Written by Greg Palacorolla, CFP®
Two of the biggest concerns investor’s face are rising interest rates and taxes owed on their portfolio. Conservative investors, who typically have a higher allocation to bonds, have suffered lately from historically low interest rates – many of their bonds are only paying them 1-2%, before taxes. Once the IRS takes their cut, their return on bonds ranges from .75%-1.5% (25% combined federal & state tax).
The problem for older, often retired, and more conservative investors is that an overweight position to stocks does not fit their risk profile and time horizon, thus resulting in their continued investment in fixed income. In addition to the adverse tax consequences on the yields from these low interest rates, the serious threat of rising rates looms. If rates do rise from their current, generationally low levels, the principal value of bonds and bond mutual funds would decline. Therefore, taxable fixed income is not very attractive in the current market environment because the yield may struggle to overcome a decline in principal. However, one investment offsets both taxes on bond interest and rising interest rates: Municipal Bond Ladders.
What Is a Municipal Bond?
A municipal bond (often referred to as a muni) is a debt security issued by a state, municipality, or county to finance its capital expenditures. These bonds help fund projects such as roads, bridges, schools, and hospitals. Muni bonds are always exempt from federal income tax. If you purchase a municipal bond of your resident state, the interest is exempt from state income tax as well!
Who Benefits Most from Muni Bonds?
All investors reap the same tax benefits from municipal bonds. However, the impact on high income earners is magnified. For example, the maximum combined tax bracket for Maryland residents is approximately 48.55% (39.6% federal, 8.95% state). Therefore, the interest/yield that you earn on a taxable bond could be reduced by that percentage. Conversely, identically yielding Maryland municipal bonds are exempt from both federal & state taxes, thus potentially saving high income earners a substantial amount of money.
How Muni Bonds and “Laddering” Protect Your Portfolio Against Rising Interest Rates?
Rising interest rates pose the biggest threat to fixed income investments, which typically are considered low risk. As interest rates rises, the value of your principal investment in a bond will drop. If you are only receiving a few percentage points of yield due to low rates, dramatic downward movements in the price of your bond could negate any profit from these typically “safe” investments. Interest rate risk can be eliminated if you purchase an individual bond outright and you hold until maturity. However, purchasing a bond and holding until maturity presents some obstacles and challenges as well. First, most retail investors only have the capital or ability to purchase a bond fund. Bonds funds are a collection of individual bonds, wrapped together. As a shareholder, you own a share of the fund, not the actual bond. Therefore, your ability to offset rising rates via the “hold to maturity” strategy is unavailable as you only own a piece of numerous bonds. As rates rise, your bond fund will likely decline in value. So, if you are able to purchase a bond outright, you are able to avoid risk to your principal as you’ll recoup your initial investment at the maturity date. But, with rates at current levels, you may have to lock into a rate such as 2% for 10 years! As an investor, is a flat, 2% return on your investment sufficient for your needs? Most investors would say no.
Municipal Bond Ladder
So, how do you avoid rising interest rate risk and minimize the impact of taxes on your portfolio through the use of muni bonds? The answer is to construct a municipal bond ladder. A municipal bond ladder is a portfolio that is comprised of numerous muni bonds, each with a different maturity date. The maturity dates are staggered over a specific time horizon that suits your personal situation, providing consistent liquidity to the portfolio which will allows you to capitalize if current interest rates are higher than when you initially starting investing.
Rather that purchasing a single, $100,000 bond with a 10 year maturity, you could purchase five, $20,000 bonds that mature every other year (Year 2, 4, 6, 8, 10). This strategy allows a new bond to mature every few years as interest rates gradually rise. Therefore, if interest rates go from 2% to 3% in the first two years, you would reinvest the proceeds from the first bond that matures at the 3% level (rather than being locked in at 2%). If rates subsequently increased to 5% in year 4, a bond in your ladder would be maturing, thus creating capital that could be strategically reinvested at the HIGHER interest rate.
How Geier Asset Management Can Help
Mitigating taxes for our clients is a central focus in all of our financial planning efforts, including the portfolio. In addition, it is our responsibility to analyze the condition of all financial markets (equity, bond, etc.) to strategically align client portfolios with our forecast. Therefore, with the rise in interest rates looming, we actively seek ways to avoid the risk associated. In the fixed income portion of your asset allocation, the municipal ladder accomplishes our tax objectives and combats the risks in the bond market simultaneously. While we cannot predict what future tax rates will be or how soon interest rates will rise, we’ll do our best to navigate the financial landscape in an effort to maximize your opportunities while minimizing your downside.
© Geier Asset Management, Inc. July 2015. Greg Palacorolla is the Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Palacorolla and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.