The 8.7% Yielder You Will Want To Own Come December 31st

December 31st, 2012… It’s a date that every income investor in America is surely aware of.

On that day, the “Bush” era tax cuts are set to expire. If Congress doesn’t intervene, dividends will be taxed as ordinary income, and your marginal tax rate could go up.#-ad_banner-#

The 33% marginal tax rate will increase to 36% and the 35% bracket to 39.6%. In addition, taxpayers in the top two tax brackets will be hit with a 3.8% Medicare surtax on investment income. That means you could be forking over as much as 43.4% of your dividend income to Uncle Sam.

While there’s no telling how this situation will pan-out in Congress, if the prospect of higher-taxes keeps you up at night, then you do have some options.

One asset class still offers steady dividends, above-average yields, and better yet… the distributions you receive from these investments are 100% tax free.

I’m talking about municipal bonds.

Municipal bonds, or munis, are bonds issued by states, cities, and agencies to raise money to build bridges, highways and other infrastructure. These bonds come in two main types — general obligation bonds and revenue bonds.

Most general obligation bonds are backed by the full faith and credit as well as taxing power of the government that issued them.

In contrast, most revenue bonds are issued for improvements that generate income from power plants, airports, swimming pools, and other projects. Because there is often more risk associated with these bonds, they tend to pay higher yields.

While some munis are taxable, most throw off interest income that’s exempt from federal income taxes. As a result, to compare the yield on a tax-exempt muni to the yield on a taxable security, you need to look at the muni’s taxable-equivalent yield.

That’s the yield needed on a taxable investment you’d need to find to make it equal to that of a tax-free muni bond. The formula for calculating a muni’s taxable-equivalent yield is:

Muni yield / (1 – Your Federal Tax Bracket)

For example, one of my top municipal bond fund picks, American Municipal Income Portfolio (NYSE: XAA) sports a nominal yield of 5.6%. But if you’re in the top (35%) tax bracket, XAA’s taxable-equivalent yield is a whopping 8.6% (5.6/0.65).

You can see why muni bonds are so attractive to the top wage earners in the country, married couples filing jointly that make $388,350-plus a year.

But the taxable-equivalent yields are still very robust even if your income is far less. If you’re a married couple in the 28% bracket ($142,700 to $217,450), the taxable equivalent yield on XAA is still 7.8%. For joint filers in the 25% bracket ($70,700 to $142,700), the taxable-equivalent yield of 7.5% is certainly nothing to sneeze at.

If the tax advantage of municipal bonds has you thinking about investing, you’re probably concerned about default risk.

Recent municipal bond defaults by three California cities — Stockton, San Bernadino, and Mammoth Lakes — have rattled some muni investors. The defaults were even enough to turn Warren Buffett, who had been sanguine on munis, cautious. The billionaire investor commented in July on Bloomberg TV that declaring default has become less of a “stigma” given that some cities haven’t honored their obligations. Moreover, the fact they defaulted makes it more likely other cities will follow suit.

Still, municipal defaults are, in fact, reasonably rare. Between 1970 and 2009 there were only 54 municipal defaults and only three on general obligation debt, according to Moody’s. The last state to default was Arkansas in 1933, during the depths of the Great Depression.

So far in 2012 there have been nine municipal bankruptcy filings worth a total of about $1 billion in value. That amount is less than 0.03% of the total value of munis outstanding.

If the recent defaults still make you wary, then you can always mitigate risk by investing in a municipal bond fund. By holding a portfolio of municipal bonds, a fund can minimize the impact of any single bond that may go into default.

That’s one reason I like American Municipal Income Portfolio right now. With nearly 130 holdings, XAA is well diversified. The highest concentration is in healthcare revenue bonds (37%), followed by general obligation (22%) and education revenue bonds (10%).

However, just because a bond fund is diversified, it doesn’t mean it is without risk. With an average maturity of just over 18 years, a lot of XAA’s holdings are positioned at the long end of the credit spectrum. If interest rates begin to rise, the fund could get caught.

Action to Take –> That said, municipal bonds are one of the few asset classes that offer tax-exempt income. And unless Congress acts quickly, muni bonds’ tax-free yields will be an even bigger benefit come December 31.