How The Smart Money Gets More Income With Tax Free Municipal Bonds

by: Glen Rosenberg

(For a video version of this example, click: Get More Income With Tax Free Municipal Bonds.)

Years ago, most tax free municipal bonds individual investors were buying were AAA insured. That's not the case any longer. Now more than ever, informed bond investors have a tremendous advantage over uninformed muni bond investors.

This article will focus on one of the ways that the smart money generates more yield (income) than the typical individual muni investor. It is by taking advantage of a misperception of risk, in particular, the differences between AAA rated and BBB rated tax free municipal bonds.

To informed investors, this misperception represents an amazing opportunity to produce significantly more income while maintaining a high quality portfolio with a performance record that is a lot closer to AAA than most people realize.

At different times the additional income an investor can achieve in BBB rated munis vs. AAA rated munis varies. In certain markets this difference can be as little as 15% and in other markets it can be as much as 50% more income.

For example, today, October 2012, new AAA 30 year munis are coming out around 3.10% tax free while new BBB 30 year munis are coming out around 4.4% tax free. That is a difference of approximately 130 basis points, or close to 37% more income*.

Let's look at that in dollars:

(For a video version of this example, click: Get More Income With Tax Free Municipal Bonds)

On a $1 million portfolio, that could mean a difference in income of between $13,000 / year. Over a 10 year period, considering the reinvestment of the additional annual income each year, the additional income could easily grow to an additional $130,000 of portfolio value, not including compounding interest.

On a multi-million dollar portfolio, the difference can likely be in the millions.

This is the reason why you, as a bond buyer should have great motivation to understand this misperception better. It could mean hundreds of thousands, if not millions to you over your lifetime.

Now let's take a look at the actual default statistics of the various classes of bonds. We will reference a study that was produced by Standard & Poor's that covers the safety record of municipal and corporate bonds over a recent 15 year period (1986 - 2008)**:

AAA rated munis: 100% Paid

A rated munis: 99.89% Paid

BBB rated munis: 99.63% Paid

AAA rated corporate bonds: 99.35% Paid

These statistics provide a very simple conclusion, which, for many investors is a surprise.

BBB rated tax free municipal bonds have a superior safety record than AAA rated corporate bonds during the 15 year period in the study.

Keep in mind, AAA rated corporations are companies like Microsoft (NASDAQ:MSFT), Pfizer (NYSE:PFE), Johnson & Johnson (NYSE:JNJ), and Exxon (NYSE:XOM).

The reason investment grade municipals have had such a stellar safety record over the years is because in many cases they have what is effectively a "captive" audience.

For example, if my water bill goes up from $80/month to $180/month, I can call up and complain, but I have to pay it because there is no one else to buy water from.

So the simple conclusion is if you would feel comfortable buying bonds from companies such as those listed above, you could certainly feel comfortable buying bonds from a BBB rated municipality, as the BBB rated muni has demonstrated a better safety record over a long period of time.

And remember, the difference in income between AAA and BBB rated munis can add up to $150,000 - $250,000 per $1 million invested over a 10 year period (including compounding interest).

Speak to your broker or a bond specialist to identify overlooked and undervalued opportunities that take advantage of this misperception of risk and offer additional income.

*Generally speaking a high credit rating is not a seal of approval and a lower rated bond may very well indicate a higher risk of default.

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. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.