How To Protect Your Income From Out-Of-Control Government Spending

Last week, the Department of the Treasury announced something that I bet most people missed.

We passed another inauspicious milestone that most citizens (and investors) know is a problem yet seem to shrug off with each passing year.

The U.S. national debt passed $31 trillion for the first time ever.

As The New York Times points out, higher interest rates mean borrowing money will be even more costly. That means a higher national deficit as debt servicing costs eat up more of the budget, which means we will need to borrow even more.

Source: Statista

The staggering amount of our national debt is a big deal. (It’s also a bipartisan problem.) That’s been the case for decades. Spending has been growing faster ever since the financial crisis, and it suddenly took an even bigger jump when the pandemic struck. Governments around the world increased spending in the form of stimulus payments and other measures in an attempt to keep businesses afloat and provide relief to citizens.

You may be wondering what this has to do with the markets. I get it… I usually try to avoid political discussions. But sometimes, it’s unavoidable. That’s especially true with midterm elections right around the corner.

Politics intersects with investing all too often these days. But the folks in Washington can (and often do) exert their influence on everything from energy policy to infrastructure projects, military spending, foreign trade, and more.

Then you have stimulus packages… monetary policy… regulatory changes. Sometimes, the crossover between politics and the markets is inevitable.

It’s time to face reality. Unless something drastic and unexpected happens, the spending spree will likely continue. And since we can’t keep borrowing forever, taxes are much likelier to go up than down.

Fortunately, there is a solution for investors worried about higher taxes.

I’m talking about municipal bonds.

How Muni Bonds Work

I think muni bonds are presenting us with a great opportunity right now — and savvy investors would be wise to give them a good, hard look. Before we get into why muni bonds are worth a look, let’s cover some basics.

Municipal bonds are debt states, cities, and other agencies issued to raise money for public works. We’re talking about new roads, bridges, schools, hospitals, water treatment plants, etc.

They generally come in two varieties. General obligation (GO) munis are backed by the full faith and credit of the government that sold them. The taxing authority that issues them can always increase property or sales taxes (if necessary) to ensure interest and principal on the bonds are paid.

Revenue bonds are slightly different. They finance specific projects like airports, sports stadiums, and toll roads. The revenue generated by these facilities is then used to repay the lenders over time. Revenue bonds are considered riskier than GO bonds but carry higher yields.

The risk of non-payment for both varieties of munis is exceptionally low. In my experience, you may have one or two delinquencies amid thousands of issuers in any given year. Even then, muni creditors eventually recover about 65 cents on the dollar versus 49% for corporate notes. What’s more, some of these obligations are even underwritten by private insurance companies that guarantee the full repayment of principal and interest — so they carry top-notch “AAA” credit ratings.

For this reason, munis have a well-deserved reputation for being among the safest investments around, suitable for “widows and orphans.”

The Case For Muni Bonds

Now that I’ve explained the basics, here’s the real appeal of muni bonds: They are exempt from federal income taxes (and often state and local taxes).

Contrast this with the income from corporate and taxable bond funds, which are generally taxed at the federal and state level at ordinary income tax rates in the year it was earned.

To compare the payout on a muni bond to that of an ordinary corporate or Treasury security, you need to determine its taxable equivalent yield (TEY). The calculation is quite simple:

Muni yield / (1 – Your Federal Income Tax Bracket) = Taxable Equivalent Yield.

I’ve also included a table (below) showing the comparison between yields based for a single-filer status. (You can also find handy calculators online, like this one.)

Source: NY Life

Cutting the IRS out of the equation can significantly impact your portfolio. Generally speaking, the higher your tax bracket, the bigger the benefit.

Let’s say you’re in the top bracket — 37%. (For simplicity’s sake, we’ll leave out the 3.8% investment income tax.) We’ll compare a $100,000 initial investment in a taxable bond fund yielding 5% and a comparable muni fund paying 4%. The corporate bond fund would generate $5,000 in annual interest. But when April 15 rolls around, you will owe Uncle Sam $1,850. That reduces your income to just $3,150.

Meanwhile, the muni fund would throw off $4,000 in pure tax-free income. We’re talking about nearly a full percentage point of after-tax yield. Compounded over 10 years, the muni fund would accumulate to $148,024, versus $136,362 for the taxable fund — putting almost an extra $12,000 in your pocket.

Muni Funds Can Put More Cash In Your Pocket

Why Muni Bonds Make Sense Right Now

As long as there are income taxes, municipal bonds will always attract buyers looking to keep the IRS out of their pocket. But here’s the thing…

Right now, interest rates continue to head higher. And the first and most important rule of fixed-income investing is that bond prices move inversely to interest rates. So bond prices have generally dropped.

That’s true for muni bonds as well. Because of this, many muni bond funds are trading at significant discounts to their net asset value (NAV) right now. That means savvy investors looking for income and who want to avoid a tax bite can instantly diversify into this asset class while locking in higher yields at a nice discount.

For example, one of my top picks over at High-Yield Investing touts a 5% payout thanks to the recent dip. For those in the 37% tax bracket (plus the 3.8% investment income tax for high earners), that equates to a tax-equivalent yield (TEY) of 8.45%. In essence, that’s what a taxable bond fund would need to yield to match this tax-free payout.

I may weigh in more on this topic soon. For now, do yourself a favor and research some of the well-managed funds in this space, particularly if you’re in a higher tax bracket.

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