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If you're looking for income sheltered from Uncle Sam, look
no further than the opportunity in municipal bonds.
Earlier this year, panic-stricken municipal bond investors
were fleeing for the exits. The muni market was roiled by
fears that issuers would default and bond insurers couldn't
make good on their guarantees. Bond prices plunged. Yields,
which move inversely to prices, were the highest relative to
comparable Treasuries in half a century.
Now the fears appear to have been largely overblown, and
what seemed like a crisis was really an opportunity (as I
told High-Yield Investing readers back in March). The
pendulum has swung in the other direction as value-seeking
investors move back into the market -- but bargains still
abound.
For example, Western Asset Municipal High Income Fund (NYSE:
MHF) reached almost $8.50 a share in 2008. Then last
September it began a steep plunge, hitting a low of $5.12 a
share on October 10th. Back then, it was yielding an
unprecedented 8.7%. Today, the yield has come down, but it's
still a solid 6.0%.
That may not sound like much, but the income can be
tax-free. Municipal bonds are issued by state and local
governments for things like building schools and repairing
bridges. The federal government doesn't tax the income
earned from munis as an incentive to invest.
 So
really that 6.0% yield turns into a taxable-equivalent yield
of 9.2% if you're in the highest tax bracket. In addition,
there is the potential for capital appreciation. As you can
see in my chart, the spread between munis and comparable
Treasuries has narrowed (indicating the fear of default has
lessened) -- yet MHF is still well below the highs it saw
back in 2008.
But many investors are scared away from investing in bonds
-- they seem archaic, and a lot of folks aren't sure how to
trade them.
To battle this, you might look toward closed-end funds
focused on muni bonds. These muni funds are as simple to buy
and sell as a stock, and you can access them through any
full-service or discount brokerage account. The funds offer
access to a professionally selected basket of bonds and,
unlike an individual bond which pays interest twice a year,
many CEFs pay their tax-advantaged distributions every
single month.
But not every fund will cut the mustard. There are a few
things you should know before diving into just any muni
fund...
How to Pick the Safest Muni Funds
If safety is your top priority, you want a fund focused on
general obligation bonds. These bonds are backed by the tax
revenues of the state, city, or school district that issues
them. If needed, the issuer can raise taxes to repay the
principal and interest. In contrast, revenue bonds and
industrial development bonds are backed by the revenue
streams of a specific project or facility, which tend to be
less secure.
Pre-refunded municipal bonds can also offer a greater degree
of security. These are previously issued munis which are
secured by an escrow fund. Escrow funds using U.S.
Treasuries or State and Local Government Series (SLGS) to
make bond payments are generally the most secure.
Leverage -- a Double-Edged Sword
Most closed-end muni funds use leverage to juice yields.
They borrow money by issuing floating-rate preferred shares
or investing in tender-option bonds and use these short-term
loans to buy longer term, higher-yielding munis. Some investors
love this because it means they can earn even higher
yields.
The problem with preferred shares is that regulations
require an asset coverage of 200% -- assets have to cover
the value of preferred shares issued by 2-1. If that level
isn't maintained, the fund can be forced to cut or suspend
its distribution to preserve cash.
Most funds are careful to watch this line, but in the market
turmoil between October and March, falling asset values
forced some funds to cut their payments.
How to Stop Interest Rate Risk in its Tracks
Investors should also check into a bond fund's "duration."
Simply put, a bond's duration refers to the number of years
it takes for you to get back your original capital through
both interest payments and the return of principal at
maturity. A short duration of say, two years, means you will
get back your capital in about two years, either from high
interest payments or a short maturity date.
Duration also measures a bond's interest rate risk. A bond
or bond portfolio with a 10-year duration has a greater
chance of suffering from rising interest rates. If rates
rise, the bond price will fall to match the prevailing yield
of new bond issues. Longer-duration bonds generally offer
higher yields to compensate investors for the greater
potential risk.
If you're interested in tax-free municipal bond funds, my
research staff has put together an exciting list of muni
funds for new
High-Yield Investing subscribers. They found a
total of 44 muni funds yielding more than 6% that also trade
below the value of their assets. Their top find pays 10.9%,
for a taxable-equivalent yield of 16.8%.
Subscribe today and you'll receive this exclusive
list.
Good Investing!
Carla Pasternak's Dividend Opportunities
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