If you have read any of my other articles, you know that I am a dividend growth, dividend income kind of guy at heart. If you read my complete series on early retirement, you will also know a lot about my situation. I am building a dividend growth and income portfolio designed to pay me in good and bad times. I may give up a little in capital gains during times when the bulls run rampant, but I plan to have a source of steady income paying me day in and day out even when the bears temporarily have the bulls on the run. (Long term, I believe the bulls always win, but that is for another discussion.) As a side benefit, my dividend growth investing philosophy also serves me pretty well in the capital gains department, but today I want to talk about something completely different - municipal bonds.
Okay, please do not leave yet; hear me out before you move on to the next article. I have hinted at this strategy in some of my previous articles when I mentioned what I was doing in my taxable account. Municipal bonds really can play a role in your retirement income. I am not buying any municipal bonds for my retirement accounts, that would not make sense to me, but I am adding municipal bonds to my taxable account as a way to add some higher dividend income without paying federal taxes. In fact, I am selling off some of my underperforming assets and trading them in for municipal bonds to take that much income off of my tax return.
I will admit that bonds are not my cup of tea. I have been burned in the past with things like mortgage bonds, and I have suffered through minimal returns on US Savings Bonds. I am deathly afraid of high yield corporate bonds. I really like real estate investment trusts and good old dividend paying, dividend growing stocks like the Dividend Aristocrats; however, a relative of mine recommended I invest in municipal bonds because that is what his money manager was doing for him. I disagreed with his approach on many levels, including his turning over his investment decisions to a money manager, but I will admit that that conversation got me motivated to study bonds again. I looked at many types of bonds and eventually I took action in my own portfolio as I will describe in this article.
First of all, what are we talking about? Municipal bonds are debt instruments issued by local government entities to enable them to carry on the business of providing the services we have all come to expect such as roads, bridges, clean water, sewers, garbage service, schools, parks, and innumerable other things that we take for granted. The interest and principle on these debts are guaranteed to be paid off by future tax revenue. Sometimes, as in this most recent election, local governments tie a bond issue to a new tax approved by the electorate. This sounds pretty good. We can loan money to a local government, receive regular interest payments, get our principle back when the bond comes due, the payments are guaranteed by future tax revenue, and the federal government encourages us to participate by making the interest tax free on our personal income tax return. What could possibly go wrong?
Well, the most important thing that could go wrong is default. Unlike the federal government, a local government cannot print money. Local governments can file for bankruptcy, although some states restrict or disallow that action. The most recent examples of local government bankruptcies include Detroit, MI; San Bernadino, CA; Mammoth Lakes, CA; Stockton, CA; and Jefferson County, AL. It almost happened to Miami, FL, in 1996 when I lived in south Florida. So there is a risk, and a lot of local governments appear to be struggling right now. The headlines can have you running scared.
In fact, however, the percentages of good quality municipal bonds that actually default are very low. Over the past 40 years, on average only 2 out of 10,000 investment grade (A, AA, AAA) municipal bonds have defaulted. Those are pretty good odds if you know what you are doing, so I decided I would study to see what I could make of the situation. I used various websites where I could potentially buy municipal bonds over the counter. I could see the interest rate, the maturity, the name of the government entity, the purpose of the bond, and the rating. They also showed the minimum investment sum allowed, which could be very high for a single investment, at least by my standards.
I was disappointed that the "safest" bonds tended to pay what I consider very low rates. My rules as stated in some of my previous articles are that I look for 5% or more in yields on positions that do not provide dividend growth. (I know that 5% tax free is really like 7% or 8% after taxes, but I still want my 5% because the only reason I am going here is for the tax benefit.) Some lower rated bonds paid bigger rates, but I struggled with the question of whether a semi-retired person can afford to put a significant minimum investment in one position that may have a higher chance of default. What really made me nervous, though, was the gnawing fear that looking at charts and lists of available investments does not really tell me what is going on in the minds of those local politicians, or in the minds of the electorate that may kick those politicians out of office next year. So many questions, so little time.
The ideal way around these problems is to use Exchange Traded Funds. This is similar to the strategy I used for foreign investments in my IRA. ETFs allow me to place smaller investments and invest in a basket of bonds to even out some of the risk rather than putting all my cash in one, or a few, specific bonds. The key is to find ETFs with a track record of success and let the experts work for you. Here are the ones I have chosen for myself.
My first choice, and still my number one recommendation, is the Invesco Value Municipal Income Trust (IIM). IIM invests mainly in high quality bonds. More than 77% of their bonds are A, AA, or AAA. Another 20% are invested in B, BB, or BBB, with the majority (17.5%) being the higher rated BBB. The remainder are either not rated or rated low. The largest single sector, 12% of the total, is composed of hospital bonds. More than 21% of the bonds are not callable. The average bond yields about 4%, but the company uses leverage to juice that up a little bit. The current yield as of today is 5.57% and dividends are paid monthly. The dividend history shows that payouts have been rock steady. They have paid 0.075 per share every month since August of 2011. Before that they paid 0.0725 per month from November 2009 to August 2011. Prior to April 2009 dividends tended to be a little more erratic, but considering the financial crisis, payouts were actually very good and included a large special dividend at the end of the year. I first invested in IIM in January 2014 and have added to it steadily through the year. I also have the DRIP turned on to reinvest dividends every month taking advantage of that monthly compounding. Currently, IIM is my largest single holding in my taxable account, making up almost 7% of that account. So far this year I also see capital gains of 12.5% for IIM. Add in the tax free dividends and it is doing quite well, but 7% is about my comfortable limit for new money here (other than my DRIP) so I went looking for other high quality ETFs.
That led me to my second largest holding, the BlackRock MuniVest Fund II (NYSE:MVT). This position makes up 1.3% of my taxable account, so you can see that it is a much smaller holding than IIM, and it is a much more recent purchase. This fund looks somewhat similar to IIM in quality of holdings. More than 43% of holdings are AA. A, AA, and AAA account for about 76% of the total. A little more than 19% is B, BB, or BBB. The rest are not rated, CCC rated, cash, and derivatives. The sector focus is a little different from IIM. More than 17% is related to health care, but the largest portion is related to transportation at 18.5%. The average annual return for the last 10 years is 7.8% and the dividend is a very good 6.44% paid in monthly installments. The monthly dividend seems to have periods of steadiness punctuated by adjustments, either up or down, but generally these moves have not been big. For example, they paid 0.0885 per month every month this year until October. They paid 0.083 for October and November, but then the December payment will be a healthy 0.097. There seems to be a similar pattern every year with a base monthly payout and an end of year adjustment. I bought my position in MVT in September 2014. The share price is basically flat in that short time, but I have already earned two dividend payments and will get the larger end of year payment on December 31, all of which will buy more shares through DRIP.
My third largest municipal bond holding is the Nuveen Quality Income Municipal Fund (NQU). NQU makes up a little less than 1% of my taxable brokerage account. I invested in this position three times, opening the position in October and adding to it twice in November. A full 52% of NQU bond holdings are rated AA. Together A, AA, and AAA make up more than 78% of holdings. Only 1.2% are not rated and the balance is B, BB, and BBB. Overall, more than 90% of NQU holdings are rated BBB or higher which should make for a very high quality portfolio. The average annual return for the past 10 years is around 6% and the current dividend is 5.91% paid in monthly installments. Since 2009 NQU appears to pay an annual base with an adjusted dividend in December like MVT. In the dividend history listed on the Nasdaq website, the December dividend has always been larger than the other months. I am running a DRIP on NQU dividends, and in addition, NQU is my first choice right now for adding new money to my taxable account.
My fourth position is the BlackRock Municipal Income Trust II (NYSE:BLE). BLE makes up about 0.9% of my taxable brokerage account. I invested in this position twice, opening the position in October and adding to it in November. This fund may be a little more speculative. Only about 63% of bond holdings are A, AA, or AAA while more than 24% are BBB, but overall that still gives 87% that are BBB or better. About 5.8% are not rated and 7.7% are rated BB or lower. The average annual return for the past 5 years is around 15%, but over the past year it has been down about 10%. The current dividend is 6.18% paid in monthly installments. Like some of the others listed here, BLE appears to pay an annual base with an adjusted dividend in December. I am running a DRIP on BLE dividends, but I do not think I will be adding new money to this position in the near future.
The last ETF I will mention is the AllianceBernstein National Municipal Income Fund (NYSE:AFB). This is my smallest position at about 0.8% of my taxable account total. Like some of the others, I invested in this position twice, opening the position in October and adding to it in November. This appears to be a very high quality fund. More than 53% of holdings are rated AA. Investment grade, A, AA, and AAA, makes up more than 86% of the total. Another 5.6% are BBB. More than 72% of their bonds have maturities 10 to 20 years from now. The average annual return for the past 10 years is around 6.5%. The average coupon is 5.4% and the current dividend is 6.32% paid in monthly installments. The dividend payout has not been very volatile, much like IIM. It has paid 0.0729 per month every month since March 2013. Before that it paid 0.0775 per month from December 2009 until March 2013. I am running a DRIP on AFB dividends, and AFB may be my second choice for new money going forward.
So there you have it. Right now municipal bond ETFs make up about 11% or so of my taxable brokerage account, and I will probably grow that a little as time goes on. If I include my IRA in the accounting, these muni-funds make up about 4% of my overall holdings. As you can tell from the size of my holdings, I am still not a committed bond investor, but I like these funds. They appear to combine relatively safe, relatively high income with a little capital growth and a big tax advantage. Remember that if you are paying 30% federal tax, you have to earn more than 8% to clear 6%. With these municipal bond funds, 6% really is 6%. I like that.
As always, study hard, do your due diligence, and good luck with your own investing.
Disclosure: The author is long IIM, MVT, NQU, BLE, AFB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long and intend to stay long IIM, MVT, NQU, BLE, and AFB for the foreseeable future. This article serves as a journal of my own experience. I am not a certified financial expert of any kind. As always, do your own due diligence before investing your hard earned cash.