Why Treasury Bonds Today Are a Sucker Bet

by: Investment U

By Alexander Green

In the three weeks since I pointed out the bubble in the U.S. Treasury market, those securities have gotten walloped, as yields have risen over one half of one percent.

I’ve received letters from many readers, asking what they should do now with the fixed-income portion of their portfolios. For income investors, I have three answers:

  1. High-yield corporate bonds.
  2. Inflation-adjusted Treasuries (TIPS).
  3. Tax-free municipal bonds.

Especially tax-free bonds. Here’s why:

  • They yield more than Treasuries.
  • They’re exempt from federal income taxes (and state income taxes if you buy state-specific bonds).
  • Your taxes will soon be going up.

Why Income Doesn’t Properly Reflect Real Wealth

I know, I know, Washington politicians promise they aren’t going to raise your taxes, and that they’re only going to raise them on the 2% of American households that make $250,000 or more. This is horse manure.

Having deliberately set up a fiscal crisis over the past decade, our elected misrepresentatives will soon be searching for ways to raise revenue to meet these obligations. The politically convenient idea is to raise taxes only on “America’s wealthiest.”

Yet earned income is often a poor indicator of wealth. Apple (NASDAQ:AAPL) CEO Steve Jobs, Citigroup CEO (NYSE:C) Vikram Pandit, Google (NASDAQ:GOOG) CEO Eric Schmidt, Yahoo (NASDAQ:YHOO) CEO Jerry Yang, Oracle (NASDAQ:ORCL) CEO Larry Ellison and Berkshire Hathaway (NYSE:BRK.A) CEO Warren Buffett all receive annual salaries of $1.

Real wealth is determined by looking at a balance sheet not an income statement. The tax code is set up to punish high-income earners, many of whom are not rich but rather striving to become rich.

The problem with raising taxes on high earners is that this country badly needs to create jobs in the private sector. These top 2% – who already pay almost half of all income taxes, according to the Internal Revenue Service – are overwhelmingly small business owners. If the economy is going to grow, we want to encourage them to open new businesses and expand existing ones.

I know some economists claim that raising taxes doesn’t discourage risk-taking. Let’s put that theory to a simple test:

The Small Business Tax Roadblock

Imagine if someone offered you $50 to deliver an important document to a business located in the next town. Would you do it? How about if he offered $40? How about $30? Or $20?

If you feel less inclined to accept each declining offer, congratulations. You’ve recognized that the more you pay in taxes – which is the same thing as being offered less money to do the same job – the less interested you are in doing the work.

Of course, small business owners are primarily wage payers, not wage earners. Take a moment and put yourself in their shoes. Imagine risking your hard-earned capital on a new business, fully aware that customers may complain that you charge too much, employees may believe you pay them too little, suppliers may claim you drive too hard a bargain, government officials may insist you aren’t complying with their mountain of regulations, and competitors, plain and simple, would like to drive you out of business.

Factor in the well-known fact that four out of five new businesses fail in the first five years. If you manage to meet these challenges and become profitable, the government – between federal income taxes, state income taxes, social security taxes, Medicare taxes and others – will take up to half of what you make. And some argue that higher taxes aren’t a disincentive to start or expand a business?

The Problem With Taxing the Top 2%

Of course, you can’t run a government without collecting taxes. But here’s the key. You increase revenue by expanding the tax base not increasing tax rates. (That means expanding the private sector, not the public one.)

You want to reward education, hard-work and risk-taking. In short, you don’t raise up the wage earner by pulling down the wage payer. Of course, many of our elected “leaders” have never held a job in the private sector, so – to them – this is all just the sheerest conjecture.

I hate to burst anyone’s bubble. But we won’t solve this nation’s fiscal crisis on the backs of the top 2% of income earners. Nor should we try. Sure, it’s a political winner in some circles. But history shows that “soaking the rich” doesn’t work.

Which state has the biggest fiscal crisis in the United States? California. Which state has the highest state income taxes? California. Other high-tax states are in a similar pickle. And look at Greece. The country has a top marginal tax rate of 40%, plus a 23% value added tax (VAT), recently raised from 21%. Yet the country is a financial basket case. Why?

Because governments around the world are overreaching and politicians – ever intent on securing their re-election – are addicted to spending.

How to Beat the Washington Pick-Pockets

As Margaret Thatcher pointed out a couple decades ago, the problem with the social-welfare system is that eventually you run out of other people’s money.

With the current state of the economy, most politicians are reluctant to raise taxes. But history shows that they simply will not cut spending. (That includes Republicans. Witness the rise of the Tea Party movement.) Heck, they won’t even cut the growth of spending.

Needless to say, it’s only a matter of time before Washington turns its attention to your wallet. And that, in a nutshell, is why you ought to own high-quality tax-free bonds, even though the outlook for investment grade bonds is less than salutary.

You can mitigate the effects of any future rise in interest rates by owning individual bonds and keeping maturities relatively short. Because your taxes will be going up. Not immediately, but before long. And that will make tax-free yields look even more compelling. Don’t say we didn’t warn you.

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