Investing in T-bills (Part 15)

The meandering mini-series continues with some further comments about taxes and municipal bonds.

As a sidebar to what seems like a series of sidebars, meandering is not a bad thing with these blog posts. What ends up presenting is the opportunity to touch on a number of related subjects. Researching and writing about these topics helps me learn. Hopefully you can gain something too in the form of some well-rounded financial understanding.

Because T-bills (along with all Treasury bonds) are subject to Federal tax [exempt from state and local taxes], I often see the recommendation to hold them in tax-advantaged retirement accounts such as traditional or Roth IRAs. Traditional IRAs owe tax on bond interest only when funds are distributed (withdrawn) rather than as interest is earned. This allows for longer compounding. Roth IRA contributions are fully taxed up front allowing bond interest to be effectively tax-exempt.

Retirement accounts must be cash accounts. Cash accounts are not eligible for margin loans from the brokerage (“trading on margin”). Neither are cash accounts subject to initial and maintenance margin requirements* that enable certain types of option trading such as call writes and short puts.

To me, the cash-versus-margin-account delineation clarifies the bond recommendation from above. Fixed income (i.e. T-bills or other bonds) may be managed as one asset in a diversified portfolio (e.g. an allocation made up of 50% large-cap stocks, 20% small-cap stocks, and 30% fixed income) for which a cash account like an IRA is perfectly suitable. If using T-bills to maximize return on cash left over from option trades, however, then T-bills and options must be in the same account: likely a [option-enabled] margin account rather than an IRA (cash account). The above recommendation would not apply.

With tax on T-bill interest weakening the case for trading synthetic long stock + T-bills in lieu of long shares,** municipal bonds come to mind. “Munis” (municipal bonds) are tax-exempt. They are generally a better choice for higher tax brackets because the amount saved by not owing tax on bond interest taxed is greater. When comparing munis with other bonds, a “tax-equivalent yield” (TEV) is often calculated: TEV = muni yield / (1 – marginal tax rate***).

Given the T-bill from Part 12 paying 5.355% YTM, would a muni paying a 3.8% coupon be a better choice? Assuming a 24% tax bracket (marginal tax rate), the muni:

TEV = 3.800% / (1 – (24 / 100)) = 5.000%

All else remaining equal, in this case T-bill is the better way to go.

I will continue next time.

* — To be addressed later
** — Recall this comparison was the real purpose of the entire mini-series. As discussed in
         the first paragraph of Part 11, I got my answer early.
*** — Marginal tax rate is the percentage at which my last dollar of taxable income is taxed.