAV of $10, you’re essentially buying $10 of assets for a 20% discount.
This is like giving someone eight dollars and them giving you $10 back.
When you can find a closed-end fund that invests in municipal bonds and is selling at a discount, it’s nearly a no-brainer investment.
Now don’t get me wrong, just like stocks, bonds, mutual funds or ETFs, not all closed-end muni bond funds are created equal. Taking a look at how the fund historically trades in relation to its NAV is important. So is looking at how and where the fund is invested, as well as the fund’s expenses, leverage and management.
The Tax Advantage
But not only do these securities offer safe, secure yields to investors, they also offer tax advantages that other bonds — namely corporate bonds — don’t.
You see, in order to ensure demand for the bonds that will fund a municipality’s projects, Uncle Sam is willing to not tax you on this investment. So are many state and local governments tax income.
Take, for example the Invesco Value Muni Income Fund (NYSE: IIM). This is a muni fund that’s been a pillar of our premium income newsletter, The Daily Paycheck, since December 2009.
This fund’s portfolio consists of bonds issued to build hospitals, toll roads, roads, and bridges in states throughout Texas, California, Illinois, Florida, and New York.
IIM currently offers investors a 4.8% yield. That’s nice, but on a tax-equivalent basis it’s much better. How much depends on your tax bracket. The table below shows the tax equivalent yield that a fully taxable investment (like a corporate bond) must yield in order to equal our muni bond yield:
So let’s say invest in IIM today. And let’s assume you fall in the 35% tax bracket. You’d have to find a stock, bond, or ETF offering a close to an 8% yield to get the same amount of income as IIM’s tax-free 4.8%.
And in today’s Fed-driven low-interest rate world, I’d challenge any investor to find an investment yielding 8% that’s as safe as IIM.
Action To Take
Now, keep in mind that you’re not probably not going to blow the cover off the ball with IIM. This is a stable fund that’s best suited for the portion of your portfolio devoted to income.
Still, muni bond funds offer yield-hungry investors a great opportunity to invest in a safe fixed-income investment in any environment. Just because this low-interest rate environment has pushed the yields down on many stocks and bonds, it doesn’t mean investors should go “yield chasing.” This is a great way to lose a lot of money. There are still plenty of investments like muni bonds that offer safe, reliable dividends.
Now, I should mention that my colleague Nathan Slaughter first turned me on to IIM a few years ago. And if you’re looking for some guidance on where to find more income picks like this, then I highly recommend checking out his advisory, High-Yield Investing.
To gain access to Nathan’s latest research, including the names and ticker symbols of some of his favorite dividend-paying stocks, go here now.