Posted by Fred Lake

Dividends The IRS Can’t Touch and Why

Dividends The IRS Can’t Touch and Why

What if there is a way to protect your portfolio without giving up big gains and income? Will you be interested? Well, it is understandable if you will be but a little skeptical. In investing and pretty much everything, it is a good thing being skeptical. 

To be frank, what we will discuss is poised for very nice gains as volatility drives scared investors to look beyond stock-- it is also one of the most unsexy investments you can think of. 

Municipal bonds, debts issued by state and local government to fund badly needed infrastructure projects is what we are talking about. 

You can take this to the bank no matter how much the politicians bicker and trillions of infrastructure cash will be spent. It is where the economy depends on. 

The sole investment the government pays you to own.

The government pays you to own what they issue you which is the “munis”, which is the funny thing here. Muni bonds’ dividends are tax-free for most Americans and mostly the government does it through an indirect subsidy. 

A huge difference is what it can make. Why? For example, through a closed-end fund (CEF) you buy municipal bonds (which is I highly recommend). And you also buy one of three munis CEFs ripe which is the Invesco Muni Opportunities Trust (VMO). 

Compared to what you get from the typical S&P 500 stock, VMO pays a 5% yield and that means triple! The fund’s real yield could hit 8% for some folks without tax applied. 

You can see why smooth upside munis are famous for and have a place in your portfolio. Check the performance of the benchmark iShares National Bond ETF (MUB) since January 1! With a solid 4.3% total return, the munis bonds’ rise has not seen a single major reverse. 

There are 141 muni bonds beating the index from the 171 muni bonds which are tracked by CEF Insider service. In other words, of the actively managed municipal bond funds, there are over 82% that are crushing the dumb index fund. 

You might be curious as to how this is possible. After all, since low-cost index funds always outperform, the press loves to tell us that active investing is not worth the fees. Yet, in their performance figures include fees, we have 82% of higher cost active funds crushing the ETF.

When looking at the compound annual growth rate, the average 10-year total return for a muni CEF is nearly double the return on the passive MUB in the same period. Only one has underperformed the MUB over a period of 10 years. And, PIMCO Municipal Income II Fund (PML) is the best performer which is up an 11.6% annualized and nearly three times better than MUB. 

ETFs: Worst ways to buy muni bonds

You might be wondering what they are beating the low-cost index fund and why we don’t hear more about this despite their high-paid managers and big research budget on these actively managed funds. The answer is: the municipal bonds market seems boring on the surface, unlike the stock market which gets a lot of attention. But it is packed with profit opportunities in reality.

The muni bond market has a ton of inefficiencies money managers can and do jump on because average investors don’t have access as big players and muni bonds are not traded as frequently as stocks. Rather than navigating this market on your own, I highly recommend buying munis through a CEF. 

Below are the three high-yielding muni funds:

With over $2.7 billion in assets under management, Nuveen Quality Muni Income Fund (NAD), one of the largest muni-bond funds. For NAD snap up the best issuance for years, Nuveen’s massive presence in the muni bond is a big help. While MUB trades at the intrinsic value of its portfolio, NAD also trades at a huge 11.7% discount to the net asset value. MUB yields 2.3% and NAD yields 4.7% which is over doubled. As its dividends are tax-free to most Americans so it’s much higher. And, at a big discount, NAD is far from the only out-performer trading. 

Trades at a 9.8% discount to NAV while paying the luxurious 4.5% tax-free yield, our second muni CEF is the BlackRock MuniYield California Fund (MCA). One of the best in the bond world with over 7 trillion dollars under management. MCA has soared over the last few decades because of the market access the rest of us can only dream of. If you are looking to sidestep volatility and grab a high-income stream, MCA is an obvious choice with its long history of outperformance and its high dividend. 

With its $810 million assets across every part of the country, there’s the Invesco Muni Opportunities Trust (VMO). This fund has crushed the index for a long time and VMO’s 9.3% discount to NAV is also amazing. VMO also pays a 5% tax-free dividend which is equivalent to an 8% yield for some taxpayers if that is not enough. 

Fred Lake
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