Municipal bond investors are clearly worried about rising rates and rising inflation. How do I protect myself—I being the investor—how do I protect myself against rising rates and rising inflation because the idea is to win without losing in this environment?
Now, one way to do that is to buy a TIP—a Treasury Inflation-Protected Security—and that will clearly protect you against inflation. But is it the most tax-efficient way to provide that inflation protection? Because a TIP, the Treasury component of it, the income off that is taxed at ordinary income tax rates. The inflation component is also taxed at ordinary income tax rates, but here’s the kicker there: you don’t receive the benefit of it the year that it’s realized. You receive it when the bond matures, yet you’re paying the income tax during the year it’s realized, something known as phantom income.
So what do you do about that? Well, a better option for someone paying taxes is to have a combination of municipal bonds and CPI swaps. And what’s a CPI swap, a Consumer Price Index swap? Very simple. All a swap is is a[n] exchange of payments. So if I enter into a five-year CPI swap with a counterparty, I’m going to pay them whatever the fixed rate is at the time we enter into that swap, and over the next five years—say it’s a five-year swap—they’ll pay me what actual inflation is.
So as yields are rising—and inflation expectations are likely rising because there’s a high correlation between the two—even though the bonds may be losing value, the swaps are gaining in value and that’s where you get your offset. And the tax efficiency comes in the form of—well, the municipal bonds are tax exempt, and the swaps are taxed at capital gain rates, not ordinary income tax rates. So that’s where you get the tax efficiency from.
Now, what I would urge investors not to do is invest in cash, because cash will lose over time. Yes, it feels safe, it’s synonymous with safety, and in the initial bouts of rising rates it may outperform an intermediate bond. But over subsequent six, 12 months, a bond portfolio will tend to outperform over time.
