The recent rout in bonds has created an opportunity to earn about 8% tax free in a few closed end municipal bond funds. This 8% yield provides a 12% tax equivalent yield. My favorite in this sector is Van Kampen Advantage Municipal Income Trust (NYSEMKT:VKI), which has lately traded at a discount to net asset value, even though in recent history it has sold at a premium. This fund mostly invests in investment grade municipal bonds. A director at VKI recently purchased about 40,000 shares of this fund at prices significantly above the current share price of about $10.80. VKI pays about 7.3 cents per share every month.
Bill Gross, "The Bond King" of Pimco, recently purchased some of his closed end muni bond funds including PCQ, PCK, PMX. If Bill Gross is buying munis now, I think it makes sense to step up and buy some as well after this significant bond correction. Some of the funds Mr. Gross bought are California muni bond funds, which, by many accounts, have the highest risk of default. VKI is invested in bonds from many states, which adds the safety of diversification.
I know everyone is afraid of municipalities defaulting, but I think this concern is more than priced in. Many municipalities can raise tolls, fees, and other taxes to increase revenues rather than default on their bond obligations. The default rate on munis is incredibly low and many muni bonds are insured in the event of default. The other concern is duration, but with tax equivalent yields of about 12%, and CD rates and other "safe" investments yielding 1% or less, even if rates went up significantly, they still could not compete with the yield VKI provides.
Another recent concern for the bond market is the recent deal to extend the Bush tax cuts. The market seems to feel that the default risk is higher if the government does not collect the tax revenues it would have had if the Bush tax cuts were not renewed. However, I think the market is overlooking the fact that the extension of the tax cuts can actually reduce the risk of default since much of the money that would have gone to the US government will now be spent by consumers which will result in higher sales taxes for state and local municipalities. This extra spending can create jobs and that also increases tax revenues and lowers the need for unemployment checks, which is draining many states like California.
The other sensible reason to buy muni bonds now is because even though tax cuts were extended for two more years, they are only going to go up from here. It makes sense to accumulate these bonds now while fewer people are interested. As the economy continues to recover, tax revenues will increase and default risk will drop. Combine that with taxes rising significantly in the coming years plus an 8% tax free yield while you wait, and you can see why few other investment options are likely to compete with VKI.
Disclosure: I am long VKI.