Munis: Get a 5% Tax-Free Yield With the Bond King

It's time for a reunion. U.S. treasuries have had a great eight months as investors fled the carnage in the stock market for safer investments. Since mid-June, the price on the 10-year T-bill has risen 13%. Over the same period the S&P 500 has fallen 7%.

Meanwhile, treasuries' non-taxed cousins municipal bonds, or munis as they're commonly called, have been going through a rough patch. If you're unfamiliar with muni bonds, they're bonds that are issued by state, city or local governments to raise capital for public projects like building a highway, sewer, or what have you. And unlike treasuries, the yields on muni bonds are tax free.

As the credit crunch hit and liquidity dried up, the big banks started clearing their balance sheets to free up cash. Muni bonds were the first to go. Liquidity problems and margin calls have since hit hedge funds, which in turn dumped billions of dollars in muni bonds in the last month. The sell-off has resulted in munis yielding their highest levels in history: 130% of treasuries.

Today, taxable long-term treasuries yield 4.4%, while non-taxed muni bonds yield 5.14%. This discrepancy is outlandish and will be corrected in one of two ways:

1. U.S treasuries fall, raising their yields more inline with muni bonds.
2. Muni bonds rally, bringing their yields more inline with treasuries.

It's time for a reunion between these two investments' yields. Personally, I'm betting on a muni bond rally.

So is the Bond King, Bill Gross. As Chief Investment Office for the Pacific Investment Management Company, or PIMCO, Bill Gross has averaged double-digit returns for over 30 years. He's the largest bond manager in the world, overseeing more than $720 billion in assets. That's more than two times the GDP of Switzerland.

Starting in 2003, Gross began shifting his money into muni bonds. Today, he still favors them. In a recent Investment Outlook, he commented:

U.S. municipal bonds are another example of a bargain in today's market. Across the yield curve, high quality muni bonds now yield the same or more than Treasuries of the same maturity, and munis are exempt from federal taxes and most state and local taxes while Treasuries are for the most part taxable.

Gross favors closed-end muni bond funds, particularly those that trade at a discount to their underlying asset value. Between the potential capital gains these funds are undervalued at their current levels and the tax-free yields, these investment vehicles offer the potential for double-digit gains. That's a great opportunity in today's volatile market.

There are still a handful of these funds available. If you're looking for a place to stash some money while the bear market begins its next leg down, this may be it. A tax-free yield of 5% is equal to a taxed yield of 8%. At that point, you're almost returning as much as stocks have historically.

Comments

[User 179157]

Any suggestions for NJ based muni fund? And I suppose there is no need to invest those muni funds in the IRA account.

[mwi]

Most, if not all, closed end muni funds use leverage and finance this leverage through the use of auction rate preferred securities, for which the market has completely disappeared. It is not at all clear that the discounts to NAV at these funds are just investor uncertainty or a reflection of the expected haircuts to NAV from the additional future costs of resolving the ARPS problems and the resulting likely higher costs of leverage to the funds.

[weiwentg]

agree with mwi here. I am not in a position to assess the safety of closed end funds, and the competence of their managers. I'm sure there are people who are in a position to do that, but as for me, I will stick with open end muni funds - probably Fido or Vanguard.

[rmj]

At least in the short term, since there is no maturity on these ARPS, the preferred holders have no liquidity alternative and therefore the equity holders of these closed-end funds will continue to enjoy the existing leverage. Morevover, given the recent sell-off of in munis the NAVs of these funds have more upside potential. So picking a fund that balances yield and discount to NAV may be a good short term bet?

[ekowalc]

How about the ETF's for muni's? What do you think about these?

[locke]

I could respect this more if he detailed the risks more.

[bsharvy]

Yeah, you have to explain the leverage via preferred shares of the closed-end funds for this article to be useful. It's a major issue.

[biomedlives]

I agree with mwi, weiwentg, and bsharvy that the preferred leverage is a major issue regarding the closed end muni funds. I wonder if these funds are affected by a reset in the preferred interest rate to a higher level if an auction fails, as has occurred with other auction rate securities.

[Dave M.]

There are numerous closed end muni funds that do not use leverage. NUV is the largest.