Tax-Free Municipal Bonds - A Great Long-Term Safe Play

| About: Fidelity® Tax (FTABX)
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Summary

In a volatile market, safe money is best to bet on infrastructure.

Local investing has added benefits of stimulating the local economy.

Think global, act local, by buying tax-free munis.

Often in investing we lose track of what's important. We need money, we need returns, we need to manage our portfolio - but at what cost? Corporate America has been found guilty of fraud, harm to the environment, and a host of other issues. While local governments aren't angels, they have at least a simplified, limited area where they operate. State, County, and City governments provide services such as water, fire protection, police protection, and education services.

At Fortress Capital, we look at investing as a whole, depending on the goals and objectives. Many investors are looking for a safe return of their money, not a return on their money. But being safe doesn't pay much in today's market. The average bank CD pays about 1%, if you're lucky.

Tax-Free Municipal Bonds offer investors a great alternative. Some pay 5%, and there are no taxes. The tax-free element is equivalent to about 2% of yield; so on a 5% investment that would be taxed otherwise, the real return is 3%. Of course, this depends on your individual tax situation. There are funds that invest in tax-free munis so you don't have to. The benefits are that they diversify investments into many offerings, which alleviates the problem of choosing the best one. The downside is there are costs associated with these funds, but they are reasonable, and many of them are "no load," meaning they don't have extra fees often associated with riskier funds. Here's a few picked from a hat (randomly) from well known issuers such as Vanguard and Fidelity:

  • Fidelity® Tax Free Bond Fund No Load (FTABX)
  • Vanguard High Yield Tax Exempt Fund Inv (VWAHX)
  • Vanguard New York Long Term Tax Exempt Fund Inv (VNYTX)

Looking on the surface, they may not seem to exciting. But take a look at this chart from Fidelity® Tax Free Bond Fund No Load (MUTF:FTABX):

FTABX Total Return Price Chart

FTABX Total Return Price data by YCharts

In the last 10 years, the average yearly return of this fund was 5.05%. That's not bad, and let's remember this is tax-free!

Even if you are actively investing and looking to keep your money in cash, these tax-free muni funds offer a reasonably safe cash alternative.

The other option investors have is to contact their local governments directly. Many municipalities will place their bonds for sale directly with local financial institutions, especially for schools. Denominations can be as low as $5,000 or even less, making them accessible to most investors.

Fundamentally, it's an investment backed by tax income. Probably, property owners will pay their taxes (and even if they don't, the county can seize the property and pay the taxes). So it is relatively certain that counties will have tax income. Many jurisdictions have rules as far as how much governments can borrow and for what purpose.

Foreigners can't get enough of them. Over the past 10 years, foreigners have increased their holdings of municipal bonds by 11 times (although they prefer the higher yield, taxable muni bonds):

Foreign investment in the U.S. municipal bond market has exploded in the last 10 years. From 2001 through the second quarter of 2012 foreign investors increased their holdings of munis by more than 11-fold. While foreign investors owned $8 billion at the end of 2001, they had increased their ownership to $89 billion at the end of the second quarter of 2012, according to the U.S. Federal Reserve.

The Fed estimates the total size of the market at $3.7 trillion, with most owned by the domestic "household sector," with $1.8 trillion. Other major holders include mutual and money market funds, banks, and property and casualty insurers.

Here enters the forex element; as all these bonds are denominated in US dollars. As explained in Splitting Pennies - this is one example of natural demand for US dollars. Before these foreigners buy the muni bonds, they must first convert their foreign currency into US dollars, thus creating a natural money demand for the US dollar. Foreigners not only appreciate the returns, they also enjoy the legal protections offered by the US, including the extensive class action securities litigation industry, which is not present in other countries.

Of course, for US buyers, the forex element is irrelevant, but it is important that foreigners are snapping up muni bonds at such an increased rate.

Municipal bonds are supported, not threatened, by the Fed raising interest rates. The Fed has raised interest rates by a small amount (not 5% or something) - but at least they are raising. QE is unwinding a little bit (tapering). That means the trend for interest rates for the USD is positive, meaning they will probably continue to raise rates, and probably not lower rates. This is good for muni bond investments.

Emerging markets have been a big trend for investors, because of the unique opportunity for growth. It's simply not possible for big industrialized economies to grow with double digits. The BRICS have provided many opportunities for investors to grow their portfolios. But now that China has proven that it isn't the consistent double-digit earner we all thought it was, maybe serious investors will reconsider their EM investments, and explore investing in local emerging markets, such as growth areas still undeveloped in the United States, such as the south. And there's no better way to safely play this trend than tax-free munis.

Disclosure: I/we 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.