Munis: Get a 5% Tax-Free Yield With the Bond King

Includes: MAF, PYN
by: Graham Summers

It's time for a reunion. U.S. treasuries have had a great eight months as investors fled the carnage in the stock market for safer investments. Since mid-June, the price on the 10-year T-bill has risen 13%. Over the same period the S&P 500 has fallen 7%.

Meanwhile, treasuries' non-taxed cousins municipal bonds, or munis as they're commonly called, have been going through a rough patch. If you're unfamiliar with muni bonds, they're bonds that are issued by state, city or local governments to raise capital for public projects like building a highway, sewer, or what have you. And unlike treasuries, the yields on muni bonds are tax free.

As the credit crunch hit and liquidity dried up, the big banks started clearing their balance sheets to free up cash. Muni bonds were the first to go. Liquidity problems and margin calls have since hit hedge funds, which in turn dumped billions of dollars in muni bonds in the last month. The sell-off has resulted in munis yielding their highest levels in history: 130% of treasuries.

Today, taxable long-term treasuries yield 4.4%, while non-taxed muni bonds yield 5.14%. This discrepancy is outlandish and will be corrected in one of two ways:

  1. U.S treasuries fall, raising their yields more inline with muni bonds.
  2. Muni bonds rally, bringing their yields more inline with treasuries.

It's time for a reunion between these two investments' yields. Personally, I'm betting on a muni bond rally.

So is the Bond King, Bill Gross. As Chief Investment Office for the Pacific Investment Management Company, or PIMCO, Bill Gross has averaged double-digit returns for over 30 years. He's the largest bond manager in the world, overseeing more than $720 billion in assets. That's more than two times the GDP of Switzerland.

Starting in 2003, Gross began shifting his money into muni bonds. Today, he still favors them. In a recent Investment Outlook, he commented:

U.S. municipal bonds are another example of a bargain in today's market. Across the yield curve, high quality muni bonds now yield the same or more than Treasuries of the same maturity, and munis are exempt from federal taxes and most state and local taxes while Treasuries are for the most part taxable.

Gross favors closed-end muni bond funds, particularly those that trade at a discount to their underlying asset value. Between the potential capital gains these funds are undervalued at their current levels and the tax-free yields, these investment vehicles offer the potential for double-digit gains. That's a great opportunity in today's volatile market.

There are still a handful of these funds available. If you're looking for a place to stash some money while the bear market begins its next leg down, this may be it. A tax-free yield of 5% is equal to a taxed yield of 8%. At that point, you're almost returning as much as stocks have historically.

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