Investing in MLPs – Risks and benefits

What is an MLP?

Managed Limited Partnerships (MLPs) have grown in popularity in the past several years. Many U.S. energy firms have reorganized their slow-growing, but stable cash flow businesses, such as pipelines and storage terminals, into MLPs.

MLPs are very attractive to income-seeking investors. They must pass at least 90% of their income to their partners (investors). As a whole, the MLP sector offers on average 6% annual yield with some MLPs reaching over 15%.

Companies that operate as MLPs tend to be in very stable, slow-growing industries, such as pipelines and energy storage. The nature of their business offers few opportunities for price appreciation. On the other hand, cash distributions are relatively stable and predictable giving the MLPs features of both an equity and fixed income investment.

The number of public MLPs increased dramatically in the past 20 years. There were more than 18 IPOs in 2014 from almost zero in 1984.

MLP IPO History 1984 – 2015

MLP IPO History

 

Legal structure

There are two types of MLP owners – general and limited partners. General partners manage the day-to-day operations of the partnership. All other investors are limited partners and have no involvement in the company’s activities. MLPs technically have no employees.

MLP investors buy units of the partnership. Unlike shareholders of a corporation, they are known as “unitholders.”

Each unitholder is responsible for paying their share of the partnership’s income taxes. Unitholders are required to file K-1 forms in each state where the MLP operates, regardless of the size of revenue generated from that state. This filing requirement makes the direct MLP ownership.

Additionally, open-end funds like traditional ETFs are restricted from investing more than 25% of their portfolio in MLPs. Therefore most ETFs choose a C-corporation or ETN structure in order to track the MLP market.

 

Returns

In the past ten years, MLPs had outperformed S&P 500 and similar sectors like Utilities and REITs. MLP reported 9% average 10-year return versus 7.2% for S&P 500, 7.9% for Utilities and 6% for REITs.

Alerian MLP 10 year performance

Source: Alerian.com

Distributions

MLPs provide generous income to their investors. The average yield is around 6% as some small MLPs pay up to 15%. The distributions from MLP consists of non-qualified dividends, return on capital and capital gains.

Since MLPs pass through 90% of their income to unitholders, each type of distribution has different tax treatment.

Dividends are taxed at the ordinary income tax level, up to 39.6% plus 3.8% for Medicare surcharge.

Capital gains are taxable as either long-term or short-term. Long-term capital gains have favorable tax treatment with rates between 0, 15% and 20%. Short-term gains are taxed at the ordinary income level.

The largest portion of MLP distributions comes as a return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income. Return on capital distributions are tax deferred. Instead of being immediately taxable, distributions decrease the cost basis of the investment. Taxes are only due to these distributions when investors sell their units. In fact, investors can defer paying taxes indefinitely by keeping their shares.

Tax Impact

MLP distributions are not sheltered from taxes in retirement accounts. According to the Unrelated business taxable income (UBTI) rule, unitholders will owe taxes on partnership income over $1,000 even if the units are held in a retirement account.

Individual MLP holdings, ETFs, mutual funds and CEFs are most suitable for long-term buy and hold investors in their taxable investment accounts. Those investors can benefit from the tax-deferred nature of the cost of capital distributions, which will decrease their cost basis over time. They will pay taxes only when they sell their units. Investors can avoid paying taxes indefinitely or until cost basis reaches zero. In that case, they will owe taxes on the return of capital distributions at the long-term capital gain rate.

Short-term investors may consider ETNs for their better index tracking. All distributions from ETNs are taxable as an ordinary income level and do not provide any preferential tax treatment.

Risk considerations

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices compared to other oil & gas companies. Historically, MLPs as a group is less volatile than the broader energy sector. MLP price tends to have a direct correlation with the partnership distributions. Higher payouts drive higher prices while lowers distributions push the price down.

Between September 2010 and October 2016, the largest MLP ETF, AMLP had a standard deviation equal to 14.8%. As a comparison, the largest energy ETF, XLE, had a standard deviation of 19.61%.

MLPs are often treated as an alternative investment due to their considerable ownership of real assets. They also have a lower correlation with the broad equity and fixed income markets while simultaneously having characteristics of both. AMLP has 0.57 correlation with S&P 500 and -0.16 to the 20-year treasury.

 

Investing in MLPs

Direct ownership

As of March 31, 2016, 118 energy MLPs were totaling $304 billion in market capitalization.

The most popular index tracking the MLP space is Alerian MLP. The index has 44 constituents and $298 billion market capitalization.

There are ten companies dominating the sector. They make up close to two-thirds of the Alerian MLP Index. The remainder consists of hundreds of small and mid-size partnerships. 

Largest public MLPs

 

Direct MLP ownership is a popular strategy for yield-seeking investors. The direct investing also provides the most beneficial tax treatment of MLP distributions – tax deferral.

However, the biggest drawbacks of direct investing are the large tax filing cost and the exposure to a single company.

Investors interested in direct ownership in MLPs should consider buying a basket of partnerships to diversify their risk more efficiently. They should also weight the tax benefits of direct ownership versus the cost of year-end tax filing.

ETFs and ETNs

MLP ETFs and ETNs have the most complex legal and tax structure of any other ETFs. Due to these complexities, most funds are structured as ETNs.

There are 28 MLP ETFs and ETNs currently listed on the exchange. Their total Asset Under Management (AUM) is $17.7 billion with the top 4 ETFs dominating the space with total AUM equal to $15.9 billion.

 

List of MLP ETFs and ETNs

 

AMLP

AMLP is the most popular and liquid MLP ETF. It tracks the Alerian MLP index. AMLP is the first ETF to address the complexity of direct MLP ownership.  This ETF offers a broad diversification to the largest publicly traded MLPs.

AMLP offers simplified tax filing by issuing standard 1099 form. Because of its legal structure, AMLP can pass the tax-deferred treatment of MLP distributions to its investors.

To satisfy the legal restrictions on ownership, AMLP is structured as a corporation, not an actual ETF.  AMLP pays taxes at the corporate level. The structure requires the fund to accrue the future tax liabilities of unrealized gains in its portfolio. Doing this is causing the fund to trail its underlying Alerian Index during bull markets and beat it during down periods.

AMJ

AMJ is the next most popular fund in this category. It i
s structured as an exchange-traded note.

ETNs are an unsecured debt instrument structured to track an underlying index’s return, minus management fees. Unlike exchange-traded funds, ETNs do not buy and hold any the underlying assets in the indexes they track. They represent a promise by the issuing bank to match the performance of the index.

AMJ is issued by JP Morgan and capped at the market value of $3.885 billion. Investors in AMJ have credit exposure to JP Morgan in case they are not able to pay the performance of the index.

Due to the lack of actual MLP ownership, AMJ can replicate the performance of the Alerian MLP index much closer than AMLP.

AMJ also issues single 1099 tax form. However, all its distributions are taxable as ordinary income, for up to 39.6% plus 3.8% of Medicare surcharge. AMJ distributions do not have the preferential tax treatment of AMLP and individual MLP ownership.

This ETF is suitable for short term investors willing to bet on the MLP sector and not interested in any potential income and tax benefits.

EMLP

EMLP is the only traditional ETF in this group. Because of the regulatory restrictions, EMLP holds only 25% stake in MLPs and the remaining 32% in Energy, 40% in Utilities and 2% in Basic Materials. Unlike the other funds, EMLP has a broader exposure to companies in the energy infrastructure sector. According to the prospectus, the fund invests in publicly traded master limited partnerships and limited liability Canadian income trusts,, pipeline companies, utilities, and other companies that derive at least 50% of their revenues from operating or providing services in support of infrastructure assets such as pipelines, power transmission and petroleum and natural gas storage in the petroleum, natural gas and power generation industries.

Mutual Funds

The three Oppenheimer mutual funds are dominating this niche. They manage almost 50% of the $20b AUM by MLP mutual funds.

A list of the most popular mutual funds by AUM.

MLP Mutual Funds

 

The MLP mutual funds tend to have higher fees than most ETFs. They utilize the corporate structure which allows them to transfer the majority of the income and tax advantages to their shareholders.

Closed-End Funds

Closed-End funds (CEF) are another alternative for investing in the MLP sector. Similarly to mutual funds,  CEFs are actively managed. The difference is that they only issue a limited number of publicly traded shares.

Most MLP closed-end funds use leverage between 24% to 40%  to boost their income. These funds borrow money in order to increase their investments.

MLP Closed End Funds

CEFs shares often trade at premium or discount from the NAV of their holdings. When purchased at a discount they can offer potential long-term gains to interested investors.

MLP CEFs also use the c-corp structure. They issue a 1099 form and pass current income and return on capital to their investors allowing for tax-deferral benefits on the distributions.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,  Image Copyright: <a href=’http://www.123rf.com/profile_kodda’>kodda / 123RF Stock Photo</a>

 

 

 

 

 

 

10 Ways to reduce taxes in your investment portfolio

10 Ways to reduce taxes in your investment portfolio

Successful practices to help you lower taxes in your investment portfolio

A taxable investment account is any brokerage or trust account that does not come with tax benefits. Unlike Roth IRA and Tax-Deferred 401k plans, these accounts do not have many tax advantages. Your contributions to the account are in taxable dollars. This is money you earned from salary, royalties, the sale of property and so on. All gains, losses, dividends, interest and other income from any investments are subject to taxes at the current tax rates.  In this post, we will discuss several successful practices that can help you lower taxes in your investment portfolio

Why investors put money into taxable accounts? They provide flexibility and liquidity, which are not available by other retirement accounts. Money is readily accessible for emergencies and unforeseen expenses. Many credit institutions take these accounts as a liquid asset for loan applications.

Since investment accounts are taxable, their owners often look for ways to minimize the tax impact at the end of the year. Several practices can help you reduce your overall tax burden.

1. Buy and Hold

Taxable investment accounts are ideal for buy and hold investors who don’t plan to trade frequently. By doing that investors will minimize trading costs and harvest long-term capital gains when they decide to sell their investments. Long-term capital gains are taxable at a favorable rate of 0%, 15% or 20% plus 3.8% Medicare surcharge. In contrast, short-term gains for securities held less than a year are taxed at the higher ordinary income level.

Individuals and families often use investments accounts for supplemental income and source of liquidity. Those investors are usually susceptible to market volatility. Diversification is the best way to lower market risk. I strongly encourage investors to diversify their portfolios by investing in uncorrelated assets including mid-cap, small-cap, international stocks, bonds, and real assets.

2. Invest in Municipal Bonds

Most municipal bonds are exempt from taxes on their coupon payments. They are considered a safer investment with slightly higher risk than Treasury bonds but lower than comparable corporate bonds.

This tax exemption makes the municipal bond suitable investment for taxable accounts, especially for individuals in the high brackets category.

3. Invest in growth non-dividend paying stocks

Growth stocks that pay little or no dividend are also a great alternative for long-term buy and hold investors. Since the majority of the return from stocks will come from price appreciation, investors don’t need to worry about paying taxes on dividends. They will only have to pay taxes when selling the investments. 

4. Invest in MLPs

Managed Limited Partnerships have a complex legal and tax structure, which requires them to distribute 90% of their income to their partners. The majority of the distributions come in the form return on capital which is tax-deferred and deducted from the cost basis of the investments. Investors don’t owe taxes on the return on capital distributions until their cost basis becomes zero or decide to sell the MLP investment.

One caveat, MLPs require K-1 filing in each state where the company operates, which increases the tax filing cost for their owners.

 5. Invest in Index Funds and ETFs

Index funds and ETFs are passive investment vehicles. Typically they track a particular index or a benchmark. ETFs and index fund have a more tax efficient structure that makes them suitable for taxable accounts. Unlike them, most actively managed mutual funds frequently trade in and out of individual holdings causing them to release long-term and short-term capital gains to shareholders.

6. Avoid investments with a higher tax burden

While REITs, taxable bonds, commodities and actively managed mutual funds have their spot in the investment portfolio, they come with a higher tax burden.

The income from REITs, treasuries, corporate and international bonds is subject to the higher ordinary income tax, which can be up to 39.6% plus 3.8% Medicare surcharge

Commodities, particularly Gold are considered collectibles and taxed at a minimum of 28% for long-term gains.

Actively managed funds, as mentioned earlier, periodically release long-term and short-term capital gains to their shareholders, which automatically triggers additional taxes.

7. Make gifts

You can use up to $14,000 a year or $28,000 for a couple to give to any number of people you wish without tax consequences. You can make gifts of cash or appreciated investments from your investment account to family members at lower tax bracket than yours.

8. Donate 

You can make contributions in cash for up to 50% of your taxable income to your favorite charity. You can also donate appreciated stocks for up to 30% of AGI. Consequently, the value of your donation will reduce your income for the year. If you had a good year when you received a big bonus, sold a property or made substantial gains in the market, making donations will help you reduce your overall tax bill for the year.

9. Stepped up cost basis

At the current law, the assets in your investment account will be received by your heirs at the higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and proceeds received in cash), they are not subject to taxes on any long-term or short-term capital gains. Your heirs will inherit the stocks at the new higher cost basis.  However, if your investments had lost value over time, you may wish to consider other ways to transfer your wealth. In this case, the stepped-up basis will be lower than you originally paid for and may trigger higher taxes in the future for your heirs.

10. Tax loss harvesting

Tax loss harvesting is selling investments at a loss. The loss will offset gains from other the sale of other securities. Additionally, investors can use $3,000 of investment losses a year to offset ordinary income. They can also carry over any remaining amounts for future tax filings.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image Copyright: <a href=’http://www.123rf.com/profile_adamr’>adamr / 123RF Stock Photo</a>

 

 

 

 

 

 

 

 

High Dividend ETF Strategies

Introduction

The market has been observing consistently declining yields ever since the start of the financial crisis in 2008. In the current low yield environment, 10-year Treasury bond pays a mere 1.6% in interest and S&P 500 yields just above 2% in dividends.

Furthermore, we observe negative interest rates in Japan, Switzerland, and Germany.

At the same time, saving account rates in the US are at a record low with no prospects to go higher anytime soon. Oil hit $30 per barrel, and many energy companies that traditionally pay high dividends cut their payout.

The recent UK vote to leave the EU, more concerning news from China and sluggish growth in the US are very likely to delay another rate hike for a long time.

Income-seeking investors are facing challenges in finding safe investments that can provide them with a supplemental income. In their quest for yield, many investors are exploring more exotic asset classes that they have neglected previously. Furthermore, each of these asset classes has specific economic risks and tax treatment. Subsequently, investors interested in higher yielding investments need to understand how each one fits within their risk tolerance and asset allocation target.

For all yield-seeking investors, ETFs represent a low-cost and tax efficient alternative. Therefore we have seen significant inflows into passive high-dividend ETFs in the past few years.  We will walk you through the major asset classes that drive that interest. Also, we will show the largest ETFs by Asset Under Management (AUM) in each category.

 

High Dividend US Equity

Dividends are a significant driver of total returns. Historically, dividend income has accounted for about 40% of the return from stocks, with the remainder coming from growth in earnings and inflation.

DVY, VYM, SDY, SCHD are the most popular ETFs investing in high dividend US equity. As of September 12, 2016, all four ETFs had outperformed SPY by a significant margin. DVY and SDY reported price return of 15.1% and 16.27% versus 6% for SPY.

List of US Equity High Dividend ETFs

Large Cap US Equity Dividends ETFs

Most ETFs tend to invest in companies with a history of consistent or increasing dividend payout. While all of them try to achieve the same goal, they have different ways of doing it. Some ETFs tilt towards large cap finance and utility stocks. Others lean towards mid and small size companies. Most of the ETFs on the list do not invest in REITs and MLPs. They pay qualified dividends which are taxable at the more favorable rate at 0%, 15% or 20% plus 3.8% Medicare surcharge.

The highest risk with this strategy is that companies can cut dividends upon company discretion. Instead of paying dividends, management can direct funds to cover operational expenses or expected losses. For instance, many of the financial companies cut their dividend significantly during the crisis of 2008-2009. Most recently, energy companies decreased their dividends as the price of oil reached $30 per barrel.

Sectors

Utilities and Energy are among the sectors with the highest dividend payout apart from REITs. There is the list of the largest ETFs invested in these two areas.

Utilities ETFs

Energy ETFs

 Energy ETFs

International Equity

International high dividend strategy seeks the highest dividend paying securities outside of US. Investments comprise of a wide range of companies from Europe to Asia and Australia and from large to small sizes.

Foreign stocks have underperformed US stocks consistently for the past ten years. On the other hand, high dividend international stocks have outperformed broad market foreign stock on both absolute and risk-adjusted basis. An additional benefit of investing in this strategy is the lower correlation to the US market which will decrease the risk in a diversified portfolio.

 International Equity High Dividend ETFs

REITs

Equity REITs

An equity real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties bundled together and offered in the form of unit investment trusts. REITs must pay out 90% of its taxable income to shareholders as dividends.

Consequently, they can deduct dividends paid to shareholders from its taxable income. This income is exempt from corporate-level taxation and passes directly to investors. REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties,  prisons, theaters,  golf courses, and timberlands.

REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties,  prisons, theaters,  golf courses, and timberlands.

VNQ dominates the REITs ETF space with$34 billion of AUM.

REITs ETFs

 

Mortgage REITs

Mortgage REITs provide real estate financing through the purchase of mortgages and mortgage-backed securities (MBS). They profit by exploring the difference between long term and short-term financing rates. Mortgage REITs are among the highest dividend paying companies. They are also one of the riskiest. They are highly sensitive to interest rates and economic cycles.

There are only two mortgage REIT ETFs – tickers REM and MORT.

Mortgage REITs

Investors who are looking for more diversified exposure may also consider IYR. This ETF invests in a broader range of equity and specialty REITs including mortgage and timber REITs.

Tax Treatment of REITs distributions

REITs dividend distributions for tax purposes come as to ordinary income, capital gains and return on capital,  which have different treatment for tax purposes. REIT ETFs must provide shareholders with guidance on how to allocate their dividends in the various categories.  The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

The majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6%, plus a separate 3.8% Medicare surtax on investment income.

Capital gains distribution is taxable at either 0, 15 or 20 % tax rate, plus the 3.8% surtax.

Return on capital distributions are tax-deferred. They decrease the cost basis of the investment. Investors owe taxes on these distributions only after they sell them.

MLPs

Another favorite dividend alternative for yield-hungry investors is the master limited partnership or MLP. MLPs resemble some of the features of the REITs. They are required to pass at least 90% of their income to their partners/investors. This structure is especially popular with energy companies that own and operate liquid and gas pipelines along with storage facilities and processing plants that bring energy products to market.

List of MLP ETFs and ETNs

MLP ETFs and ETNs

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices. Therefore MLPs as a group is less volatile than the broader energy sector. Bear in mind that 2015 oil prices drop to $30 per barrel negatively impacted many MLPs. As a result, the Alerian MLP Index went down by -38%, triggering sustainability concerns about many of the smaller size MLPs.

Legal Status, Tax Treatment, and Placement

The largest portion of MLP distributions is in the form of return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income.

Due to their legal structure, direct MLP ownership requires federal K-1 tax forms filing in every state in which each MLP operates. MLP ETFs and ETNs address the issues with the filing and provide broader diversification.

ETFs and ETNs have entirely different legal status. MLP ETFs are organized as a C-Corporation. As a result, most distributions are tax-deferred, similar to the underlying MLPs.

ETNs are unsecured debt instruments. MLP ETNs are not backed by underlying securities but by the issuing bank’s promise to pay. Because of that, MLP ETN distributions are treated as ordinary income.

Both structures can suit different types of investors. All tax, economic and legal issues need to be considered carefully before purchase.

 

 

Preferred Stocks

Preferred stocks are a hybrid between equity and fixed income. They trade on the stock exchange. These shares represent a special ownership in the equity of a company with a fixed dividend payout. Preferred stocks do not usually give voting rights, but offer a higher claim on assets and earnings than common stock.

PFF leads this segment with over $17 billion of AUM.

Preferred Stock ETFs

Risk Exposure

Preferred shares are less volatile than common stock. They have a lower downside risk but also smaller upward potential. They are suitable for investors seeking more reliable income and less interested in price return.

Traditionally the financial sector is the primary issuer of preferred stock. For that reason, these asset class was hurt very hard during the financial crisis in 2008-2009. Furthermore, many of the high-yielding preferred stocks currently available on the market were issued during or after that same recession.

Investors interested in preferred stock will face credit risk. The average credit rating of the issuances held by major ETFs is BBB, which is the lowest investment grade rating. The credit rating determines the ability and risk of the issuer to pay off its debt.

Preferred stock investors have exposure to interest rate risk. Preferred shares are inversely related to changes in interest rates. Therefore, their value will decrease as interest rates go up and increase as rates go down.

Preferred stocks are positively correlated with the equity market. Their seven-year correlation to US market is equal to 0.6. While their correlation with the broad bond market is 0.2.  Preferred shares are not as volatile as equity stocks and have more predictable returns.

In the current low-interest environment, the issuers of preferred stocks (such as like Wells Fargo, HSBC, Barclays, Citigroup, Deutsche Bank) can decide to call them back, convert them to ordinary stock or replace them with lower yielding alternatives.

Tax treatment

U.S. corporation can exclude up to 70 percent of the preferred dividend from their taxable income as long as they hold the shares at least 45 days.

This benefit is not available for individual investors. For them, the dividends are taxable on the full amount at the favorable rate for qualified dividends – 0%, 15%, and 20%.

Placement

Due to their high dividend, favorable tax rate, and low expected volatility, the preferred stock ETFs are a suitable option for all investment type accounts.

 

High Yield Bonds

High Yield Bonds are fixed income securities issued by companies with below investment grade rating.  To attract investors, high yield issuances offer a higher yield. Currently, an average high yield bond pays 2% more than comparable investment grade bond. Also known as junk bonds, they present a much higher credit risk compared to equivalent investment grade bonds. Their embedded credit risk rating ranges between BB and CCC.

HYG and JNK are the most popular ETFs in the High Yield space with AUM of $15 billion and $11 billion respectively.

High Yield ETFs

Risk Exposure

Similarly to preferred stocks, high yield bonds have a positive correlation with both equity and bond markets. They have much stronger correlation ratio to the US markets, 0.76, versus US bond markets, 0.2.  This relationship extends from the issuer’s ability to pay off the debt, which more often depends on the success of their business model rather than changes in interest rates.

High yields bonds over-perform comparable investment grade bonds during a stable economy cycle and a low-interest environment. Rising rates, increasing credit spreads, recession and spike in business defaults will negatively affect high yield bond markets. In these cases, the value of the bonds will decline driven by adverse factors that will lower the issuers’ ability to pay off current debt.

For individual investors, high yield bond ETFs provide much better diversification than holding individual bonds. The largest ETF, HYG, owns over 1,000 bonds.  Without significant investment in research, ETFs offer low-cost alternatives into the high yield bond segment versus mutual funds.

Tax treatment

Investors in high-yield bonds pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.

Placement

Due to their high tax rate and greater volatility than other fixed-income instruments, high-yield bonds are more suitable for tax-exempt and tax-deferred accounts.

 

Emerging Market Bonds

Emerging market bonds are government and corporate bonds issued by states and companies from the group of emerging economies. Primary EM bond issuers come from countries like Mexico, Turkey, Philippines, Indonesia, Russian Federation, Hungary, Brazil, Poland, Colombia, South Africa, and few others.

EMB and PCY are the leading Emerging Market Bond ETFs. Their AUM is $9 billion and $3.9 billion respectively. Like other investment classes, ETFs investing in emerging market bonds offer diversified regional and industry exposure.

Emerging Market Bond ETFs

Risk Exposure

Frequently, emerging bank bonds receive a below investment grade rating, which shows the significant credit risk to bondholders. There have been many examples of emerging economies not being able to pay off their debt. The most recent case was Argentina and Brazil. In the not so distant future, Russia and Turkey had similar troubles. The International Monetary Fund (IMF) or the World Bank often intervene in a case of country debt default.

In addition to credit and interest rate risk, investors in these securities have exposure to currency risk. For instance, a significant depreciation of the local currency can significantly undermine the USD value of the bonds from that country.

Similarly to high yield, emerging market bonds have ties to both equity and bond markets. They have an equal correlation to US equity and bond markets with correlation ratio equal to 0.48.

Tax treatment

Investors in Emerging market bond pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.

Placement

Similarly to high yield, the emerging market bonds come with a high dividend, unfavorable tax rate, and higher expected volatility. Due to these factors, high-yield bonds are more suitable for tax-advantaged accounts such as Roth IRA, 401k, and Traditional IRA.

Muni Bonds

Municipal bonds are debt securities issued by municipal authorities like states, counties, cities and their related companies. The primary objectives of Municipal bonds are funding general activities or capital projects like building schools, roads, hospitals, and sewer systems.

The size of the muni bond market is equal to $3.7 trillion dollars. There are about 350 billion dollars of Muni bonds issuance every year.

MUB is the largest Muni ETF with AUM of 7.6 billion dollars. It holds a broad basket of national municipal bonds with intermediate maturities.

Muni ETFs

Risk Exposure

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates go decline, the bond prices will rise.

Individual municipal bonds and municipalities receive a credit rating by major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the issuer to pay off its debt.

Unlike corporations, which can go bankrupt and disappear, municipals can’t go away. They have to continue serving their constituents. History proves that municipal bonds have much lower default rates than comparable corporate bonds.

Tax Treatment

To encourage people to invest in Municipal Bonds US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. Furthermore, when the bondholders reside in the same state as the bond issuer, they do not pay state taxes.

Therefore, the majority of the municipal bond issuances enjoy tax-free status. Bondholders do not pay federal taxes on the coupon received from these securities. Besides, investors residing in the same state enjoy a state tax-free status as well.

Particular Municipal bonds related to business activities can affect their owners’ AMT status and potentially increase annual taxes.

Also, there is a small but growing group of taxable municipal bonds. These issuances relate to activities that do not provide a significant benefit to the general public.

Placement

Tax Exempt Municipal Bonds are only suitable for taxable accounts where investors can take advantage of their tax-free status.

Finally, investors interested in taxable or AMT bonds can consider placing them in their tax-deferred accounts like IRA and 401k.

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com