A good long-term investment plan does not change very often, but short-term cash and extra funds that you can dedicate to speculative opportunities should be constantly reevaluated. The current markets present an extraordinary opportunity every individual should review.
If you are in a high tax bracket, tax-exempt bonds have historically offered a slightly better after-tax return than comparable taxable investments. Over the last year, due to the liquidity crisis in the financial sector, tax-exempt bonds, a.k.a. municipal bonds or “munis,” have become extremely undervalued. They now offer nominal returns that are roughly the same as taxable equivalents, which means that if you are in a high tax bracket you will end up with a lot more money if you put it in munis.
Clouding the situation has been the fact that bond rating agencies have historically put municipal bonds on a separate but identically named risk scale. The Wall Street Journal notes, “[I]nvestment-grade corporate bonds between 1970 and 2000 had a 10-year default rate of about 2.3%, far higher than the 0.03% default rate of investment-grade munis.” I.e., the finance industry has historically pretended that munis are as risky as taxable bonds that in actuality have proven to be seven times more risky.
Munis are not without risk. Municipal institutions can default on their bonds, and they will be more likely to do so during a recession. Also, muni bonds are exposed to the same price risks as most other bonds: Their value will decline if interest rates or inflation rise above the levels currently anticipated by the market. Nevertheless, the risk level of investment-grade bonds is considerably lower than that of stocks or real estate.
First Action Item: If you are in a high tax bracket, this is definitely the time to move any non-retirement assets that you would normally invest in bonds into muni bond funds. Your after-tax risk-adjusted earnings will be far higher with the munis. Examples of good funds are Vanguard’s VWLTX, or USAA’s USSTX.
This is also a good time to consider a speculative angle on munis: Not only are they underpriced relative to taxable bonds, but they are also close to “support” levels where even non-taxable entities would start to buy them. As soon as their nominal yields exceed those of comparable taxable bonds they will be bought by large investors that don’t benefit from the tax exemption — pension funds, endowments, etc. I.e., they are below their historical and intrinsic price (which is the price a high-tax-bracket investor would pay to own them), and they are so low that they cannot fall much further relative to taxable fixed income.
Buying large amounts of municipal bonds with taxable funds could produce not only an attractive current yield, but also significant capital gains if they revert to their historical price levels relative to taxable bonds. The best way to speculate on this dislocation is with leverage, and it turns out to be easy to leverage exposure to municipal bonds using Closed-End Funds (CEFs). A typical leveraged muni CEF will employ leverage of 30% — which means you get roughly 30% more dividends and 30% more exposure to price swings than you would have from a conventional muni fund. There are literally hundreds of CEFs in the municipal bond sector. I look for high-yielding CEFs that are trading at a discount to their historical discount. (There are a number of reasons why CEFs trade at a permium or discount to their NAV. Without getting into those nuances just follow the rule-of-thumb that the practical “discount” for a CEF is defined with respect to its historical discount. I.e., you’re getting a bargain if you buy a CEF at a discount to its discount. Visit ETFConnect to look at the historical discount for any CEF.)
Second Action Item: This is a great time to speculate on munis using leverage. Just realize that like all speculative strategies this is subject to greater risks: I.e., you can lose more money if things go wrong. If you have speculative capital to put to work, look for a high-yielding muni CEF that is trading at a discount to its historical discount (I consider the average 52-week discount for this purpose). Current examples would be: