What to Do If Washington Takes Your Retirement Dividends Away

Your next strategy depends on your tolerance for risk

       

If you live in New York State, are married, filing jointly and earn between $300,001 and $2 million, your highest state income tax rate for 2012 is 6.85%, and your taxable equivalent yield is 4.54%. Using this rate for the taxable equivalent calculation is not as extreme as it may look, because the state income tax rate is 6.45% for couples earning from $40,001 to $150,000, and 6.65% for those earning from $150,001 to $300,000.

For New York City residents earning between $90,000 and $500,000, the income tax rate during 2011 was 3.648%. Using that rate and the above state tax rate, the taxable equivalent yield is 4.9%.

house with dollar sign What to Do If Washington Takes Your Retirement Dividends Away
Cash in on Boomers with Senior REITs

Even without considering the tax advantages, the yield on the New York Triborough Bridge and Tunnel Authority bond is higher than some corporate bonds with the same investment-grade ratings.

An IBM (NYSE:IBM) bond rated Aa3/AA- with a coupon of 1.875% expiring on Aug. 1, 2022, was trading Friday at a yield of 2.35%.

Why would a corporate with the same rating trade at a yield only slightly higher than a muni of the same quality? The answer is that the market has been rough for municipal bonds because so many municipalities are having budget difficulties, and some analysts — including Meredith Whitney in September 2010 — expressed fears that a significant number of municipalities could default. There have been a few defaults, but nothing like the “hundreds” of defaults that Whitney expected.

The New York Triborough Bridge and Tunnel Authority bond example cited above is for a new issue, and it’s too late to get in on that one. Municipal bonds are thinly traded, being snapped up immediately by institutional investors and individuals when they are issued. The best approach is to talk to your broker, request information on upcoming municipal issues, and try to make purchases “off the shelf,” which might be your only way of making these investments.

Municipal Bond Funds

You also can consider a municipal bond fund. Of course, since bond prices move in the opposite direction of interest rates, holding shares in a municipal bond fund can require a lot of patience, as you watch your share price drop while rates are rising. But if your long-term objective truly is to generate current income, you should be able to stay committed and ride out the price fluctuations over the years.

TheStreet Ratings provides free ratings for all exchange-traded funds trading on U.S. exchanges that have operated for one year, and also for open-ended funds that have operated for three years. The ratings evaluate and measure ETFs and funds according to variables that include the fund family, fund style, performance, net assets and expense ratio.

An example of a tax exempt ETF rated a “buy” by TheStreet Ratings is the BlackRock MuniHoldings Fund (NYSE:MHD), which is rated an A+ (excellent) and has a yield of 5.65% as of Friday’s close. The fund uses significant leverage, and as of June 29, the average coupon — including zero coupon bonds — was 4.47%, according to BlackRock (NYSE:BLK). The fund “primarily in portfolios of long-term, investment-grade municipal obligations.” As of June 29, 28.7% of the fund’s managed assets were rated above the equivalent of BBB ratings from S&P, while 6% of the managed assets were rated the equivalent of BB or below; 7.1% were unrated.

An example of a buy-rated open-ended municipal bond fund is the Dreyfus New York Tax Exempt Bond Fund (MUTF:DRNYX), with a 30-day yield of 1.87% as of Friday’s close. This fund seeks to invest “substantially all of its assets in municipal bonds that provide income exempt from federal, New York state and New York city personal income taxes.” Dreyfus also says “the fund will invest at least 80% of its assets in investment grade municipal bonds (Baa/BBB or higher), or the unrated equivalent as determined by Dreyfus.”

Losing Trust Preferreds

During the years before the bursting of the real estate bubble and the banking crisis in 2008, income-seeking investors faced with ever-declining municipal, corporate and Treasury bond yields (who were willing to take additional risk) moved into preferred stocks and trust preferred stocks. For many investors, these were favorable income plays, despite the lack of tax advantages.

Investors holding trust preferred shares in banks are going through a painful transition right now, because the Federal Reserve’s proposed rules to implement Basel III capital requirements will exclude most trust preferred shares from regulatory Tier 1 capital. Since this change is considered a “capital treatment event,” the banks are able to redeem the trust preferred shares, even before their call dates, often at face value, despite any premium the market previously placed on these high-yielding securities.

Banks still can issue preferred equity and have it make up between 1% and 1.5% of their Tier 1 common equity ratios, provided that the new issues are perpetual noncumulative preferred shares, meaning the issuer does not need to make up any missed dividend payments.

JPMorgan Chase (NYSE:JPM) on July 12 redeemed $9 billion in trust preferred shares, including nearly $4.2 billion with coupons higher than 6.5%. All the shares were redeemed for face value.

Bank of America (NYSE:BAC) on July 25 redeemed $3.9 billion in trust preferred shares, all of which had coupons of 6% or higher, with $2.3 billion paying over 7.5%. The company paid premium redemption prices for $1.8 billion of the redeemed trust preferred shares.

These redemptions are great news for the banks, since they have been done on the cheap as a result of the regulatory change, and will save the companies quite a bit on dividend payments. That’s good for common shareholders, too, but income-hungry investors are left in the cold.

Neither Bank of America nor JPMorgan Chase have issued any preferred shares since the trust preferred redemptions, but other banks have, at lower rates, which still will be attractive to some investors.

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