DMB - Earn Strong Tax-Free Income: DMB

2023-07-12 07:35:00 ET

Summary

• Who doesn't love paying less taxes? Now you can earn excellent income and don't have to pay any taxes on it whatsoever.
• If you love buying things that are at a discount, you'll love buying this on a double discount.
• Fund American's infrastructure and America funds your retirement.

Co-authored with Treading Softly

What I often find fascinating about the history of various criminals is that, so often, major criminals can be brought down simply on tax evasion alone. It's one of the reasons why the IRS is one of the most feared bureaucracies within the United States of America. The famous gangster Al Capone was brought down on tax evasion charges. So many other of his crimes were widely known, but they were unable to successfully pin them on him in a way that would send him to prison. But the fact that he was able to live a lavish lifestyle while reporting next to no income to the government was enough to turn it around and cause him to go to jail for tax evasion.

It's not uncommon for the rich to be accused of actively trying to avoid paying taxes in a way that would potentially be illegal. The U.S. Congress is frequently trying to close tax loopholes or find tax havens and close those opportunities so that everyone pays their "fair share." While I don't want to discuss what someone's fair share would be, I do want to help you save a few tax dollars... legally.

What if I told you that you could get paid a strong income and not have to pay a dime to the government? You probably think I was paying you under the table, but this is entirely above board and completely acceptable.

This is possible because municipal governments often need funding by creating debt that regular investors would then need to buy. To sweeten the deal, the Federal government makes this debt tax-exempt. By providing this tax break, the government helps encourage lending, ensuring local governments get the funding they need to expand the tax base.

The downside to this debt often is that it is extremely long in maturity and duration and, therefore, extremely interest-rate sensitive. So as interest rates have climbed heavily in the last year, much of this debt has been sold off heavily, with much of it trading at discounts to par. This creates an opportunity for those who are willing to buy discounted debt at higher yields and then hold it until maturity. You will not only receive large sums of interest income that is tax-free but also enjoy some capital gains when they mature.

Let's look at one such opportunity provided to us in the market today!

Welcome to Munis

BNY Mellon Municipal Bond Infrastructure Fund ( DMB ), which yields 4.5%, is a Closed-End Fund ('CEF') that invests in municipal bonds, also known as "munis". Munis have a few advantages over corporate bonds. For starters, the interest is tax-exempt at the Federal level. Additionally, municipalities historically have had a lower default rate than similarly rated corporations. This makes them attractive to conservative investors.

However, the past year has not been friendly to any debt investments, and some of the most "conservative" ones in terms of credit risk have been the hardest hit.

Note that high-yield corporate bonds, which have the highest default risk, had a positive total return in the past three years, while U.S. Treasuries, which have no default risk at all, have had a significantly negative total return.

This is how bonds work; when interest rates go up, prices come down. Longer-term and lower-risk bonds will see their prices fall more than shorter-term and higher-risk bonds. Why?

Bond prices are decided by two factors: the "risk-free rate" plus a "risk premium." When interest rates rise, it is the risk-free rate that is going up. The risk premium will vary depending on how worried investors are about future default risk. In the case of U.S. Treasuries, there is no risk premium at all, so 100% of the price is based on the risk-free rate.

Duration

Say today I bought a U.S. Treasury with a 2% coupon for $100. Tomorrow, U.S. Treasury rates shoot up to 3%, and I can buy a 3% coupon for $100 that matures just one day later. Can I sell the 2% coupon for $100? Of course not! Any buyer would rather get a new Treasury paying $3/year instead of $2. So if I wanted to sell, I would have to offer a discount. How much of a discount? That depends on when it matures.

If both matured in one year, then I could sell the 2% bond for around $99. The buyer would receive $2 in interest and $1 in capital gains, approximately the same return as the 3% coupon bought for $100.

What if they both matured in 20 years? Then I would have to sell the 2% coupon Treasury for around $85 because, for 20 years, the 3% coupon would be paying an extra $1/year, and that difference has to be accounted for. As the maturity date got closer, the discount relative to the 3% coupon would diminish.

Risk Premium

Now say a corporate bond is priced with a risk premium of 500 bps, and you buy when the risk-free rate is 2% for $100. The bond pays a coupon of 7% (2% risk-free rate + 5% risk premium). The next day, the risk-free rate rises 100 bps to 3%, and the company issues a new bond at the same risk premium. The new bond pays a coupon of 8%. How much is the 7% coupon worth?

With the same 20-year maturity for each, as described above for the Treasuries, the 7% coupon would be worth around $90 to have a yield to maturity of 8%.

What This Means For DMB

Obviously, interest rates don't change so dramatically in one day, so the math above is overly simplified. When interest rates change, you are comparing bonds with varying coupons and varying maturity dates. Also, the risk premium is not fixed; it frequently fluctuates with investor sentiment.

The bottom line is that shorter-term and higher risk will mean a lower pricing impact from changes in the risk-free rate, while longer-term and lower-risk bonds will experience a higher impact.

DMB invests in longer-term, lower-risk bonds. The change in the risk-free rate since the Fed began its hiking cycle has been the primary contributor to the price downside DMB has experienced. Source

Some investors look at DMB's price action and run away. Investors often do when it is the best time to buy. This isn't the first time in history that DMB's NAV has fallen. The last time was in 2013, and NAV is at about the same level it was in early 2014.

Those who paid attention to the bond markets will remember the "taper tantrum," which until last year, was one of the worst years for bonds in history. What happened to those who were buying at those prices?

DMB outperformed the S&P 500 over the next 6 years.

It was, in short, a fantastic time to be a buyer of munis and DMB in particular.

At HDO, we bought DMB as part of our strategy to be "agnostic" towards interest rates. We wanted a holding that would perform best if the Fed pivoted. Well, the Fed hasn't pivoted... yet. We all know that, eventually, they will. We can be quite confident that there isn't going to be a massive wave of defaults in DMBs portfolio. When bond prices recover, DMB will be holding the same bonds and will benefit from rising prices. We are quite happy to buy while prices are low, both for bonds in general and for DMB, which is trading at a 9% discount to NAV.

Conclusion

While DMB has sold off heavily in the last year, it is currently trading at a deep discount to par, while owning bonds that are also trading at a discount. This means that you combine the fun of a discount on its book value while it holds bonds at a discount to par, in essence, you are doubling the discount that's available for your funds, making each dollar stretch farther.

This leaves a highly attractive total return possibility looking forward as we feel that interest rates are near their top and eventually going to be held steady or start to decline. In the meantime, it pays excellent Federal tax-exempt income while you wait.

One important aspect of being an income investor and being a professional income investor is that you understand that time is your friend. You can look back at history to understand the cycles of how interest rates impact various funds and use that history to help you understand what's going on in the present and estimate the future. Furthermore, we are paid to wait, so every dividend received is an irrevocable return to your portfolio. Someone can't decide to come and take that back from you later - it's a locked-in return.

This means that the income investor who capitalizes on this opportunity can simply sit back and enjoy an excellent income. You can enjoy the summer sun at the beach, go for a walk with your dog, or spend time with loved ones without worrying about what your portfolio is doing because you know where your income is coming from.

That's the beauty of my Income Method. That's the beauty of income investing.

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