Don’t Follow the Crowd into Muni Bonds

Marc Lichtenfeld By Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

Retirement Planning

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





Analog Devices





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.