(For a video version of this demonstration click here: Municipal Bonds For Growth Vs Income.)
To the typical stock investor, muni bonds are thought of as an older person's investment; like your father's Oldsmobile. But I'm going to demonstrate how you can GROW your portfolio by investing in muni bonds, and without fear of inflation.
Before we get started, we need to consider two important points …
- Many investors look at bonds incorrectly - they are thinking in terms of profit and loss as a result of their experience investing in stocks. We don't invest in bonds for profits. We invest in bonds for income. So as we go through this demonstration, if you have never done so, I would like you to let go of any thoughts about profit and loss and simply think of bonds in terms of their income.
- While the market value of a municipal bond portfolio will naturally fluctuate over time, how you choose to USE the income from your bonds is up to you. You can use the income to live off of, and you can also use the income to grow your portfolio. If you are re-investing your bond income in new bonds, you have effectively changed the use of your investment in bonds from income to growth.
Now let's get started …
The following is a hypothetical example. There is no guarantee that this could be achieved as the reinvestment rate can fluctuate and it presumes that there are no issuer defaults on the payment of interest or principal.
Also, if you prefer a visual demonstration of the example below, search the title to this article on YouTube.
Imagine we were to invest $1 million dollars in a portfolio of 5% tax free investment grade muni bonds. This portfolio would produce $50,000 of tax free income per year. If we re-invested the $50,000 income each year in new 5% tax free bonds over a 10 year period, our portfolio would grow to approximately $1,706,000. The income on this portfolio at the end of the 10 years would grow to approximately $77,500 tax free (a 55% increase over base year).
What about default risk?
All growth related investments such as equities carry risk. Investing in municipal bonds also involves risk, including market fluctuations, potential loss of principal, and reinvestment risk. However, according to a Standard & Poor's study of a recent 15 year period (1986 - 2008), BBB investment grade munis have a lower default rate than AAA rated corporate bonds.
Nonetheless, to mitigate default risk our $1 million dollar portfolio would be diversified with no more than $25,000 to $50,000 in any position, limiting default risk exposure of each bond position to 2.5% to 5% of our overall holdings.
What about inflation?
My answer might sound confusing at first …
Inflation would be a good thing. Yes, that's right - a good thing! We would hope for higher interest rates.
To fully appreciate why inflation would be a good thing, I must remind you again to think about the income the bonds produce, not the value of the principal of the investment.
Consider the following 3 key points:
- Individual bonds have a maturity date. On the maturity date, the face amount of the bond is returned to the investor regardless of any changes in value prior to maturity.
- The income is fixed and remains unchanged despite any changes in portfolio value.
- Our imaginary portfolio's entire income would be re-invested in new bonds at prevailing interest rates each and every year.
It is these three points that quite literally reverse our thinking on the affect of inflation on our portfolio.
If interest rates went up, then it would simply accelerate the rate at which we would grow our income since we would be re-investing in new bonds at higher yields.
If this last section regarding inflation protection did not fully make sense to you, I would encourage you to go back and read it a few times until its meaning fully registers with you, as it is this section that turns conventional wisdom about bonds and inflation risk on its head.
Now ask yourself a few questions:
- If your income does not change, and the face amount of your bonds is paid upon maturity, what difference does it make if the value of your bonds is less than your cost basis for any period of time prior to maturity?
- Just the same, what difference would it make if the value of your bonds is more than your cost basis for any period of time prior to maturity?
Using the very simple strategy described above, we have transformed the use of municipal bonds from income into growth. This simple strategy would provide many benefits, some of which are:
- Compounding growth - Reinvesting the portfolio's income in new bonds would increase the income each and every year. The increasing income would result in the ability to purchase more and more bonds each year, hence compounding growth.
- Built in inflation protection - Inflation would accelerate the growth of both the income and consequently the principle as income would be re-invested each year in new bonds at prevailing interest rates.
- Less speculation - While investing in stocks and bonds each carry their own risks, this particular strategy would have far more certainty built into it, since the return would be "realized" each year through the receipt of income and the purchase of new bonds, increasing the value of the portfolio.
One question you may be left with after reading this article is how do I build a bond portfolio. The SeekingAlpha article Building The Ideal Municipal Bond Portfolio lays out the principles we follow as muni bond specialists in populating a portfolio. Of course, working with a muni bond specialist would be very advantageous to any strategy involving municipal bonds.
Investing in municipal bonds involves risk, including market fluctuations and potential loss of principal. This has been produced solely for informational purposes and is not to be construed as a recommendation of any particular investment or investment strategy. It is also not a solicitation or an offer to buy or sell any securities or related financial instruments. You should consider consulting a broker or investment professional before investing or implementing any investment strategy. The preceding presentation is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.