How to Legally Pay Less Tax on Your Fixed-Income Investments

Right now, income investors have an amazing market anomaly available to them. 

This anomaly is two sided. It's an anomaly in stocks. It's anomaly in bonds. It will pay you some of the safest double-digit yields in the world. 

Before I reveal what this anomaly is, it's important to know the difference between a stock and a bond... 

When you buy stock, you're an owner of a business. You're entitled to whatever profits the business makes after tax. And you're entitled to vote on anything related to the company. 

A bond is a debt. When you buy a bond, you're making a loan. And making a loan to a company is entirely different than buying its stock. 

First, the company has a legal obligation to pay interest on your loan. Unlike a common stock dividend, which management can cut or raise any time it fancies, interest is nondiscretionary. Management must pay you the interest promised, on time, every quarter. 

For another thing, the company has a legal obligation to redeem your loan at full value. In other words, if you loan the company $1,000, it must pay you back $1,000 when it's done using your money. With stock, you get whatever price someone else is willing to pay. The company has no obligation to return your investment. If a company declares bankruptcy and has to liquidate its assets, management must pay debtors the money it owes them in full before common shareholders see a penny. 

Here at DailyWealth, we mostly cover investments that are convenient (and cheap) to buy and sell. Occasionally, we'll tell you about the world's safest way to trade options or the best ways to own physical gold... But in general, our readers prefer easy-to-trade stocks and funds, and so do we. 

Well, there's no "one click and you're done" way to buy bonds like you can with stocks. The big banks are the bond exchange. They buy and sell bonds among themselves and distribute them to brokers, funds, clients, and the public. Most brokers can sell you bonds, but the minimum investments might be more than $10,000 and the selection is poor. 

But there's one exception to that rule. Some bonds trade on regular stock exchanges. Right now, there are hundreds of these "stock market bonds." They have symbols you can type straight into Yahoo Finance, and any discount broker can buy them for you. 

You can get in and out of these stock market bonds at any time. Commissions should be the same as on common stocks, and you can hold these in your IRA, just like stocks. 

The official name for these stock market bonds is "preferred stock." Don't let the word "stock" confuse you. Preferred stock is a debt instrument and has almost nothing in common with stock. So if preferred stock is a debt, what's the difference between it and a regular bond? 

Maturity date is one difference. Preferred stock has no maturity. In other words, the company can pay back your loan – "redeem" your preferred stock – any time after an initial lock-up period. Bonds mature on a set date. 

There are other small differences. For instance, bondholders have a senior claim on assets in a bankruptcy over holders of preferred stock (who have senior claim over regular shareholders). And bondholders pay income tax on their interest income, whereas the interest from preferred shares counts as dividend income. The IRS taxes it at only 15%. 

Here's the thing: Right now, you can buy preferred stock at a big discount to "face value." It's because of an anomaly created by the credit crunch. Big banks and hedge funds owned a lot of preferred stock last year... and many had to liquidate their holdings in order to raise emergency cash. Their buying hasn't flowed back into the market yet, which is great news for us. 

It means you collect bigger yields – 10%-12% for the safest preferred stocks – and a guaranteed capital gain when the company redeems your preferred stock at full value. 

There are a handful of preferred stock funds on the market right now. Just type "preferred" into the search box on the excellent websitewww.etfconnect.com. The search turns up around 15 funds. 

But I'd rather do my own homework and buy super safe preferred stock from individual companies. (Click here for a list of all the preferred stock issues.) I intend to take full advantage of the anomaly in preferred stocks.

Good investing, 

Tom 

P.S. Last month, I told my 12% Letter readers about a preferred stock trading at a 24% discount and paying an 11% current yield. In the worst case, we'll collect a double-digit income and full value for our loan in the space of about 12 months. In the best case, we'll keep collecting a safe 11% for years to come. 

To make sure you receive my next preferred stock recommendation, come on board as a 12% Letter reader. You can learn how to do so here.