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Author: boad Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35362  
Subject: Re: Bonds and Bush Proposal to End Dividend Taxe Date: 12/8/2002 2:47 PM
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Lok, you probably know most of this, but here's a bit more info about 
what may enter into an asset allocation decision between munis and 
dividend-paying stocks.

My original point 1:

1. If done at individual level, one newsletter writer 
chortled,  "This would destroy the municipal bond market and would 
cause more money to pour into the stock market."  Won't destroying the 
municipal bond market have serious downside -- e.g., taxpayers (i.e., 
us) will have to make up any funding slack?

Well, this point was also subsequently made on the Rukeyser show 
Friday night on CNBC, and is a question about asset allocation 
decisions by individuals:  will individuals who invest in munis now 
find some stocks more attractive?  After all, unlike most other bond 
markets which are dominated by institutional investors, 75% of munis 
are held by individuals.  Also, although munis are the second largest 
bond market -- after Treasuries -- with $1.7 trillion in outstanding 
obligations -- the market is pretty illiquid (i.e., people hold onto 
them--for reasons described below).  And munis are pretty riskless 
since insured for default.  Munis are also "individual investor"-
friendly as issued in units of $5,000.  And because interest is paid 
every six months, muni holders have to put that money somewhere.

Some stocks have pretty decent returns: Check out preferreds, or 
REITS, and, here's a just couple of others that come to mind: ConAgra 
(CAG) is yielding 4.08%; Allied Capital, the business development 
company, 9.79%; EnerPlus Res Fund, a oil/gas royalty trust, over 13%.
Of course, as you point out, if people piled into these stocks, the 
yields go down.

But when it comes to investment returns, how much an investment earns 
is secondary to how much you earn after taxes.

Here's a description from Quicken on the interplay of tax bracket and 
municipal bond returns.
http://www.turbotax.com/articles/TaxBenefitsofInvestinginMunicipalBonds.html

Municipal Bond Yields
As you move to higher tax brackets, you get even more benefit from the 
tax exempt status of municipal bonds, so the real yield is even 
greater than the income you receive from the bond.  Imagine a 
situation in which a municipal bond offers a 5.4% yield.

If you're in the 27% federal tax bracket, the 5.4% yield has a taxable 
equivalent yield of 7.4%.  In other words, you need to get a 7.4% 
yield from a taxable bond to equal the 5.4% payout of the municipal 
bond.

If you're in the 30% federal tax bracket, the 5.4% municipal bond 
yield is the equivalent of 7.7%. 

If you're in the 35% bracket, your yield is 8.3%. 

And if you buy a bond issued within your state, you can usually shield 
the income from your state income.

Recall how the tax brackets work (adjusted gross income; joint 
return; cut roughly in half for singles):

$0-$12,000            10.0%
$12,000-$46,700       15.0%
$46,700-$112,700      27.0%
$112,700-$171,950     30.0%
$171,950-$307,050     35.0%
$307,050 and up       38.6%

These are of course marginal brackets.  The first $12,000 for all is 
taxed at 10%; the $59,250 increment from $112,700-$171,950 at 30%, etc.

So basically, an individual is not even interested in munis until 
joint AGI is about $47,000, and gets more interesting after that.  And 
this is just the Federal take; obviously shielding income from State 
income taxes is a big incentive as well.

Now, I haven't looked for data on ownership of munis by income 
bracket, but I guess it's mostly folks in the upper brackets -- who 
have a long-term investment plan, understand tax-efficient strategies, 
and a comittment to preservation of capital.  (I was reading 
a bio of John Maynard Keynes, who when building his fortune through 
speculation was a wildman, but after making his pile, became quite 
conservative in his investments.  Another point:  TMF seems to have a 
mission of bringing commerical financial planning to the masses--not a 
bad idea.)

I've posted a couple of messages about the distribution of income in 
the U.S.  Most recent link:
http://boards.fool.com/Message.asp?mid=18252084

These messages had implicit (if not stated) value for understanding
the wider investment environment.  After all, in the US all wealth is 
essentially owned by individuals, and individuals, or their agents 
(institutional investors, mutual funds -- and asset allocation 
decisions between stocks and bonds (and maybe some futures and 
currencies in managed accounts for the bold) undoubtedly move markets.

Now, if Federal government started exempting dividends from income 
taxes, for certain high net-worth individuals who buy munis dividend-
paying stocks might look more attractive, particularly since also 
offer a potential capital return.  Of course, that total return bears 
more risk than munis themselves.  The answer to this question is not a 
matter of logic, but a math model.

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