Treasury Secretary Janet Yellen urged Congress on Wednesday to extend a July 31 deadline to pay down a portion of the federal government’s $28 trillion in debt to investors and foreign governments.
Without the extension, she warned of an “absolutely catastrophic” default that would imperil the nation’s economic recovery from the pandemic.
“I think defaulting on the national debt should be regarded as unthinkable,” she told the Senate Appropriations Committee, calling it “utterly unprecedented in American history for the US government to default on its legal obligations.”
Though borrowing is a routine cycle the federal government uses to keep the country running through the sale of bonds, it’s reaching its “debt ceiling” on July 31 and needs to service its debt before it can borrow more. The Treasury has some ability to keep payments flowing beyond that date, but Yellen said it could exhaust those measures sometime in August during the month-long Congressional recess. Increasing the debt ceiling does not mean additional federal spending.
If the federal government defaults, Yellen said it could jumpstart a chain reaction of cash shortages starting with US bond holders, which include individuals, businesses, and foreign governments.
“I believe it would precipitate a financial crisis,” Yellen said. “It would threaten the jobs and savings of Americans and at a time we’re recovering from the COVID pandemic.”
Congress last suspended the borrowing limit in July 2019 for two years under President Donald Trump. Yellen also emphasized the pandemic is causing uncertainty around the Treasury’s emergency powers to step in with emergency payments if it became necessary.
Some Republicans have signaled they will press for spending cuts in exchange for signing onto a debt ceiling increase, despite supporting a surge of red ink under Trump. Among many Democrats, memories of a 2011 brawl between House Republicans and President Barack Obama on the debt ceiling are still fresh, as it sent stocks tumbling and caused the first downgrade to US credit.
“This is a page from the Obama-era economic sabotage playbook, and I’m not going to let Republicans play games with the economy for their political benefit,” Sen. Ron Wyden of Oregon, chair of the Senate Finance Committee, told Insider in April.
The US Treasury market is showing investors are preparing for a faster pickup in inflation and borrowing rates, after the Federal Reserve indicated last week it could raise interest rates sooner than previously expected, but they don’t expect that to last.
When the Fed said after its monetary policy meeting that it could raise rates by the end of 2023 in response to more robust economic growth and inflation, global equities sold off, along with other interest-rate sensitive assets such as commodities, and short-term Treasurys in particular, sending 2-year yields to their highest in well over a year.
But that same hawkishness has not played out across the whole of the Treasury market. Since Wednesday last week, the yield on the 30-year US Treasury bond has dropped by around 20 basis points to its lowest since February, reflecting a belief among investors that the Fed will likely be successful in warding off a damaging inflationary spike.
It was last at 2.064% at 9.23 am E.T. on Monday.
In contrast, yield on the two-year Treasury note has risen by around 13.5 basis points since the Fed’s announcement, bringing yield up to 0.27% as of the early hours of US trading on Monday – its highest since January. This has brought the gap, or spread, between 2-year and 30-year yields to its narrowest since February.
St Louis regional Fed President James Bullard added fuel to the trade. He said in an interview on Friday the central bank could even raise rates by the end of next year. He also confirmed the Fed was discussing winding down its asset-purchase program.
The two-year Treasury note is the most sensitive to shifts in interest rate expectations and Bullard’s comments prompted the yield to almost double at one point in the day on Friday, before subsiding somewhat.
The steeper drop in yields on longer-term Treasurys, however, indicates investors believe the Fed will be likely be successful in tempering inflation and that they do not believe markets will experience a series of aggressive rate increases in the long-term. Instead they seem to expect a slowdown in economic growth, coupled with low levels of inflation in the long-term – even if inflation levels should rise sharply in the immediate future, analysts said.
Equities at least could be for more pain, at least in the short term, according to Jeffrey Halley, senior market analyst at OANDA. “If it continues, we may see an overdue reckoning for some of the dumber investment decisions being made by investors searching for yield in a zero per cent world-high yield credit and SPACs for a start.” he said.
All investments generate income in one way or another – sometimes as you hold them, sometimes only when you sell them for a profit. And that investment income tends to be taxable.
Bonds are no exception. But as an asset class, they’re a particularly diverse group. And so is the way they’re taxed. Some bonds are fully taxable, some partially taxable, and some not at all.
And because they generate income in a few different ways, their tax rates vary too.
Let’s examine bonds and taxes in more detail.
How are bonds taxed?
Bonds and bond funds generate two different types of income: interest and capital gains.
Bonds are a type of debt instrument. When you buy a bond, you’re loaning money to the government or company that issued it; in return, that entity pays you interest. Most bonds pay a fixed, predetermined rate of interest over their lifespan.
That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it’s received.
The rate you’ll pay on bond interest is the same rate you pay on your ordinary income, such as wages or income from self-employment. There are seven tax brackets, ranging from 10% to 37%. So if you’re in the 37% tax bracket, you’ll pay a 37% federal income tax rate on your bond interest.
If you buy a bond when it’s first issued and hold it until maturity – the full length of its lifespan – you generally won’t recognize a capital gain or loss. The money you get back is considered a return of your principal – what you originally invested in it.
However, after they’re issued, bonds often trade on financial exchanges, just like stocks. If you sell them before their maturity date on the secondary market, the bonds can generate capital gains and losses, depending on how its current price compares to your original cost. Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund.
So, the profit you make from selling a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they’re short-term or long-term.
Short-term capital gains apply if you hold the bond for one year (365 days) or less. Then the gain is taxed at your ordinary income tax rates.
Long-term capital gains apply if you hold the bond for more than one year. Then you can benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.
Are all bonds taxed?
Bonds are divided into two classes: taxable and tax-exempt.
A bond’s tax-exempt status applies only to the bond’s interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond.
The interest income from taxable bonds is subject to federal, state (and local, if applicable) income taxes.
Taxable bonds include:
Global bond funds
Diversified bond funds
Municipal bonds, aka munis, are the main type of tax-exempt bonds.
Munis are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building schools, hospitals, highways, and other public buildings.
Interest income from muni bonds is generally not subject to federal income taxes. It can also be exempt from state or local income taxes if your home state or city issues the bond. Interest income from muni bonds issued by another state or city is taxable on your state or local income tax return.
Fast fact: Muni bonds exempt from federal, state, and local taxes are known as “triple tax exempt.”
US Treasuries, bonds issued by the US Dept. of the Treasury, and savings bonds are also tax-exempt – to a degree. If you own them, you owe federal income tax on them. However, they are generally free from state and local income taxes.
How can I avoid paying taxes on bonds?
Here are a few strategies for avoiding – or at least reducing – the taxes you pay on bonds.
Hold the bond in a tax-advantaged account. When you invest in bonds within a Roth IRA or Roth 401(k), the returns are tax-free, as long as you follow the withdrawal rules. Bond income and profits from sales earned within a traditional IRA or 401(k) are tax-deferred, meaning you don’t pay taxes until you withdraw the money in retirement.
Use savings bonds for educational purposes. Consider using Series EE or Series I savings bonds to save for education. When you redeem the bond, the interest paid is tax-exempt as long as you use the money to pay for qualified higher education expenses and meet other qualifications.
Hold bonds until maturity. Holding a bond until maturity, instead of selling it early on the secondary market can help you avoid paying taxes on capital gains. However, you still owe tax on any taxable interest generated by the bond while you owned it.
The financial takeaway
Minimizing the tax consequences of bonds comes down to investing in tax-exempt bonds, such as muni bonds and US Treasuries, and using tax-advantaged accounts where your money can grow on a tax-free or tax-deferred basis.
If you invest in bonds outside of tax-advantaged accounts, you’ll receive a Form 1099 from the bank or brokerage holding your investments around January 31 of each year. Hold on to these forms, as you’ll need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.
If you miss reporting any income, they’ll be sure to let you know.