Editor’s note: Today is Labor Day – a market holiday. In lieu of our normal edition of The Bleeding Edge, we’re sharing a piece of premium research recently shared with our elite members. Read on to discover a unique investing strategy from Jeff, and how it could secure tax-free income for years or even decades.
I’ve got a guy. He’s on the inside.
Not in Leavenworth or anything like that. He’s an industry insider.
I like to think of him like he’s part of the Kansas City mob. Not that kind though. The kind that deals in bonds… Municipal bonds.
For now, let’s just call him “Tony from Kansas City.”
It may sound strange to refer to a bond insider as being part of the mob. But in many ways, municipal bonds are an “old boys club.”
Even though this is a $4 trillion market, much of it is largely “controlled” by a handful of storied brokerage firms.
We usually won’t find the names of these firms in The Wall Street Journal. The “insiders” don’t make appearances on CNBC.
But quietly – behind the scenes – they see everything that happens in the “muni bond” market.
And if we want to find the best opportunities in this market, it helps to “know a guy.” That’s where Tony comes in.
But before I tell you more about Tony, it’s worth taking a step back to understand these investments.
Today, I’ll give us a look into the world of municipal bonds and why I believe they could be the perfect investment for this market…
Your Rich Uncle
Broadly speaking, municipal bonds represent non-federal government borrowing of municipalities. If you live in the U.S., you’ve likely heard of these bonds sold by states, counties, cities, and school districts.
There are smaller categories of muni-governments that also issue bond debt. Some common examples would be rural water districts, housing authorities, hospital districts, fire protection districts, and other not-for-profit entities.
I love municipal bonds, also known as “munis.” And while they aren’t the most exciting in the world, munis are about as close as we can get to a “buy and forget it” kind of investment.
Munis are elegant in their simplicity. They are purchased relatively easily, typically with a simple phone call. And after we’ve purchased a muni bond, all we do is sit back and collect our coupon payments every six months.
Tony has an expression: The coupon is like your rich uncle.
Twice a year – on Christmas and your birthday – your rich uncle sends you a nice check. And we can spend it however we want.
Muni bonds are like our rich uncle… And this is a massive market.
In 2021 alone, $475 billion worth of municipal bonds were issued in the U.S. Overall, it’s a $4 trillion capital market with around $9 billion trading every day.
Yet most of us know little to nothing about it.
Why is that?
Why is it that one of the largest markets in the world, and the one that is responsible for funding our utilities, schools, residential developments and so much more, is largely ignored?
Bonds Are Boring
It’s because bonds are boring.
Even the language of the debt markets isn’t inspiring.
Discussing equity markets often feels like we’re heading into battle. Stocks “catch fire,” “rally,” “surge” and “collapse,” or “get crushed.” Stocks tank, swoon, and crash all the time.
By comparison, bonds sound utterly dull. Bonds trade in basis points, known as “bips.” One hundred basis points equals 1%… “Bips” are boring.
But given what we’ve been through this year, a “boring” investment strategy sounds very appealing. And municipal bonds have another appealing feature… They are ridiculously safe.
Near Zero Defaults
When we buy a municipal bond, we will collect our coupon payments twice a year. Then, at a predetermined time, we are all but certain to receive the entirety of our initial investment returned to us.
I used the phrase “all but certain” because municipal bonds tend to be exceptionally safe. In Tony’s lifetime, he tells me that he’s never sold one that has defaulted – ever. And while he’s lively, he’s no spring chicken.
Going all the way back to the Great Depression, municipal bonds have a general default rate across all municipal bonds issued, including the low-quality ones, of less than ½ of 1%. (A default means a missed principal or interest payment.). And the default rate of high-quality muni bonds is near zero.
And with this low risk comes safe, consistent, and perhaps, a bit “boring” return. But when markets are being turned upside down, words like “safe” and “consistent” have considerably more appeal.
And the reality is that we all will get to a stage in our life when we no longer need or want to grow our investments. We simply want the preservation of capital with regular income generation to provide us with cash to live life.
And the best part about muni bonds aside from the preservation and income generation? The coupon payments that they deliver every six months are – almost always – FEDERALLY TAX-EXEMPT.
The Yield is Much Better Than It Looks
Muni bonds are typically measured by yield to maturity (YTM). This is the amount of interest that we’ll make annually while we wait for our muni bond to “mature.”
Typical YTM for muni bonds tends to be in the 2.5% to 5% range for high-quality bonds, with a national average of 3.18%.
Now, before we turn our nose up at 3.18%, we need to first remember that we pay no federal income tax on the interest payments (and sometimes no state tax as well).
To discover our real yield on our muni bonds, we need to account for the tax-free nature of the interest payments.
As an example, someone in the highest federal tax rate (37%) has a tax-exempt bond that has a YTM of 3.18%. The formula is the yield to maturity, divided by one minus your tax rate or:
Taxable equivalent yield = tax-exempt yield / (1 – federal tax rate)
So, in our above example, the taxable equivalent yield is:
Taxable equivalent yield = 3.18% / (1-.37) = 5.05%
In other words, on $10,000 invested, you’ll get $318 annually, which is the “taxable equivalent” of getting $505 when accounting for taxes.
But now, the obvious question…
Which munis should we buy?
“Flyover Country Pays Its Bills”
While the default rate on munis – in general – is ridiculously low, some are still better than others. That’s why it helps to have a guide in this market.
Tony has an expression that I love: Flyover country pays its bills.
What he means is that municipalities in the American heartland tend to always pay their bondholders. And because of that, their muni bonds are some of the very best on the market.
Each state has different rules, and of course, some states run themselves with fiscal discipline. Others do not.
A perfect example is the difference between Missouri and Illinois. A Missouri general obligation (GO) bond is triple A-rated, and an Illinois GO bond is triple B-rated, which is just above a junk bond rating.
I can probably guess what we’re thinking. Investing in bonds for water treatment in Missouri? Now that’s boring. But what’s wrong with boring?
A Long Time Coming
Readers may be surprised to hear me speaking so favorably about municipal bonds. After all, readers likely know me as a technology analyst.
The truth is I’ve been waiting for the right time to share this idea with everyone.
Many of us may be earlier in our careers and more growth-oriented. But there will always be a point – or points – in life where capital preservation and income generation are important to us.
For many, I believe that time is now.
Editor, The Bleeding Edge
Editor’s Note: Elite members should be on the lookout for Jeff’s first official municipal bond recommendation in the coming days. And for any readers that would like to join our elite membership and take part in these municipal bond investments, you can learn more about membership right here.
And remember, we want to hear from you. Do you want to invest in municipal bonds? Is this research valuable to you? Send us a note at [email protected].
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