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Think Taxes Will Rise? Part I: Consider These Municipal ETFs

|Includes:HYD, MQT, MUS, MYC, PIMCO Municipal Income Fund (PMF), PRB

                     "The only things certain in life are death and taxes."
                                                                                   -- Benjamin Franklin

Death and taxes may be inevitable, but do they have to tax us to death? That may be a  possibility going forward. Somebody has to pay for Goldman Sachs’ (NYSE:GS) executive bonuses!  Since many of the 40 million or so investing households are on to them,  why not cast the net a little wider and take a little something from each of the 60 million or so remaining households?

The previous and current administrations, each in their own way, were/are composed of Ivy League or Chicago Machine or Texas back-room politicians, all of whom thought they were the brightest kids in the room, and all of whom absolutely knew they knew what was best for the rest of us. You can’t finance that sort of paternalism and incumbency re-election without higher taxes.

Ordinarily, in a two-part article, I’d discuss the tax situation in this country, then talk about the role of munis. But since I suspect many readers are already well on board in our mutual disgust with the imminent “soak the rich, share the wealth” campaign, I’m cutting straight to the chase and discussing the benefits of munis for everyone who pays taxes. (Since 38% of households pay no federal taxes, that would be the remaining 62% of “filing units,” whether, single, married or whatever –

If you’re in the 15% tax bracket, you’ve been told that munis are not for you. I say, “Not so fast.” The tax exemption from munis is likely to last for the rest of our investing lifetime, and taxes are only going one direction, at least in the immediate and intermediate future.  That will make them your muni holdings ever more valuable without you having to do a thing.  

This is not because the elites who think they know how to run our lives better than we do wouldn’t love to get their manicured little hands on more of our dollars, but rather because the tax-exempt status of munis depends upon reciprocity. The feds don’t tax cities and states and the cities and states don’t tax the feds (so federal military bases, VA and Public Health facilities, etc. are exempt from paying taxes to states and local communities.)

That's why I believe that munis today are for everyone who pays taxes, not just the wealthy.  I don’t believe for a minute that tax rates aren’t going higher. Even if they didn’t (right!), I’m buying munis for myself and my middle-age to senior clients simply because I believe they offer greater safety, greater stability and a remarkably low correlation to stocks in uncertain times.

I avoided munis for much of 2008 until I could see which way this crisis was going to unfold. But I’ve been buying for the past few months as risk levels – in munis at least -- have returned to more normal levels.

Defaults have always been exceptionally rare in the municipal securities market. The Public Securities Association estimates that only 0.5% of all municipal securities issued since 1940 have ever missed a regularly scheduled payment.

There is still risk, of course. Default risk is historically 0.5%, not 0.0%. And that low default rate may be scant relief to investors in Orange County bonds, where an incompetent, over-reaching city treasurer and  all-too-willing Merrill Lynch bond salesmen caused investors to lose $1.7 billion. And, there’s always interest rate risk, as well – the probability that these bonds will go down in value as interest rates go up. That’s why I recommend the diversification of ETFs and closed-end funds, though it now looks as if deflation, not inflation, is our first stop along the way to rampant inflation.

Another thing I like about a portfolio of well-diversified munis: In today’s equity markets, 75% of all trading is done by institutions. (For a start on a solution to that problem, I’ll discuss it in an upcoming “Fractured Wall Street Fairy Tales” article – part of our ongoing series.) For now, one solution is for you and me to return to a market where large dinosaurs don’t trample everything in their path.

While 75% of equity trading is controlled by institutions, 75% of the roughly $2.7 trillion in municipal debt is owned by individual investors. Except for ripping off individuals at the time of purchase and sale of individual bonds, there simply isn’t enough meat for these large carnivores to tear apart in munis.

If you are an investor in the 28% tax bracket earning 7% on a taxable bond, you will actually earn 5.05% after taxes. In purely monetary terms, that would still be a better investment than a tax-free muni bond that returns, say, 5%. But there are other benefits – like the lowest default rate of any bond except Treasuries; way less time messing with taxes because you don’t have to declare this income; and perhaps the biggest benefit, less tax dollars flowing to the yahoos in the national government, who will always spend total tax receipts plus x. Starve the Beast.

General Obligation and Revenue Bonds

There are two primary types of municipal bonds. General obligation bonds (“GOs”) are issued by city, county, and state governments in order to raise money for items for the common good like highways, bridges, airports, schools, and hospitals. They are backed by the “full faith and credit” of the issuer, which has its own ability to tax residents over time for these improvements. They are exempt from Federal taxes and, typically, from state taxes as well if the investor resides within that state.

Revenue bonds are issued by state or local government-sanctioned entities. This might be for something pretty darn safe, like a local water utility company, or it could be for some ego-play for the local mayor, like building a 10,000-seat AAA ball park. The interest is serviced solely by the revenue generated from the business or consortium that backs the obligation. In the case of a water utility, bond holders are paid as customers pay their water bills; in the case of a baseball stadium, they are paid only if W.P. Kinsella (author of Shoeless Joe, retitled Field of Dreams for the movie) was right ("If you build it, [they] will come…”)

You can read more about the characteristics, like taxable equivalent yield and payment schedules, and benefits, like incredibly low beta (correlation) with your equity portfolio, on scores of investor sites.

In terms of selection, when seeking individual bonds or baskets via ETFs and closed-end funds, I don’t think we can do better than to heed Benjamin Graham’s advice in (the 1942 edition of) Security Analysis. He recommended that municipal bonds should possess the following characteristics:
An issuer with a population of 10,000 or greater (I'd raise that to 250,000 today),
An issuer with a diverse economy, and  
An issuer with a history of punctual payment on past obligations.  

The classics never go out of fashion.

So – What to Buy

Within the municipal bond sector, there are variations in risk, from “pre-refunded” munis to “high-yield” munis. Depending upon the client, we might vary the percentages of each category, but we typically run the gamut of offerings. Higher yields generally mean higher risk, of course.

One of the lowest yielding, but most rock-solid ETFs is the Market Vectors Pre-Refunded Municipal Index Fund (NYSEARCA:PRB). “Pre-re’s” are typically backed by U.S. Treasury securities held in escrow. That gives them a credit rating on par with Treasuries. Since most issuers don't have the money to retire them without using at least some proceeds from a new bond issue, they use the proceeds from the new bond sale to buy Treasury securities with maturities similar to the “call date” of the original bond. These are held in escrow to pay off the original loan when the call date arrives. PRB's current yield is just 1.25% but, then, it’s like buying a 1-5 year Treasury that’s tax-free…

At the opposite extreme is the Market Vectors High-Yield Municipal Index (HYD.) Their holdings are the equivalent of corporate “junk bonds” – except that, even in this rarified air, junk corporates (below S&P BBB ratings) may see anywhere from 20-30% default rates, in munis the average is a bit over 4% -- and you are well-compensated for this risk. HYD has a 25% allocation to investment grade triple-B bonds and 75% to non-investment grade bonds and yields 7.18% today – equivalent to an 8.44% taxable yield equivalent even in the 15% bracket and 11.04% in the 35% bracket.

Between these two extremes of risk and reward, there are literally scores of ETF and closed-end offerings. Some specialize in just one state’s issuers in order to provide tax-free income against that state’s tax levy, as well. I won’t list them all. Here are a few our research has focused on, however:
 PIMCO Municipal Income Fund (PMF - Yield 7.9%.) High yield, yet a consistent performer, even in these troubled times. The debt obligations of many communities in several states are represented. It pays monthly and has done so every month except 3 since inception.

Eaton Vance Insured Massachusetts Municipal Bond Fund (MAB - Yield 6.1%) This is an example of a single-state ETF from one of the highest-taxing states in the nation, Massachusetts. MAB has also paid a steady monthly dividend, missing just twice since inception.  

And because we have a number of clients in California, we also own a good bit of BlackRock MuniYield California Fund (MYC – Yield 6.7%) Yes, I know, the common assumption is that California is ready to fall into the ocean at any moment and, if it doesn’t, it will drown in a sea of red ink. I disagree. Even in an absolute worst case, it would be pretty hard for the national government to give trillions in bailouts to now be in the banking, auto manufacturing, brokerage, real estate, mortgage, and insurance businesses and pretend they aren't in the United States business.

Others we are now researching or own smaller positions in include SMB, ITM, MLN, MUS, and MQT.  I’ll respond to any questions or brickbats for the benefit of all in Part II, where we can also discuss how we might rationalize the irrational social-engineering and lobbyist-satisfaction scheme we call the US Tax Code.

Good Investing!

Disclosure: We are long PMF, HYD, and MYC, and in lesser amounts PRB, MUS and MQT.

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