How to Earn Yields Up To 5.4% — Without Paying The Tax Man

We’ve still got about two weeks to go until April 15 (thankfully). But the clock is ticking, and most of us will need to start gathering W-2s, brokerage statements and other information to file our tax returns soon (if you haven’t already).

If you’re like me, all those dividends and interest payments that you cheered through the year will start to elicit more of a groan once the distributions are tallied up and reported to Uncle Sam.

[ad#Google Adsense 336×280-IA]If you’re in the upper income tax brackets and haven’t done so already, now may be an opportune time to explore options in the municipal bond arena.

As you may know, muni bonds are used to fund things like roads, schools and bridges in cities all over the country.

They are generally exempt from federal taxes, and possibly state taxes as well, depending on where you live and where the bond was issued.

I’ve had several of my High-Yield Investing readers ask about muni bonds over the past few weeks. This is an asset class we’ve invested in before, albeit sparingly.

My biggest problem with this particular group is that I think it’s only suitable for a portion of readers (lower income readers are usually better off looking elsewhere).

That being said, I don’t expect every reader to invest in every security I cover. So I felt the time was right to say a few words about this corner of the income world — and not just because tax season is approaching.

2013 was a terrible year for municipal bonds. The city of Detroit filed for bankruptcy that July, the largest municipal failure in U.S. history. That had investors worried about what other cities might be at risk. At the same time, fears of Fed tapering and subsequent increases in interest rates had many traders on edge.

Money poured out of municipal bond funds, and most suffered ugly losses.

But this group bounced back nicely last year. Worries about widespread defaults proved unfounded, and the Fed held the line on interest rates. Meanwhile, issuance of new bonds remained relatively subdued. So supply failed to keep pace with demand.

Most municipal bonds turned in healthy gains, particularly higher-yielding ones with longer maturities and/or less-than-perfect credit quality. Investors responded by pouring nearly $30 billion back into muni bond funds over the course of the year.

Given recent appreciation, this group isn’t quite as attractive as it was six months ago. But it’s still worth considering. Default rates are miniscule (0.00% for “AAA” rated munis between 1970 and 2013 and just 0.32% for “Baa,” versus 4.61% for comparable corporate bonds).

Meanwhile, total muni bonds outstanding have declined in each of the past four years, and new issuance has reached the lowest levels in a decade. That enhances the supply-demand picture. And yields are still respectable, particularly on a tax-equivalent basis.

I would focus on the lower-grade high-yield sector of the muni market. These bonds are less sensitive to interest rate risk (which is growing) and more sensitive to economic and credit risk (which is shrinking).

In the table below, you’ll find some of my favorite mutual funds, closed-end funds and exchange traded funds to consider.

I would be comfortable with any of these funds as a way to gain broad exposure to municipal bonds. But I would pay particular attention to BlackRock MuniAssets (NYSE: MUA), which has top-notch management, a tax-equivalent yield above 9% and a portfolio right in the sweet spot.

— Nathan Slaughter

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Source: Street Authority