Seven Trillion Dollars Can’t Be Wrong (Or Can They?)
Before we talk about risk, taxes, and inflation, note that I was recently interviewed by Andrew Tanzer in Kiplinger Magazine on covered-call ETFs. Those things have been hoovering in investor dollars like there’s no tomorrow. Tanzer’s piece does a great job of covering what you need to know if someone tries to sell you a covered-call (aka “equity income” or “premium income”) ETF. Read more: https://www.treussard.com/newsletter/treussard-in-kiplinger-equity-income.
Let me start with a simple fact: There has never been more money sitting in money-market funds.
Never.
In fact, as of last week, there are now seven trillion dollars in money-market funds (Source). Now, let’s keep some perspective on this.
Like it or not, most other things in life are also at all-time highs:
The stock market
Our national output (GDP)
Even the number of Americans with jobs
I know, it’s shocking when you actually say it.
Many of these dollars are parked in money-market funds because they seem like "a deal too good to pass up." I don’t blame anyone if getting a sweet 5% or so for "no risk" feels like a great deal (The quotes are important here. Unless a money-market fund owns Treasuries only, there is some risk. How much risk depends on what’s in there).
But let’s move from "feeling" to "thinking." I promise this is simple math, using yields from last week.
A one-year U.S. Treasury will earn you roughly 4.3%. That’s about as "risk-free" as you’ll get.
The good news about Treasuries is you pay federal income tax on them, but you’re left alone when it comes to state or local taxes. Still, if you’re in the top federal bracket, your marginal tax rate is 37%.
So, after you’ve paid your taxes, you’re down to an after-tax return of 2.7%.
That’s not awful, but then you realize that inflation clocked in at 2.6% last year.
So…
If inflation stays here for the foreseeable future, you’re basically treading water in terms of purchasing power. That’s not the worst deal in town, but is it a "sweet deal?" And what happens if inflation picks back up from here? That sweet money-market fund may well become a real wealth incineration machine.
None of this should be surprising.
The market doesn’t make a habit of handing you free money. To make matters worse, when people face significant uncertainty, certainty goes for a premium, even if it’s just the illusion of safety. And uncertainty has been high for years and shows no signs of letting up.
So, Treasuries are basically a fair-money proposition, net of taxes and inflation.
Against this backdrop, the stock market is at all-time highs (with near all-time-high valuations against long-term inflation-adjusted earnings) and corporate bonds earn you about as little on top of Treasuries as they ever have in history (despite presumably more risk… unless you think that Anheuser-Busch, T-Mobile, and CVS are about as credit-worthy as the U.S. Government).
None of this suggests you should run away, necessarily. But it does suggest this is a time to be open-minded about other possibilities.
So You’re Worried About Inflation?
Let’s pretend you’re more worried about inflation than taxes. That seems like a reasonable baseline. If Treasuries deliver “no frills” outcomes when inflation is 2.5%, what happens if inflation runs hotter? I think you know the answer… Your wealth may grow in dollar terms, but it may lose ground in consumption terms.
Against that backdrop, what about Treasury Inflation-Protected Bonds? These are issued by the U.S. Government, and their face value is adjusted for inflation as a way to mechanically but imperfectly “protect” you against rising prices.
My description “mechanical but imperfect” warrants an explanation. The adjustment is mechanical (your bond’s face value is adjusted for inflation) but imperfect because that’s deemed valuable by the IRS (and it is), and thus taxed... The bite of taxes makes the whole thing imperfect. But what do they say about not letting great be the enemy of good?
Let me give you the basic rundown here, using roughly the interest rates on bonds of the same maturity over the last few days. Let’s use round figures for ease.
Let’s pretend you invest $1M in a Treasury at a yield of 4.3% or in a TIPS at 2%. What happens after a year?
Taxes…
Well, the Treasury produces $43,000 of income, which is taxed at the federal level.
Assuming you’re in the top bracket, that’s a tax bill of almost $16,000, so you keep $27,000 and end up with roughly $1,027,000. So far, so good.
Things get trickier with TIPS. You get 2% on the principal amount, which is the $1,000,000 grossed up for inflation.
Let’s pretend inflation is 3%, which means you’re getting 2% on $1,030,000 of “adjusted notional,” or roughly $20,500.
And the $30,000 adjustment is deemed income to you (value is value, and you’ve got to pay the piper now…).
So you receive $20,000 in cash, $30,000 in “shadow income,” which earns you the right to pay the government almost $19,000 in taxes (Doesn’t leave much free cash, does it?).
But… if you’re in it for moving wealth through time and not for income, you realize that you end up with almost $1,032,000, which, you know… is more than the $1,027,000 from the regular Treasury.
You may say, that’s nice, but that’s a lot of work to add $5,000 to the bottom line. And you’re right. But now, let’s bring in the value-eroding effects of inflation.
Inflation…
Since inflation was 3%, your dollars are worth 3% less in groceries, gas, and whatever else you consume.
And here is the real wedge: $1,027,000 turns out to be worth less than your original $1,000,000 in terms of stuff at the store, while $1,032,000 just manages to be worth a hair more than your original investment in terms of consumption.
You can tell this is complicated, and there are weird cases lurking in the shadows. You may owe more in taxes than you’re getting in cash flow if inflation is high, and the “protection” becomes really leaky with higher inflation. That’s how we end up with good vs. great fighting it out in the ring.
But hopefully, this gives you a sense of where TIPS fit in the world of bonds when inflation becomes a concern. Needless to say, there is an argument for holding TIPS in tax-advantaged accounts if that’s an option. That’s where “asset location” (as opposed to asset allocation) comes in.
Even if your taxable wealth accounts for the vast majority of your estate, at least you know how to weigh the pros and cons.
I repeat, the above is a classroom-type illustration. You should work through the details on your own or ask for help.
And If Taxes Are Bringing You Down
Now let’s talk about taxes and investing. We’ll keep it high level because the details are so critical here that it’s best not to pretend this does justice to the details.
As you know, we are going through a wave of “innovation” in wealth management products and—given the incentives in asset management—not every innovation hitting the market seems to be good for your financial health (My recent ETF Revolution 2.0 piece here).
But sometimes there is something worth a look.
In this case, two somethings.
Capitalizing income into long-term gains:
Pretend you like the risk-return profile of short-term Treasury bills.
Maybe it’s dry powder, as the expression goes; money to put to work if and when the market tanks. But again, the income on those is taxed as regular income at the federal level, and pretend that you’re in the highest tax bracket (37%). It’s fine, though not ideal. But this is dry powder, so patience is key, and the last few years have taught that you may be waiting for a while.
What if there was a way to use the ETF format to create a risk-return profile that’s “like” that of T-bills but one that could cleverly use the creation-redemption process that makes ETFs more tax-efficient? If you could do that, you could delay producing income and capitalize the gains instead. Then, when you want to put money to work, you liquidate some of your holdings, and the gains are treated as long-term capital gains (if it’s been more than a year)? This kind of ETF definitely takes some engineering, but for once, it looks like engineering worth understanding more deeply.
Long-short exposure for added tax efficiency:
If your tax bill is really bringing you down, here is another avenue worth exploring. This is more of an “at scale” thing, given that we’re not talking about ETFs here, but rather separate accounts or even limited partnership arrangements. But here is the idea (very, very high level).
Instead of owning a position in the S&P 500, pretend that you are invested in a portfolio that is long stocks and short stocks in a way that keeps your overall exposure kinda sorta like the S&P 500. The portfolio would likely have quantitative “tilts” to the longs and the shorts, because those strategies are designed for the sake of investment returns, not tax returns… Maybe you’re long 150% and short 50% (Notice this requires leverage. Another reason this is more applicable to higher-net-worth situations). Net, you’re long 100%, but you do have those short positions in there.
And pretend that the market does what it does “usually.” It goes up some, and not all stocks move in the same exact amount. You would imagine that some of the stocks turn out to create losses (maybe those short positions in rising stocks, for instance). Those losses could prove to be valuable if your estate is generating significant gains elsewhere, now or later. There are even cases where these things could reduce your regular income, not just capital gains. This is not meant to be more mysterious than it needs to be. Just a very high-level summary at the end of a fairly long newsletter.
With that, thanks for reading! I hope you saw value in this education-heavy piece.
And Happy Thanksgiving to those of us residing south of the Canadian border.
Disclaimer: This content is for educational purposes only and does not constitute financial advice. Treussard Capital Management LLC is a registered investment advisor. All investments are subject to risk, including risk of loss to the principal. There are no guarantees in investing. Please visit our website for more information and full disclaimers. Always consult with a qualified financial advisor before making any investment decisions.