Since the financial panic hit in earnest over the past two weeks, all sorts of interesting opportunities have developed with varying degrees of risk.
Today I want to point out one that is so rare it is without precedent. I’m talking about the current yield on municipal bonds relative to Treasuries.
As you know, investors have flocked to Treasuries as a safe haven during the current economic storm. T-bills are yielding less than a half of one percent. Ten-year and 30-year Treasuries are yielding about 3.5% and 4% respectively.
Yet municipal bonds of 15-year and higher maturities are currently yielding more than 5%.
Why is that so unusual? Because the interest from municipal bonds is exempt from federal taxation. As a result, munis ordinarily offer yields at 90% of the level of Treasuries. Today they are yielding as much as 140% of Treasuries.
"Valuations have really gotten out of whack," says Paul Breenan of Nuveen Investments, who manages more than $13 billion of municipal bond assets. "They’re at historic levels we’ve never seen before."
2 Reasons To Buy Municipal Bonds Right Now
Besides the higher yields, there are two other reasons you should buy tax-free municipal bonds right now:
- One is that this month, Moody’s is about to begin rating municipal bonds the same way it rates corporate bonds.
"There will be an uplifting of credit quality of many muni securities," says Jim Colby, senior municipal strategist for fixed income at Van Eck Global. "Chances are that when Moody’s changes its ratings, you’ll get higher credit ratings and better prices."
Under the new system, many A-rated bonds will become AAA-rated. That will cause the price of those bonds to rise.
- The other reason to buy municipal bonds now is that it looks like Senator Obama will win the election next month. He has pledged to raise the top marginal tax rate. So it’s reasonable to expect a major uptick in the demand for tax-free bonds in the year ahead.
Why aren’t these investors swooping in to buy these bonds already? Some of them are. But a big source of muni buying is typically banks and insurance companies. Right now these companies are de-leveraging. Selling assets, in other words, not buying. This has pressured the market, creating the juicy tax-free yields we see today.
The Best Ways To Play The Municipal Bond Phenomenon
What are the best ways to play this unusual municipal bonds phenomenon?
- The first, of course, is to buy individual municipal bonds. If you own an individual bond, there are no annual expenses and you are assured of receiving $1,000 per bond at maturity.
Pick your bonds depending on which state you live in. If you live in a high tax area like New York or California, for instance, you will definitely want to own your own state’s bonds to avoid both state and federal income taxes.
Follow the link to get information on your state’s individual municipal bonds.
- Another way to own munis is through Vanguard mutual funds. Why Vanguard? Because it has the lowest expenses in the industry. (The average mutual fund company charges expenses six times as high as Vanguard.) It’s a simple equation: The lower your annual expenses, the greater your net returns.
Follow the link for a complete menu of Vanguard tax-free municipal bonds.
- Yet another way to buy tax-free bonds is through a closed-end fund like Nuveen Insured Municipal Opportunity Fund (NYSE: NIO).
This fund also holds a portfolio of tax-free bonds. The annual expense ratio is 1.15%. Although this is higher than Vanguard, it is actually cheap by closed-end fund standards. Many closed-end funds have expenses that total more than 2% per year.
And NIO offers something that Vanguard cannot. You currently have the ability to buy this fund for 33% less than the net asset value. In other words, you can buy a dollar’s worth of assets for sixty-seven cents.
And you should. The deep discount is causing the fund to yield 7% tax-free. (If you’re in the top tax bracket, the taxable equivalent is over 10%.)
If the market price moves back to net asset value when things settle down, which is likely, you’ll have a 33% capital gain down the road as well.
The Risks of Buying Municipal Bonds
What are the risks of buying these municipal bonds? There are two mainly:
- The first is that all this government spending turns out to be inflationary and so bond yields rise. That would cause bond prices to decline, at least temporarily.
- Then there is the risk of default. But this is pretty negligible. According to Moody’s, the 10-year default rate on all investment-grade bonds is 2.1%. For AAA-rated corporate debt it is 0.52%. The default rate for investment-grade municipal bonds is a scant 0.07%.
In short, these are three good ways to capitalize on the credit crisis that is gripping the nation. They won’t last forever. So you ought to take advantage of them now.