How To Earn A High Yield While Also Beating The Tax Man…
One day many years ago, 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 all this construction was being funded by a bond. This was before I had ever started my career in finance, so bonds were an unfamiliar thing. But when I began my investment career, I soon realized that I could actually invest in these things. And the more I learned, the more 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, or “muni” bond for short. These bonds are used for everything from helping fund 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.)
One Of The Safest Investments Around…
Now before I go any further, I need to address something. You may have seen headlines over the 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, 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 had 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 0.1% over the past 50 years, according to Moody’s. (This commentary from Raymond James also makes the case for muni bonds.)
The point is, muni-bonds are 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.
The Best Way To Own Munis
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.
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. This means when you find a closed-end muni fund that 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.
Significant Tax Advantages
Not only do these securities offer safe, secure yields to investors, they also offer significant 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 that have income taxes.
Take, for example, a muni fund that my colleague Nathan Slaughter has recommended to his High-Yield Investing subscribers — the Eaton Vance Municipal Income Trust (NYSE: EVN).
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. The fund currently offers investors a nice 4% yield — more than double the average S&P 500 stock. But on a tax equivalent basis, it gets even better… 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:
|Income Tax Rate||Taxable Equivalent Yield|
So if you invest in EVN today, and you fall in, say, the 35% tax bracket, you’d have to find a stock, bond or ETF offering an 6.15% yield to get the same amount of income as IIM’s tax-free 4%. And while there are probably plenty of good choices out there, in today’s low-interest rate world, I’d challenge any investor to one that’s as safe as EVN.
Action To Take
Now, keep in mind, none of this should be considered tax advice. And remember that if you’re buying muni-bonds through a closed-end fund, then try to buy the fund at a discount to its NAV if you can. Helpful websites like Morningstar to provide this information for you.
But the point is muni bond funds offer yield-hungry investors a great opportunity to invest in a safe fixed-income investment.
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.
If you’re looking for some guidance on where to find some of the best paying dividend securities out there, I highly recommend checking out Nathan’s premium newsletter High-Yield Investing for more information like this.
In fact, Nathan just released a brand-new report on 5 “Bulletproof” stocks that have a proven track record of holding up in any market — and enriching shareholders year after year. Each of these stocks yield more than 5% right now — and all of them are worthy candidates for any serious investor’s portfolio.