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Investing in Municipal Bonds

Written By Brian Hicks

Posted March 27, 2008

Wilbur Ross. Warren Buffett. Bill Gross. When it comes to any one of these investors the Street hangs on their every word and action. And it’s all for a good reason–they have earned it.

After all, they are among the world’s greatest and most renowned money makers.

So when all three of them suddenly decide that one beaten-down corner of the market has suddenly reached the value stage, it’s hard not to take a look at what there are up to–even if those investments are as about as exciting as watching paint dry.

Between them they spent billions of dollars investing in municipal bonds in one way or another since the turmoil in the credit markets began.

That’s because–unlike the alphabet soup of bonds, like CDOs and MBSs, that have been causing all the trouble in the credit markets–defaults in municipal bonds are practically unheard of.

That puts them on par with the portion of the market that everyone thinks of when they are considering a flight to safety, U.S. Treasuries.

There is however, one important difference these days. Muni bonds, as they are known, currently pay a higher yield than Treasuries.

I’ll share more on that later.

First, though, I’d like to clear up a few common misconceptions about municipal bonds.

3 Reasons to Consider Investing in Municipal Bonds

You see, they’re not only just for the very old, the very rich or for the very conservative. In fact, municipal bonds can be an important component of a strategically balanced portfolio at every stage of an investor’s life. Muni bonds can:

  • Provide investment stability to help buffer against the volatility of the stock market (not a bad idea these days).
  • Pay a steady stream of income, sometimes tax-free income, which can help with living expenses. (Tax-free cash flow? Sign me up.)
  • Provide high rates of return to grow your capital (higher-yield with lower risk).

So What Is a Municipal Bond?

Municipal bonds are IOU’s issued by any municipal organization, including cities, counties, states, and school districts. The purpose of these bonds is for general expenditures or to fund specific projects such as highways, new schools, or an athletic stadium.

These bonds offer the municipality the ability to raise funds without directly raising taxes. Of course, what makes them so intrinsically safe is that their cash flows and repayments come courtesy of the taxpayers.

That’s why municipal bonds are generally considered much safer investments than corporate bonds, because a local government is far less likely to go bankrupt than a corporation. Its tax base, as with Treasuries, is the ultimate backstop.

There is, however, one important difference between Treasuries and municipal bonds. Munis generally also carry less interest rate risk overall.

That’s because, unlike Treasuries, which have big overseas investors, municipal bonds are 70% owned by individual investors like you and me who hold them until maturity. So prices for municipal bonds tend to stay relatively stable.

But that’s only part of what makes investing in muni bonds so attractive to billionaires and non-billionaires alike.

Municipal Bond Investments Beat U.S. Treasuries

The real reason is the difference in yield these days between municipal bonds and risk-free U.S. Treasuries. Factoring in the tax breaks, muni bonds actually beat U.S. Treasuries pretty handily.

Consider this.

In today’s tumultuous credit markets, intermediate-term muni bonds now yield around 3.7%. That’s already higher than the 3.5% yield on a ten-year Treasury note, which is also taxable.

But with the muni bonds’ tax-free status, that "true yield" actually rises to 5.5%, assuming a 33% federal tax bracket. That’s a significant increase in yield over Treasuries, which can’t even keep pace with the current inflation rate.

So while it is true that munis did experience one of their worst monthly declines in February, it is also true that they have been beaten down to value levels too good for the some of world’s best investors to ignore.

As for Bill Gross, the king of the bond kings, he recommends buying municipal bonds funds that trade at a discount of at least 10% to net asset value (NAV) and a 5% yield or higher.

One would be the Nuveen Insured Muni Opportunity Fund (NYSE:NIO). It’s trading nearly 9% below its NAV and carries a tax-free yield of 5.27%.

So if you’re looking for the safety of Treasuries but with much higher yields, muni bonds aren’t as boring as they used to be. Gross, Ross, and Buffett are definitely on to something.

Your yield-hunting, billionaire-watching analyst,


Steve Christ, Editor