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By Alexander Green

In my last Investment U column, I made the case that fears of cash-strapped cities, counties and states causing a near-term collapse of the municipal bond market are overdone.

Yes, there will be defaults, perhaps 100 or more this year in small municipalities. That’s big in a market where the historical default rate is just .07%. But it won’t cause a domino effect or drive rates sharply higher. (Although rates could rise for other reasons.)

Why will the much-predicted municipal bond crisis fail to occur?

With Muni Bonds, Falling Supply Props Up Prices

You’ll notice that the most dire predictions always begin with the words, “If nothing is done …”

But of course, things will be done. Listen to New Jersey Governor Chris Christie and Ohio’s Governor John Kasich. They’re telling the public employee unions and others, with their hands outstretched, that the money simply isn’t there to fund their laundry lists. And there hasn’t been any political backlash. Their poll numbers are rising. In addition …

  • Revenue for U.S. municipalities is increasing in this recovery, not falling. That’s putting many on a sounder footing.
  • Because Obama’s Build America Bond program ended in December, municipal bond issuance will drop by 10% to 20% this year. Falling supply firms up prices.
  • Tax-free munis now yield more than taxable Treasuries. Bargain-hunters will eventually swoop in to take advantage.
  • The extension of the Bush taxes cuts will end in December next year. Does anyone seriously believe – with our federal deficit – that Congress will lower tax rates in the years beyond that?

Ok, let’s assume you agree that the sell-off in municipal bonds is overdone and they’re due for a rebound. How do you play it?

Three Ways to Play the Muni Bond Rebound

You have three primary choices…

  1. Buy a low-cost municipal bond fund.
  2. Invest in a closed-end bond fund.
  3. Buy individual tax-free bonds.

Let’s take the last one first. If you buy individual bonds, you’ll see their price fluctuate. But if you hang on – and there’s no default – you’re guaranteed of receiving $1,000 per bond at maturity.

Thirty-year AAA and insured tax-free bonds are currently yielding 5.1%. If you’re in the 35% tax bracket, you’d have to earn almost 8% taxable to receive that kind of after-tax return. Not bad.

Worried that the municipality and the insurer could both default? (Unlikely but not impossible.) Then buy only tax-free bonds insured by Berkshire Hathaway Assurance Co., a subsidiary of Berkshire Hathaway with a stellar AAA-credit rating. You can’t get much safer than that.

And if you don’t want to select individual bonds?

The Low-Cost Muni Bond Option

Option #1 above includes investing in a low-cost fund like the Vanguard Long-Term Tax-Exempt Fund (VWLTX). The current yield is 4.21% and the average maturity is just over 10 years.

Sure, it yields less than some individual bonds and there’s no guarantee of principal. But it will be less volatile than 20- or 30-year bonds and you can reinvest monthly dividends if you’re so inclined. (Those in high-tax states will want to choose a state-specific Vanguard fund, of course.)

Want to play a potential muni-bond rebound more aggressively, with a higher yield and greater capital appreciation potential? Go for Option #2 …

Why You Should Pick Up Tax-Free Bonds Now

Consider the Nuveen Insured Municipal Opportunity Fund (NYSE:NIO).

This closed-end fund also holds a portfolio of high-grade tax-free bonds. The annual expense ratio is 1%. Although this is higher than Vanguard, it’s actually cheap by closed-end fund standards. Many closed-end funds have expenses that total more than 2% per year.

This fund currently yields 6.5% and the income is exempt from federal taxes. If you reside in the top tax bracket, you’d have to earn 10% to get this after-tax yield. Why is it so high? Because the fund is using 41% leverage, the equivalent of buying bonds on margin. If muni bond prices recover, however, this fund will really jump.

But will they? I don’t have a crystal ball. But recognize this: The yield on the benchmark index of 30-year AAA municipal bonds is higher now than in the depths of the recent credit crisis.

If you’re any kind of contrarian, now looks like a good time to pick up some tax-free bonds.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Source: How to Play a Muni Bond Rebound