Schwab Bond Insights: Muni Tax Traps, Retirement Income Planning, Convertible Bonds
- Investors continue to flock to Treasuries and are starting to flee riskier parts of the bond market.
- If you're interested in tax-free municipal bonds, watch out for these seven tax traps.
- It's important to understand your risk capacity when planning for your retirement income.
- Convertible bonds have posted attractive returns, but we think bond investors should view them more like stocks.
U.S. Treasury bonds continue to defy expectations for yields to rise this year, as a recent decline has pushed yields down to 2.43%. That's barely above the 2014 low of 2.34% reached in late August.
We don't see that trend changing anytime soon, as demand for Treasuries is likely to remain high due to geopolitical events, as well as the yield advantage that Treasuries offer relative to many other developed market government bonds.
As investors flock to Treasuries, however, they're starting to flee from riskier parts of the bond markets. And we think the Fed’s eventual tightening of interest rates—and subsequent withdrawal of excess liquidity—could further hurt parts of the market that benefit from excess liquidity, like high-yield bonds, bank loans, and emerging market bonds. We're already seeing the impact in the high-yield bond market.
While Treasury yields are falling, high-yield bond yields are rising. In September alone, the average yield-to-worst of the Barclays U.S. Corporate High Yield Bond Index rose by more than 90 basis points, leading to a loss of more than 2%. A basis point is one-hundredth of a percentage point. Investors appear to be taking note of the risks. Through August, high-yield bond mutual funds have posted three straight months of net outflows, according to Morningstar, while bank loans have seen five straight months of outflows.
We continue to think many of the riskier parts of the market have poor risk/reward profiles, and we’re seeing an increase in volatility with these types of investments.
Over the next month or two, we expect bond markets to swing back and forth quite a bit. The fundamental factors are mixed: Growth is picking up in the U.S. but faltering in the rest of the global economy, the dollar is rising and commodity prices are falling, and inflation as well as inflation expectations remain low. Quantitative easing is ending but the first rate hike is still most likely months down the road. We wouldn't look for the bond market to follow any clear direction anytime soon.
7 tax traps of municipal bond investing
Although municipal bonds are one of the few investments that pay interest that is generally exempt from federal income taxes, the interest payments are not always free from all taxes. Below we identify some of the taxes that could apply if you buy muni bonds.
It’s important to note that taxes can be very complicated so we suggest speaking to your tax professional or reviewing IRS Publication 550: Investment Income and Expenses to determine what taxes apply to your situation.
Tax trap #1: Alternative minimum tax
The alternative minimum tax, or AMT, sets a limit on the amount of tax deductions and other tax preferences you can claim to reduce your tax bill. If the reductions would reduce the total tax below the AMT limit, the IRS requires you to pay the higher AMT. Determining your personal AMT amount can get complicated, as it involves adding back certain items.
Some municipal bonds—for example, those that fund stadiums, airports, hospitals, or more business-like enterprises—may be subject to AMT. If you are subject to AMT, your interest income from a municipal bond that is also subject to AMT is generally taxed at the rate of 28%. This would reduce the yield on a municipal bond that pays 2.50% down to 1.80%.
Next step: The good news is that you can avoid investing in munis that are subject to AMT. You can find out if a municipal bond is subject to AMT by viewing the Municipal Bond Security Description Page on Schwab.com or contacting your local Schwab representative.
Tax trap #2: De minimis tax
The de minimis tax rule mandates a higher tax rate when bonds are purchased at a discount larger than maximum amount set by the IRS. It applies to bonds purchased at a discount that amounts to more than 0.25% for each year remaining until maturity.
For example, take a bond that matures in 10 years at a face value of 100. If you were to buy this bond at a price below 97.5 (or 100 minus 0.25 points times 10 years), you would be required to pay ordinary income tax on the municipal bond. If you bought at a smaller discount, meaning you paid more than 97.5 for the bond, you would pay the long-term capital gains tax, which is generally lower than the income tax.
Next step: To avoid the de minimis tax rule, consider purchasing bonds priced at par or a premium to their face value. These bonds will generally have higher coupons, causing them to trade at higher prices, or "premiums," compared to discount bonds.
Tax trap #3: Capital gains tax
We generally suggest that individuals plan to hold a bond until maturity. If you need to sell prior to maturity, though, and you receive a price greater than your cost basis, the gain will be subject to capital gains tax. Cost basis generally refers to your acquisition price after adjusting for whether the bond was purchased at a premium or a discount.
Under current tax law, the long-term capital gains tax rate is 0%, 15%, or 20%, depending upon your tax bracket. Short-term capital gains are taxed at your ordinary income tax rate.
Next step: Determining cost basis for an individual bond can get complicated quickly, as there are special reporting rules that govern the adjustments to a bond's acquisition price. These rules vary depending on whether the bond was purchased at a discount or premium and can affect the reporting of current income. The good news is that Schwab reports your adjusted cost basis on the unrealized and realized sections of your Accounts/Positions page on Schwab.com.
Tax trap #4: State income tax
If you purchase a bond from your home state, generally it will be exempt from state income taxes. However, interest paid on bonds from outside of your home state is generally subject to state income tax. This will reduce the net income you receive from the bond. However, that doesn’t mean that you should shy away from munis from other states.
Next step: If you live in a state with low tax rates or one that issues a minimal amount of municipal bonds, we would suggest looking outside of your state. The added benefits of diversification and higher yields may make up for the hit you would take by paying state income taxes.
Tax trap #5: Increase in the taxation of Social Security benefits
If you receive Social Security now, a portion of your benefit may be taxable. That amount will depend on other income, including income from municipal bonds.
The IRS considers municipal bond interest as part of your modified adjusted gross income (MAGI) in determining how much of your Social Security benefit is taxable. If your combined income, which includes interest from tax-exempt municipal bonds and half of your Social Security benefit, is greater than $44,000 for a joint return ($34,000 for individual), up to 85% of your Social Security benefits may be taxable.1
Next step: If you are receiving Social Security benefits, we suggest reviewing the IRS's Publication 915 covering the taxation of retirement benefits to determine how this might apply to your individual situation.
Tax trap #6: Increase in Medicare premiums
If you’re covered by Medicare, the federally tax-exempt interest from municipal bonds may increase the amount you pay for Medicare Part B or Medicare prescription drug coverage. If you file your taxes as “married, filing jointly” and your MAGI—which includes income from municipal bonds—is above $170,000 ($85,000 for single filers) you will be required to pay an additional amount for Medicare Part B and Medicare prescription drug coverage.
The table below shows the additional amounts you may be subject to paying. It’s worth noting that to determine your Medicare premiums, the Social Security Administration generally uses your most recent federal tax return. For example, to determine 2014 income-related monthly adjustment amounts, the Social Security Administration generally uses your tax return filed in 2013 for tax year 2012.
Modified Adjusted Gross
Modified Adjusted Gross
(Married, Filing Jointly)
Part B monthly premium
amount (for 2014)
Prescription drug coverage
monthly premium amount
Less than $85,000
Less than $170,000
2014 standard premium = $104.90
Your plan premium
$85,000 to $107,000
$170,000 to $214,000
Standard premium + $42.00
Your plan premium + $12.10
$107,000 to $160,000
$214,000 to $320,000
Standard premium + $104.90
Your plan premium + $31.10
$160,000 to $214,000
$320,000 to $428,000
Standard premium + $167.80
Your plan premium + $50.20
Standard premium + $230.80
Your plan premium + $69.30
Source: Social Seurity Administration, as of January 2014.
Next step: We don’t believe the additional Medicare premium justifies not investing in municipal bonds. Given that your MAGI will also include income from other sources, such as dividend income and interest income from taxable bonds, avoiding municipal bonds will not necessarily allow you to avoid the increase in Medicare premiums.
Tax trap #7: Taxable municipal bonds
While the vast majority of municipal bonds pay interest that is exempt from federal, and possibly state, income taxes, you can still purchase munis that are taxable. For example, interest paid on bonds issued to help fund an underfunded pension plan or bonds issued under the popular Build America Bond (BABs) program is federally taxable. Taxable muni bonds will generally pay more than tax-free bonds to make up for the tax difference, and are clearly labelled.
Next step: For investors who are in lower tax brackets (below 25%) and investing in taxable accounts, or those investing in tax-free (Roth IRAs) or tax-deferred (Traditional IRAs) accounts, we believe that taxable municipal bonds can make sense compared to other taxable bonds, all else being equal.
What to do now
Municipal bonds are one of the few investments available to income-oriented investors looking to reduce their income tax bills. They can help investors looking to preserve their principal investment and earn an attractive after-tax income compared to other fixed income investments.
However, municipal bonds aren’t always exempt from all taxes. If you've reviewed our list above, you should be aware of some of the tax issues that may arise when investing in municipal bonds. To determine whether and how these tax issues potentially impact you, please consult with your tax advisor or review IRS Publication 550: Investment Income and Expenses.
Retirement income planning and risk capacity
When you're planning for your retirement income, you need to know more than just when you'd like to retire and how much money you'd like to have. You also need to factor in investment risk.
Typically, investors are taught to think of risk as “risk tolerance” or their level of comfort with investment risk. That is, can you emotionally stomach the ups and downs of your investment portfolio? But there’s another way to think about risk.
What is risk capacity?
Risk capacity is how much risk you can afford. Will you still be able to meet your investment objectives if your investment portfolio falls in the short-term? In other words, how much can you afford to lose, and how long can you afford to wait for your investments to recover?
Over time, investments in stocks and other higher-risk instruments typically generate higher returns than lower-risk instruments, such as cash and bonds. Over short time horizons, however, they can be quite volatile. If you have a long time horizon, and can weather ups and downs without selling out of the markets, time generally works to your advantage.
The shorter your time horizon, the more important it becomes to consider your risk capacity. If you need money soon, your capacity to take risk for a portion of your portfolio is—and should be—lower than if you don't. This is one of those critical concepts in investing.
How does risk capacity apply to your portfolio?
An often-used rule of thumb on what percentage of your investable assets to invest in a combination of riskier, growth-oriented assets (such as stocks) and more predictable, less growth-oriented assets (such as cash and high-quality bonds) is to take 100 minus your age and invest that number in stocks. Then, invest the rest in cash or bonds. But we believe that approach is too simple.
Instead, consider your needs over a short time horizon. If you're nearing retirement, think about how much money you need in the next two to four years. Invest that conservatively. Then invest the rest based on your longer-term time horizon and risk tolerance. In other words, work backwards to build your allocation.
Here's an example.
Fred and Nancy, ages 65 and 63, preparing for retirement
For simplicity, let's assume that Fred and Nancy have $1,000,000 in investments for retirement. These investments are held in a combination of a brokerage account and a traditional IRA account.
Fred and Nancy would like to spend $50,000 per year from their investments. They expect to get $25,000 per year from Social Security and other income sources. That gives them a total desired "paycheck" of $75,000 annually in the first few years of retirement.
We suggest a roughly two-to-four year foundation of more stable investments—short-term bonds and cash investments—before taking more investment risk. For Fred and Nancy, a three-year projection of this need is $50,000 times three years, or $150,000 in cash investments and short-term bonds, using either a short-term bond fund or high-quality bonds or CDs with maturities from two to four years. That leaves $850,000 for other investments.
A sample portfolio to address Fred and Nancy’s needs
Sample funds, for illustration only
MWLDX – Metropolitan West Low Duration Bond
BCOSX – Baird Core Plus Bond Fund
LSBRX – Loomis Sayles Bond
LGILX – Laudus U.S. Large Cap Growth
FMIJX – FMI International Equity
All retirement assets
Source: Schwab Center for Financial Research. All sample funds are selected from the Schwab Mutual Fund Select List, managed by Charles Schwab Investment Advisory (CSIA), and the sample portfolio is created using a moderate (60% stocks/40% fixed income and cash investments) plan allocation and the Schwab Mutual Fund Portfolio Builder tool on Schwab.com. Please refer to the Select List or Mutual Fund Portfolio Builder for current sample funds.
This portfolio contains roughly 60% in higher-risk investments—including a small allocation to high-yield bonds—and 40% in cash and short- and intermediate-term bonds. This is a sound place to start with their portfolio, built on Fred and Nancy's short-term needs but also based on their long-term objectives to grow their portfolio to fund the later years of their retirement.
Although we use mutual funds in this example, you could easily use a portfolio of CDs or short-term bonds with maturities between two and four years to cover your short-term allocation. Some investors may also want to cover their cash-flow needs for four years and beyond using a portfolio of bonds with longer maturities.
As retirement progresses, Fred and Nancy may find their needs increase, and if they plan to spend what they saved, their time horizon shortens. When that starts to happen, it generally makes sense to decrease the allocation to stocks and increase it to cash investments and bonds. This allocation also happens to be about what we would suggest for the average investor at or near retirement. For additional suggestions, refer to these guidelines on Schwab.com.
Why should investors approaching retirement add a two- to four-year investment cushion?
We think having a financial cushion designed to last up to four years makes sense for most investors getting close to or living in retirement. Over the past 50 years, the average bear market for U.S. stocks lasted a little more than one year, and the time it took the S&P 500® Index to recover to prior highs was about three-and-a-half years.
Time to recovery of a market decline
Peak to trough decline of the S&P 500
Time to recovery
February 1966 to October 1966
1 year 3 months
November 1968 to May 1970
3 years 6 months
January 1973 to October 1974
7 years 7 months
November 1980 to August 1982
August 1987 to December 1987
1 year 11 months
July 1990 to October 1990
March 2000 to October 2002
7 years 3 months
October 2007 to March 2009
5 years 5 months
3 years 2 months
Source: Schwab Center for Financial Research with data provided by Bloomberg. The periods show where the S&P 500 fell 20% or more over a period of at least three months. Past performance does not guarantee future results.
Note that the table above shows the "time to recovery" of the S&P 500 index. We would not recommend a portfolio based exclusively on this index. The time to recovery for assets held in a diversified portfolio would likely have been shorter—not considering withdrawals, if any, from the portfolio.
What to do now
If you want a more personalized approach to asset allocation, consider what you will need soon and your capacity. How much risk can you afford to take over two to four years—about the time to weather a bear market? Invest the rest based on other factors—such as your risk tolerance, need for cash flow from your portfolio after four years, and other objectives.
For help, use Schwab's budgeting tools on Schwab.com to determine your needs, or talk with a Schwab consultant.
Convertible Bonds Delivering Stock-Like Returns
Convertible bonds are on track to register the highest issuance in seven years and post strong stock-like returns this year, after registering double-digit gains in 2013. While that may seem attractive for bond investors, we think convertibles make more sense as part of your equity allocation and not your fixed income portfolio.
What's a convertible bond?
A convertible bond is a type of bond that can be converted to the issuer's common stock. These bonds share some of the same characteristics of traditional bonds, like a set coupon rate and maturity date. The conversion ratio—or the amount of shares that the bond can be converted into—is typically specified up front.
For example, a corporation might issue a bond with a $1,000 par value and 10 years to maturity. Let's assume the issuer's stock trades at $50 and the bond can be converted to 15 shares of the stock. If the bondholder were to convert the bond immediately, it would only be worth $750—15 shares multiplied by the stock price of $50.
Using this example, the stock price would need to rise to $66.67 for the conversion to at least breakeven, since 15 shares multiplied by the potential stock price of $66.67 equals the bond's par value of $1,000. If the price of the stock rose even more, convertible bond holders would be able to benefit from that further rise.
In other words, when convertible bonds are issued, the stock price would need to rise by a certain amount for the conversion to actually make sense. The price at which the conversion would effectively breakeven is called the "conversion price."
New supply continues to grow
Low interest rates and rising stock values generally make issuing convertible bonds an attractive option for corporations. Corporations issued $29.7 billion in convertible bonds through the end of August, an increase of more than 50% from the same period in 2013, when $19.4 billion was issued.2 If this pace continues through the end of the year, convertible bond issuance will reach its highest level since 2007.
Recent performance has been strong
The Barclays U.S. Convertibles Composite Index has generated a year-to-date total return of 7.8% through September 26, compared to 8.9% for the S&P 500 Index and 4.06% for the Barclays U.S. Aggregate Bond Index. This comes after the same convertible bond index returned 24.4% last year, compared to a loss of 2% for the aggregate bond index. Most domestic fixed income indexes posted negative total returns in 2013.
But don't let the strong performance fool you—convertible bonds are very susceptible to sell-offs, just like stocks. In 2008, the total return of the Barclays U.S. Convertibles Composite Index was -34.7%—even worse than the return of the Barclays Corporate High-Yield Bond Index.
Low credit ratings for convertibles don't equate to higher yields
Convertible bonds often offer lower yields than the yields on non-convertible bonds issued by the same company. Investors are generally willing to accept this lower yield, as convertible bonds offer the potential to benefit if the stock price rises above the conversion price.
Convertible bonds are often issued by lower-rated companies that otherwise may need to offer higher yields. In fact, many of the bonds in the Barclays U.S. Convertibles Composite Index aren't even rated, meaning there is no credit opinion at all from the rating agencies on these bonds. The chart below breaks down the average credit rating of the Barclays U.S. Convertibles Composite Index.
As you can see, only 21% of the convertible bond index is rated investment grade, yet it offers a lower yield than a traditional investment grade corporate bond index.
The average yield of the Barclays U.S. Convertibles Composite Index was 3.05% on September 26, compared with the average yield-to-worst of the Barclays U.S. Corporate Bond Index of 3.10%.3 The Barclays U.S. Corporate High-Yield Bond Index—an index of sub-investment grade bonds, and likely a better comparison due to the low credit ratings (or lack of credit ratings) of convertibles—offers an average yield of 6.16%.
Most convertible bonds are sub-investment-grade or not rated at all
Source: Barclays, as of September 26, 2014. Barclays U.S. Convertibles Composite Index.
What's your outlook for stocks?
If you're considering convertible bonds, we think that's a reasonable question to ask. Throughout history, convertible bonds have had a strong correlation with stocks (meaning that they have a tendency to move in tandem).4 As seen in the table below, over the past 20 years, convertible bonds had a correlation of 0.01 with U.S. bonds—close to a zero correlation—while their correlation of 0.82 with U.S. stocks is very strong.
Convertible bonds have had a higher correlation with stocks than with bonds
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Correlations represent the 20-year average correlation of rolling 12-month returns from August 1994 through July 2014. Correlation is a statistical measure of how investments move in relation to one another. Indexes represented above are the BofA ML All Convertibles All Qualities Index, Barclays U.S. Aggregate Bond Index, and the S&P 500 Index. Past performance is not indicative of future results.
One key benefit of bonds is the diversification they provide to a portfolio of stocks. But if your bond allocation is heavily weighted toward convertible bonds, your portfolio may not be diversified as you think.
What to do now
Convertible bonds generally offer lower yields than traditional corporate bonds, but they have the potential to generate higher total returns if stock prices rise. We think investors looking for higher yields are generally better off in non-convertible corporate bonds. And if investors are looking at convertible bonds because of the potential for higher returns from rising stock prices, we think this should come from the equity allocation of an investor's overall portfolio, not the fixed income allocation.
We hope this enhanced your understanding of the fixed income markets. We welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor's Feedback box.)
1Social Security Administration, as of 2014.
2Securities Industry and Financial Markets Association (SIFMA) .
3The yield of the Barclays U.S. Convertibles Composite Index represents the average of the greater of current yield, yield to maturity, or yield to put for each issue, weighted by the market value of each issue. Note that for mandatory convertible bonds, only current yield is used. Similarly with preferreds, yield to maturity is less meaningful and therefore, only the greater of current yield or yield to put is used.
4As represented by the BofA Merrill Lynch All Convertibles All Qualities Index, the S&P 500 and the Barclays U.S. Aggregate Bond Index using the 20-year average of rolling 12-month total returns from August 1994 through July 2014. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.
Talk to Us
To discuss how this article might affect your investment decisions:
- Call Schwab anytime at 877-338-0192.
- Talk to a Schwab Financial Consultant at your local branch.
For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Examples provided are for illustrative purposes only and do not constitute a recommendation by Schwab or a solicitation of an offer to buy or sell any securities. The information here is for general informational purposes only and should not be considered personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Investing involves risk, including loss of principal.
Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications, and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Schwab’s Mutual Fund OneSource Select List® offers a cost effective and convenient way to invest in mutual funds. Charles Schwab Investment Advisory, Inc. (CSIA), an affiliate of Charles Schwab & Co., Inc. (“Schwab”) conducts extensive research on the full range of actively-managed funds available through Schwab's Mutual Fund OneSource® service. The Select List is built by identifying the best combination of factors such as performance, risk, and expense.
The S&P 500 Index is an index of widely traded stocks.
Barclays U.S. Corporate Bond Index covers the USD-denominated investment-grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch. This index is part of the U.S. Aggregate.
Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.
Barclays U.S. Convertibles Composite Index tracks the performance of the USD-denominated convertibles market and includes all four major classes of convertible securities (i.e., cash pay bonds, zeros/OIDs, preferreds, and mandatories). These bonds offer upside participation with an equity component (usually a non-detachable common stock warrant) and downside protection with a fixed income component (usually a bond or preferred stock) and can offer various degrees of equity exposure. The index consists of seven main categories: security type, profile, outstanding par value, credit quality, high-yield, underlying company market capitalization, and subsector. The index was created in 2003.
BofA Merrill Lynch All Convertibles All Qualities Index represents convertible securities spanning all corporate sectors and having a par amount outstanding of $25 million plus. Maturities must be at least one year. The coupon range must be equal to or greater than zero and all quality of bonds are included. Preferred equity redemption stocks are not included nor are component bonds once they are converted into corporate stock.
Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.