Don’t Follow the Crowd into Muni Bonds

Marc Lichtenfeld

I get it. It’s tough to find yield.

But I was astonished to discover that last week had the second-highest inflows into muni bond funds and ETFs since anyone started tracking that kind of data 21 years ago.

The week ending November 23 saw $1.82 billion poured into muni bond mutual funds and ETFs. The weekly record is $1.85 billion set in September 2009. Interestingly, that was the top of the muni bond market for over two years.

There are two reasons I was so surprised at the massive inflows:

  1. Uncertainty as to how munis will be taxed in the future.
  2. You still make more money in dividend stocks over the long term, even with munis’ 100% tax-free status.

No Longer Tax Free?

The first issue is that with the looming fiscal cliff, no one is certain if muni bonds will retain their tax-free status. As part of a compromise between Republicans and Democrats, tax revenue will have to be raised from somewhere. It’s possible that muni bonds will be taxed to some degree.

One popular theory is that muni bonds will remain tax free for the middle class, for those people currently paying a 28% tax rate or less. But investors above the 28% rate would see a tax bite on anything higher. So, for example, if an investor is in the 39.6% bracket (the expected top tax rate in the event of a political compromise), the investor would pay 11.6% (39.6% minus 28%) on his munis.

Of course, nothing will be known for sure until after a deal is struck between the President and Congress.

Make More Money With Dividends, Even After Taxes

If the Feds decide to leave muni bonds alone and keep their tax-free status, investing in the right dividend-paying stocks still pays more over the long term – regardless of any dividend tax increase.

Here’s what I mean:

Today, an A-rated, 10-year muni pays 2.23%. Which means in 10 years, an investor who invests $10,000, collects $2,230 over the full 10 years. Assuming that all of that interest is tax exempt, he or she keeps the full $2,230.

Now, let’s look at a Perpetual Dividend Raiser (stocks that raise their dividends every year) like Analog Devices (Nasdaq: ADI). Although it’s in the tech sector and not commonly thought of as a dividend play, Analog has raised its dividend every year for 10 years straight.

The stock pays a 3% dividend yield and boosted the dividend an average of 10.1% per year over the past five years, including a 12.8% increase in the past 12 months.

Let’s compare the income that an investor who puts $10,000 into Analog Devices shares might receive versus one who invests in muni bonds.

For the Analog Devices example, we’ll assume that the dividend continues to grow an average of 10.1%, and the investor is in the top tax bracket and must pay a 43.4% tax rate (39.6% plus 3.8% surtax on investments) on those dividends. We’ll also assume that munis retain their tax-free status. The totals in the table below are net of taxes.

Income Year 1

Income Year 5

Income Year 10

Total Income Collected

10-Year Muni Bond

$223

$223

$223

$2,230

Analog Devices

$167

$245

$397

$2,673

You can see that after 10 years, the investor in Analog Devices collected $443 (20%) more income than the muni bond investor.

For an investor who isn’t paying the top 43.4% rate, the income disparity will be even greater in favor of dividend stocks. And, of course, many investors put their dividend-paying stocks in a tax-deferred IRA. For those investors who don’t pay taxes on the dividends, after 10 years, they would have collected $4,724 in dividend payments.

Of course, there’s no guarantee that Analog continues to raise the dividend every year or does so at a 10% clip. But a company with a solid track record of dividend raises is usually a good bet to continue the same behavior in the future.

So as we count down the last days of 2012, if no deal on the fiscal cliff looks imminent, you may see dividend stocks sell off as investors wrongly believe they will generate more after-tax income elsewhere.

But now that you know how the math works, you’ll be in a position to pick up some shares at bargain prices. And these stocks should generate more income than tax-free alternatives, even if taxes on dividends go up sharply.

9 Responses to “Don’t Follow the Crowd into Muni Bonds”

  1. William Dunn says:

    So, for those of us who are fast approaching retirement age and feel the need to balance our portfolios, are we to forgo bonds entirely?

  2. Kim Benner says:

    I think Marc’s comparison of Muni Bond vs Dividend paying stock (ADI)is excellent and timely. Too many financial authors are willing to “throw the baby out with the bathwater”!

    Kim Benner

  3. timothyjhealy says:

    No argument with the notion that muni yield levels after five year maturity provide little value protection in a rising interest rate scenario. Keep in mind, however, that muni interest exemption emanates from a two hundred year old Supreme Court opinion “McCullogh vs. Maryland” not some legislative action.This is also the reason that federally issued obligations are exempt from local taxation.
    Also KIM that muni bond proceeds are spent by politicians in lieu of raising taxes.

  4. Min says:

    Compare those two can see clearly of the result. I still think MLPs and Healthcare REITs are better investment for retirement long-term plan. Even JNJ, KO, KMB… can do better job. I might be wrong, for now I will still stay tune and watch about tax issue closely. Patient and having plan B are the keys for these days.
    Thanks for offering good example. M.

  5. Chris johnson says:

    I have a number of MLP’s and I need to know more about them, such as what happens after the company has repaid 100 pct of your initial investment in distributions. Also, when the stock is gifted or passed to a beneficiary, is the basis changed? Thanks, chris

  6. Joanna Kim-Selby says:

    Currently riterees are paying taxes on muni bonds. Those muni bonds are calculated in when we calculating our social security benefit some pay 85% some 50% of their benefits for tax. Also we reach our medicare all included in again paying extra medicare fees.

    If the politicians want to charge fees interests whatever it nothing new. It has been done some years back.
    I think it has been practed for over 20 years.

    Joanna Kim-Selby

  7. r.dinoi says:

    never trust a stock broker… they would sell teir mother! my mother used to say. You look to be the first one to start to effect this belief of mine: keep up the good work, wherever you a re making your money, good luck!
    signed:
    a senior searching for an income on lifetime savings.

  8. JeanMayer says:

    All is well if you can compound, like leaving it an IRA, and the income is nontaxable until withdrawn. But what about someone like me that can’t add to their IRA. I have to pay taxes up front and that comes out of my income. So it looks to me like the $2673 would have been taxed about $1160 dollars (43.4% x 2673) which would leave me with $1510 not $2673. In which case the MuniBonds would be a better deal unless they start including them in taxable income. Please tell me where my thinking is wrong if you disagree.

    • Stan says:

      I had the same thought about the effect of taxes on the dividends, but the last line before the chart states that this analysis is “The totals in the table below are net of taxes.”, which I take to meam that the dividends are actually much higher and that the 2,673 is what’s left over after taxes have been paid.

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