Earn Higher Tax-Free Yields With A 'Sexy' New Kind Of Investment

Includes: AA, CVX, GS, MUB, MUNI
by: Mike the PhD

How would you like to earn the equivalent of a 10% yield with all of the safety of a security from a major corporate like McDonald's (NYSE:MCD), Goldman Sachs (NYSE:GS), or Chevron (NYSE:CVX)? Sound crazy? With a little homework and some phone calls, it's not.

Muni bonds have long been a well-known tool for investors looking to earn tax free yields on their savings. And as securities go, muni bonds are great: they're safe, fairly lucrative, and sufficiently simple that individual investors can invest in them easily. (In fact, more than 70% of all municipal bonds are held by individual investors.)

However, the long standing complaint about munis has been that they aren't… well, for lack of a better word, sexy! As a matter of fact, munis are frequently downright boring. They don't get talked about in the financial press or on TV much, and despite how safe they are (see my other articles or my blog for statistics), investors get scared away from them by sensational headlines from time to time.

In the last decade or so, a new alternative has taken off… an alternative that is much more exciting to most investors, yet still offers that same critical protection from the long arm of the IRS. The NY Times and others in the press who have written about these new bonds call them "qualified private activity bonds." To municipal bond professionals, they are more commonly known as Industrial Development Bonds or IDBs.

IDBs are bonds issued by towns and cities on behalf of major corporations to finance a new facility or factory in that town or city. The bonds themselves are backed by and the interest is paid for by the corporate that receives the money. For example, Alcoa (NYSE:AA) used roughly $300 million in bonds to renovate and retool an aluminum plant in Iowa. Alcoa pays the interest on these bonds, so they yield more than bonds from the state of Iowa, but because they are a special class of municipal bond, they are still federal tax free. This is an enormous benefit to investors that only grew in value after the tax increases earlier this year.

It's not just Alcoa benefiting from these bonds, though. Many other corporations, large and small, use these bonds to cover their capital needs. Chevron, Archer Daniels Midland (NYSE:ADM), Cargil, Sears Holdings (NASDAQ:SHLD), Goldman Sachs, McDonalds, Koch Industries, Bank of America (NYSE:BAC) and dozens of other firms public and private have all issued more than $100 billion in IDBs over the last 15 years.

Since IDBs are back by a corporate rather than a municipality, they tend to have higher yields and more risk than conventional munis. As a result, it's important to take a close look at the credit quality backing these bonds, but the right bonds can often be an attractive investment. MSRB (Municipal Securities Ruling Board) data shows many recent transactions involving IDBs with yields north of 6%. That kind of yield is hard to get these days, but it becomes even more attractive when you consider it on an after tax basis. That 6% yield is the equivalent of 10% after tax (6% tax free * 1/(100%-40% tax rate) = 10% taxable equivalent yield).

Virtually no investment grade firms offer those kinds of yields these days. Yet firms with IDBs are happy to pay these yields because they are only paying 6%; the other 4% in equivalent yield is essentially a tax incentive from the federal government.

Default rates on IDBs are higher than on conventional municipal bonds (see my recent article on the subject), but nevertheless, the default rates are lower than most corporate securities, and they offer stronger recovery rate prospects because the bonds are tied directly to physical assets like Aloca's aluminum plant, Chevron's oil storage facilities, or the Goldman Sachs headquarters building.

In summary, IDBs aren't for everyone, and you should do a lot more research before you invest in one, but for a lot of fixed income investors in today's interest rate climate, they are definitely worth a serious look. For those interested in IDBs, like many bonds, they are fairly illiquid, so the best way to find some is to contact a broker at a major securities firm and ask them if their muni desk has any IDBs to sell.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold a variety of municipal bonds, including IDBs backed by several large private firms.