Buying Tax-Free Bonds: Why You Need These Fixed-Income Investments Now

by Alexander Green, Chief Investment Strategist
Monday, September 20, 2010: Issue #1348

In the three weeks since I pointed out the bubble in the U.S. Treasury market, those securities have gotten walloped as yields have risen over one half of one percent.

I’ve received letters from many readers asking what they should do now with the fixed-income portion of their portfolios. For income investors, I have three answers…

• High-yield corporate bonds.
• Inflation-adjusted Treasuries (TIPS).
• Tax-free municipal bonds.

Especially tax-free bonds. Here’s why…

• They yield more than Treasuries.
• They’re exempt from federal income taxes (and state income taxes if you buy state-specific bonds).
• Your taxes will soon be going up. Way up.

Why Income Doesn’t Properly Reflect Real Wealth

I know, I know. Washington politicians promise they aren’t going to raise your taxes. They’re only going to raise them on the 2% of American households that make $250,000 or more.

Horse manure.

Having deliberately set up a fiscal crisis over the past decade, our elected misrepresentatives will soon be searching for ways to raise revenue to meet these obligations. The politically convenient idea is to raise taxes only on “America’s wealthiest.”

Yet earned income is often a poor indicator of wealth. Apple CEO Steve Jobs, Citigroup CEO Vikram Pandit, Google CEO Eric Schmidt, Yahoo! CEO Jerry Yang, Oracle CEO Larry Ellison and Berkshire Hathaway CEO Warren Buffett all receive annual salaries of $1.

Real wealth is determined by looking at a balance sheet not an income statement. The tax code is set up to punish high-income earners, many of whom are not rich but rather striving to become rich.

The problem with raising taxes on high earners is that this country badly needs to create jobs in the private sector. These top 2% – who already pay almost half of all income taxes, according to the Internal Revenue Service – are overwhelmingly small business owners. If the economy is going to grow, we want to encourage them to open new businesses and expand existing ones.

I know some economists claim that raising taxes doesn’t discourage risk-taking. Let’s put that theory to a simple test…

The Small Business Tax Roadblock

Imagine if someone offered you $50 to deliver an important document to a business located in the next town. Would you do it?

How about if he offered $40? How about $30? Or $20?

If you feel less inclined to accept each declining offer, congratulations. You’ve recognized that the more you pay in taxes – which is the same thing as being offered less money to do the same job – the less interested you are in doing the work.

Of course, small business owners are primarily wage payers, not wage earners. Take a moment and put yourself in their shoes. Imagine risking your hard-earned capital on a new business, fully aware that customers may complain that you charge too much… employees may believe you pay them too little… suppliers may claim you drive too hard a bargain… government officials may insist you aren’t complying with their mountain of regulations… and competitors, plain and simple, would like to drive you out of business.

Factor in the well-known fact that four out of five new businesses fail in the first five years. If you manage to meet these challenges and become profitable, the government – between federal income taxes, state income taxes, social security taxes, Medicare taxes and others – will take up to half of what you make. And some argue that higher taxes aren’t a disincentive to start or expand a business?

The Problem with Taxing the Top 2%

Of course, you can’t run a government without collecting taxes. But here’s the key. You increase revenue by expanding the tax base not increasing tax rates. (That means expanding the private sector, not the public one.)

You want to reward education, hard work and risk-taking. In short, you don’t raise up the wage earner by pulling down the wage payer.

Of course, many of our elected “leaders” have never held a job in the private sector, so – to them – this is all just the sheerest conjecture.

I hate to burst anyone’s bubble. But we won’t solve this nation’s fiscal crisis on the backs of the top 2% of income earners. Nor should we try.

Sure, it’s a political winner in some circles. But history shows that “soaking the rich” doesn’t work.

Which state has the biggest fiscal crisis in the United States? California.

Which state has the highest state income taxes? California. Other high-tax states are in a similar pickle.

And look at Greece. The country has a top marginal tax rate of 40%, plus a 23% value added tax (VAT), recently raised from 21%. Yet the country is a financial basket case. Why?

Because governments around the world are overreaching and politicians – ever intent on securing their re-election – are addicted to spending.

How to Beat the Washington Pick-Pockets

As Margaret Thatcher pointed out a couple decades ago, the problem with the social-welfare system is that eventually you run out of other people’s money.

With the current state of the economy, most politicians are reluctant to raise taxes. But history shows that they simply will not cut spending. (That includes Republicans. Witness the rise of the Tea Party movement.) Heck, they won’t even cut the growth of spending.

Needless to say, it’s only a matter of time before Washington turns its attention to your wallet. And that, in a nutshell, is why you ought to own high-quality tax-free bonds, even though the outlook for investment grade bonds is less than salutary.

You can mitigate the effects of any future rise in interest rates by owning individual bonds and keeping maturities relatively short.

Because your taxes will be going up. Not immediately, but before long. And that will make tax-free yields look even more compelling.

Don’t say we didn’t warn you.

Good investing,

Alexander Green

Business/Finance, Finance, Flat tax, Income tax in the United States, Political economy, Public economics, Social Security, Tax, Tax rate, Tax reform, Taxation in the United States, Value added tax

Use These “TIPS” to Protect Yourself Against Inflation

by Alexander Green, Chief Investment Strategist
Monday, April 19, 2010: Issue #1241

A recent Communiqué column of mine, in which I recommended Treasury Inflation-Protected Securities (TIPS), outraged a number of readers.

Why was it so upsetting? Because – and don’t ask me what they’re smoking – 17% of Americans actually approve of the job Congress is doing.

Taking both parties to task, however, I wrote:

#1: When George W. Bush and his fellow Republicans came to power a little more than nine years ago, they promised to cut wasteful spending, limit the size of government and move closer to a balanced budget.

Instead, they…

• Created a Medicare drug entitlement that will cost nearly $1 trillion in its first decade…
• Started a string of expensive financial bailouts that continues today…
• Passed a record number of earmarks…
• Increased federal spending 58% faster than inflation…
• Presided over a $2.5 trillion increase in the public debt.

#2: Then, last November – anxious for change – voters threw the bums out and put the Democrats in charge. The Democrats promised to change this reckless course and restore fiscal sanity to the country.

Instead, they tripled the budget deficit in their first year. The White House and the Congressional Budget Office now estimate that this year’s deficit will explode to $1.56 trillion – a post-World War II record at 11% of the overall economy – and add $9.7 trillion in debt over the next decade.

Facts vs. Opinions

Here are the other points I made…

#3: The Obama Administration’s own projections see the federal debt hitting $18.5 trillion by 2020. However, that was before the passage of the healthcare reform bill – the biggest new entitlement since the creation of Medicare in 1965.

#4: Unfunded liabilities for Social Security, Medicare, Medicaid, the prescription drug benefit and the new federal healthcare program have now jumped to $108 trillion, nearly eight times our annual GDP.

#5: Moody’s has threatened to downgrade the Triple-A rating of U.S. sovereign debt, perhaps within three years. A drop in our credit rating would both decrease the perceived safety of Treasury securities and increase the interest that Uncle Sam – excuse me, you, your children and your grandchildren – will pay on the deficit.

#6: Credit Suisse recently produced a report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath – the United States. (If you believe a picture is worth a thousand words, try this: http://www.usdebtclock.org/)

#7: Down the road, Washington – with the reluctant consent of the Federal Reserve – could opt to solve this problem the way so many governments throughout history have – by inflating our way out of it.

Inflation: The Bane of Debt-Holders & A Godsend to Debtors

Inflation is the bane of debt-holders, of course. But it is a godsend to debtors – and Uncle Sam is the biggest of them all – as they can repay fixed obligations with increasingly worthless currency.

What surprised me was not that some readers had a difference of opinion. I always welcome that. It was that respondents uniformly barked that they didn’t want to hear my “political opinions.”

Opinions? Go back through these seven points and tell me which one contains an opinion. Even the last one modestly states that Uncle Sam “could opt” to inflate our way out of this problem.

As Jack Nicholson reminded us in A Few Good Men, some people can’t handle the truth. Especially when it’s something they don’t want to hear.

For example…

• When we warned 11 years ago about the massive bubble in Internet stocks, the majority of respondents gushed about the New Era and insisted we “just didn’t get it.”
• When we warned six years ago about the ominous housing bubble, many scoffed and insisted that home prices “always go up.”
• When we talk today about the threat to your financial security that Washington is creating with its Ponzi-style entitlement schemes, a lot of investors don’t want to hear that, either.

Believe me, I hope I’m wrong. I don’t want high inflation any more than you do.

Fortunately, inflation today is as tame as a kitten.

The Benefits of Treasury Inflation-Protected Securities & Three Ways to Buy Them

I only suggest that you buy Treasury Inflation-Protected Securities ( TIPS) as an important insurance policy. (Because when inflation – the thief that robs us all – rears its ugly head, neither stocks nor bonds do well.)

You can purchase inflation-protected Treasuries (TIPS) in three ways…

• Directly ( http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm).
• Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
• Through the ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

There are several advantages to buying TIPS…

• TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
• The interest you receive is exempt from state and local (but not federal) income taxes.
• TIPS are less volatile than traditional bonds.
• They’re also excellent diversifiers.

Some investors complain that these securities haven’t done anything exciting lately. Of course not. We’ve been in the grip of disinflationary forces, not inflationary ones – and that won’t change next week or next month.

Protection Against The Government “Doing Something”

But as the deficit keeps expanding and the electorate grows increasingly unhappy, pressure will mount on the government to “do something.”

That “something” could be a decision to inflate our way out of this mess, rather than risk the kind of deflationary spiral that Japan has endured over the past two decades.

Bear in mind…

• The Fed has already taken interest rates close to zero…
• Congress has already tried a massive fiscal stimulus…
• The Federal Reserve has already created trillions out of thin air to mop up worthless securities.

If the economy stumbles again and further government action is taken, it could be even more reckless, resulting in inflation.

In the interest of full disclosure, however, that’s just my opinion.

Good investing,

Alexander Green

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Bonds, Business/Finance, debt, Deficit, Economics, Federal Reserve System, Finance, Government debt, inflation, Interest, Politics, Social Security, Treasury Inflation-Protected Securities, United States Treasury security