Psst – No, You Don’t Have to Settle for Inflation-Lagging Treasuries
Safety is costing investors plenty these days. The current yield on the 10-year Treasury is threatening to fall off the charts completely.
The current Treasury yield doesn’t even generate enough to keep your pot growing on pace with inflation. And thinking you'll make up the difference with that slug of Apple (AAPL) shares is far from a sure thing.
And though it may not be an imminent threat this week, quarter, or year, rates are gonna rise. And when they do, not only are Treasuries the most rate-sensitive segment of the bond market, the current sub-2% yield isn’t going to give you much of any cushion against falling bond prices. (When yields rise, prices fall. An investor’s total return is the combo of yield plus the change in the underlying bond price.)
Municipal bonds currently offer a far better deal. The current yield on a AAA-rated 10-year municipal bond is 2.05%. That interest payment is free of federal tax. If you’re holding your U.S. Treasuries in a taxable account you know full well that the IRS takes a bite out of your earned interest. All Treasury bond interest is taxed as ordinary income. So right off the bat the 2.05% yield on the municipal bond beats the Treasury yield. Add in the tax break and you are looking at an even better deal. If you fall into the 28% federal tax bracket that 2.05% municipal bond yield is the equivalent of a 2.85% taxable yield. Stuck in the 35% marginal bracket? The 2.04% works out to a taxable equivalent yield of 3.13%.
Investing directly in individual municipal bond issues doesn’t make a ton of sense unless you’ve got a seven-figure fixed income portfolio. The spreads on muni bond issues can be pretty large for investors looking to buy in small lots. And there’s the diversification issue: you’d need to buy at least a dozen or so issues -- or more -- to provide some insulation if any single issue were to hit a speed bump. Historically, that’s been highly unusual and is confined to un-rated issues, but bond investing is all about limiting risk, right?
Enter the ETF.
The latest 30-day yield for this ETF is 1.93%. For investors in the 28% federal marginal tax bracket that’s the equivalent of a 2.7% taxable yield. That is one percentage more than you can get on a 10-year Treasury right now. You also get diversification in spades; the index-tracking ETF holds nearly 2,000 issues, with 90% rates A or better.
The average effective duration of the portfolio is 6.6 years. Duration gives you a window into how a portfolio will react to changes in interest rates. If rates were to rise 1 percentage point in a year, the price of the underlying bonds in this portfolio would slump 6.6%. That’s something to pay attention to. Then again, buying a Treasury with a 10-year duration exposes you to even more rate-risk.,/p>