Taxable or Tax-free?For investors who wish to stick with higher-rated bonds, here's a quick comparison, illustrating the tax implications, the dismal overall rate environment, and the market pressure on municipal bond prices. Keep in mind that these are not investment recommendations. They are just examples to provide food for thought, and it would be a good idea to have detailed discussions with your broker or investment adviser about various was to invest for current income. A newly issued New York Triborough Bridge and Tunnel Authority bond that settles on Thursday and matures on November 15, 2023, has a coupon of 5.00%, with a yield of 2.26%, through its optional redemption date of November 15, 2022. The bond is rated Aa3 by Moody's Investors Service and AA- by Standard & Poor's. While that may not seem to be a very impressive yield at first, the interest is exempt from federal, New York State and New York City income taxes. In case you're wondering why the yield is so low relative to the coupon, it is because many municipal bonds are issued with above-market coupons and huge premiums. If rates move up sharply and the market price of the bond declines below par -- known as a "de minimus" situation -- some investors are subject to federal income taxes on the otherwise tax-exempt dividend. If you divide that 2.26% yield by one minus your combined marginal tax rate, you have the taxable equivalent yield, which can be used for comparison. Going to extremes, if you are in the highest federal tax bracket, with your investment income also subject to the new 3.8% Medicare tax for a combined 43.4% federal rate, your taxable equivalent yield on the Triborough Bridge and Tunnel Authority paper is 3.99%. 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.
Municipal Bond FundsYou can also 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 which include the Fund Family, Fund Style, Performance, Net Assets and Expense Ratio.
Losing Trust PreferredsDuring 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 can still 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 that the issuer does not need to make up any missed dividend payments. JPMorgan Chase ( JPM - Get Report) 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 ( BAC - Get Report) on July 25 redeemed $3.9 billion in trust preferred shares, all of which had coupons of 6.00% or higher, with $2.3 billion paying over 7.50%. The company paid premium redemption prices for $1.8 billion of the redeemed trust preferred shares.
Pursuing Higher YieldsThere are opportunities out there for investors looking for a higher level of current income, who are willing to take on greater risk than that represented by the above bond or preferred stock examples. Energy limited partnerships can offer attractive dividend yields, with some growth prospects. While the following two examples have seen moderate share price declines year-to-date, in a weak market for energy prices, they both feature attractive dividend yields, with dividends increasing over time, and very strong price performance over the long haul. Kinder Morgan Energy Partners, LP ( KMP) is mainly a gas pipeline operator. The partnership shares have a yield of 5.98%, based on the most recently quarterly distribution of $1.23 and Monday's closing price of $82.23. The company has had a very strong track record for dividend increases over the past several years. The five-year total return for the partnership units was 130%, through Monday's close. KMP data by YCharts
Regarding energy prices, Deutsche Bank analyst David Bianco on Monday said "the sharp selloff in oil prices in May-Jun was among the first signals of slowing global growth. The rebound in oil prices since then despite no improvement in China growth, stronger dollar and diminished likelihood of