| Municipal
Bond Funds with Taxable Equivalent Yields of 10.8% |
Published: July 27, 2006
Bill Gross is the master of the
bond universe. He's the founder and managing director of Pacific
Investment Management Co. (PIMCO), the world's largest bond fund. He
manages over $600 billion of other people's money -- more than the GDP
of most countries on this planet.
So where is Bill Gross putting his money now?
Municipal bonds, and more
specifically, municipal bond funds. "I own 35 of these funds
personally," Gross said recently. They're "a great deal."
"A great deal"? What's he talking about? Even after 17
successive hikes in the Fed's key lending rate, yields are still paltry
just about anywhere you turn in the bond market.
|
Register
for Carla Pasternak's High-Yield Investing newsletter
today and you'll receive as many as SIX in-depth research reports absolutely FREE!
|
|
It makes little difference if
you invest in short-term one-year bonds, intermediate five-year bonds,
or even bonds with long-term maturity dates of 10 years or more. Nor
does it matter if you invest in government Treasuries, corporate bonds,
or municipal bonds. You're still looking at the same puny 5% to 6% yield
from all of these bond classes.
Or are you? On the surface, yes. Dig a little deeper, and you'll see why
municipal bonds and the funds that hold them offer you a great deal.
Municipal bonds (commonly referred to as "munis") are
issued by state and local governments to fund public projects such as
the construction of bridges or highways. Backed by the municipalities
that issue them, munis are among the most stable, most creditworthy, and
highest-yielding bonds around.
In low-return bond markets like today, munis and the funds that invest
in them provide investors with a great way to lock in a stable,
tax-advantaged income stream while earning superior returns.
"It's not what you earn, it's what you keep"
Let's take a closer look at the yield advantage offered by munis.
Europe's biggest bank, HSBC Holdings, recently issued a five-year single
A-rated corporate bond, and this bond is now yielding about 5.5%. You
can also lock in a 5-year risk-free Treasury for about 5.2%. Or you can
buy a five-year A-rated muni issued by the city of Los Angeles, which
also offers a 5.2% yield.
Which is the better investment? All three carry a low-risk credit rating
and an equal term to maturity. Your first instinct might be to grab the
slightly higher-yielding corporate bond. Alternatively, if you're a
conservative investor, then you may go for the risk-free Treasury.
But wait! You may recall that the income you receive from most
fixed-income securities, including bonds and CDs, is taxed at your
ordinary income tax rate, up to 35%. Not munis -- they're exempt from
federal taxes. They also may be free from state and local taxes if
they're issued by your home state.
This tax advantage lifts your yield in a big way. In fact, the tax
advantage is so huge that Wall Street has developed a whole new
vocabulary to speak about munis. Bond investors talk about a muni's
"taxable equivalent" yield. That's the yield you would need to
get on an ordinary taxable bond to equal what you earn on a muni.
|
Editor's
Note: Carla Pasternak's model portfolios focus
exclusively on investment opportunities with ultra-high yields.
In fact, in each of her monthly High-Yield Investing
newsletters she provides readers with an entire portfolio of
stocks, funds and preferreds that are delivering annual
dividend yields of +10% or more. That's right -- in order to
even be considered for inclusion in this portfolio, a particular
investment opportunity must deliver cash payments of at least
10% per year. Visit
this link to learn more about Carla Pasternak's High-Yield
Investing newsletter.
|
Consider this example. The muni
just issued by the city of Los Angeles yields 5.2%. That's less than the
HSBC bond yield of 5.5%. However, the catch is that you'll need to pay
federal taxes on the HSBC bond.
Using a taxable-equivalent yield calculator, which you can find on just
about any financial website,
you'll see that the HSBC corporate bond would need to yield around 8.7%
to match the yield on the tax-free muni (assuming you pay a combined
federal, state and local tax rate of 40%).
Here's another way to look at the difference. Your after-tax return on a
$100,000 investment in the 5.5% corporate bond would be just $3,575 if
you're in a 35% federal tax bracket. (We won't count any state or local
taxes you may pay.) Compare that to the $5,200 you get to keep with a
$100,000 investment in a 5.2% tax-free muni. Compounded over five years,
the difference really adds up. Your corporate bond would earn a total of
$19,200 at maturity -- well below the $30,696 you'd earn by investing in
the muni!
By the way, these calculations also apply to government-issued
Treasuries, which, like corporate bonds, are subject to federal income
taxes (but not most state and local taxes).
Of course, the muni's tax-advantaged yield may not be as appealing if
you hold all your investments in a tax-exempt account. When you withdraw
a muni from an IRA or 401(k) type of account, it becomes subject to
taxes just like any other investment. With this in mind, municipal bonds
are best kept in a taxable (ordinary brokerage) account.
Aside from their tax benefits, munis also enjoy many other advantages
. . .
Munis are Safe
For starters, munis are among the safest bonds around -- about as safe
as Treasuries. Over the past three decades, their default rate has been
only 0.04% versus 9.8% for corporate bonds, according to credit rating
agency Moody's. While some muni funds invest in the high-yield (below
investment grade) sector of the municipal market, the funds we'll
profile in a moment focus on quality, investment-grade bonds.
What about interest rate risk? When interest rates move higher, bonds
decline in value. But here again, munis could be even safer than
Treasuries. That's because overseas investors have bulked up on
Treasuries. If these investors decide to bail out, then Treasury prices
could sink and the Treasury you buy today could be worth a lot less
tomorrow.
Munis are not likely to suffer the same fate. Over 70% of munis are
owned by individual investors like you and me, who generally hold their
bonds to maturity. As such, municipal bond prices tend to stay
relatively stable. Over the past 20 years, muni prices have fluctuated
less than 5% annually, far less than the 15% volatility of the S&P
500 or even the 7% change in Treasury bonds, according to research by
investment banker Franklin Templeton.
Why Buy a Bond Fund?
You can buy individual municipal bonds or you can invest in a fund that
holds a diverse portfolio of munis. Municipal bond funds generally offer
higher yields than individual muni bonds. They also give investors the
benefit of greater diversification, as well as the opportunity for
capital gains.
Most muni bond funds invest in a diverse portfolio of different
municipal bonds. This spreads the risk across several different state
and local governments and a range of sectors. Muni funds also have the
resources to create a laddered portfolio of dozens of bonds with
different maturities, allowing them to take advantage of changes in
interest rates.
Mutual Funds or Closed-End
Funds?
You can gain exposure to municipal bonds by investing in mutual funds
and/or closed-end funds. Because closed-end funds typically offer higher
yields and lower management fees, I've focused my research efforts on
several top yielding closed-end funds. The following funds have built
high-quality bond portfolios that should provide stable, secure income
for years to come . . .
Important
Note: Throughout the remainder of this article, editor
Carla Pasternak provides a closer look at some of today's
highest-yielding municipal bond funds, many of which sport taxable
equivalent yields of 10.8% or more. However, in order to view the
remainder of this article, you'll need to subscribe to our premium
income-oriented newsletter -- High-Yield Investing. After
you subscribe you'll receive immediate access to this full article, as
well as our monthly High-Yield Investing newsletter and a
host of additional premium content. Please visit one of the following
links to continue...
Good investing!
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
| To
receive in-depth guidance on today's leading income investing
opportunities each month, plus access to several model portfolios,
please subscribe to Carla Pasternak's premium newsletter -- High-Yield
Investing. |
Carla
Pasternak draws on a variety of financial backgrounds to make profitable
calls on income-generating stocks for her readers.
Carla has
been employed in the investment industry for more than two decades. In
addition to her work as a writer for several other nationally recognized
financial publishers, her previous experience includes a position as
President of a well-respected investor relations firm. She has also been
writing shareholder reports for public companies (annual reports,
speeches, corporate profiles, slide shows, etc.) since 1980.
A highly
successful investment analyst, Carla specializes in high-yield,
income-paying stocks. In that pursuit, she's always mindful to select
companies that not only pay rich dividends, but that also have the
potential to deliver strong long-term capital gains.
On the
educational front, Carla holds both MBA and Ph.D. degrees. When she's
not watching the market, she's teaching business courses at the college
level and managing several million dollars in portfolio assets.
