How To Double Your Safe Muni Bond Returns



Most “high bracket” investors love the idea of tax-free muni bonds. But they aren’t sure where to buy them, and often end up using exchange traded funds (ETFs) as their vehicle of choice.

Bad idea.

Muni ETFs provide a smooth but unfulfilling ride. The popular iShares National Muni Bond ETF for example has rewarded its investors with a drama-free decade. Prescient investors who foresaw the big crash of 2008 and piled into munis saved themselves a year of heartburn and earned $50,000 in Federal tax-free income on every $100,000 they saved from stocks.

Stocks, as usual, were better over the long run. The S&P 500 returned 138% versus just 51% for MUB.

But neither is a compelling income investment today. The S&P yields just 1.8% and MUB pays (a tax-advantaged) 2.4%. The muni ETF has returned 3.8% per year since inception and is likely to underperform that mark in the years ahead. After all, it pays less and trades for exactly the value of the muni bonds it holds.

We need a better way. And we have one.

Double Our Tax-Free Yield and Long-Term Return

It’s not MUB’s fault it’s so lame. ETFs are marketing products, designed to attract assets from investors. Their strategies are often mindless and their returns reflect it.

Enter CEFs (closed-end funds), the underappreciated darling of savvy income investors. CEFs are better bets for three reasons:

  1. They are actively managed by pros with a legitimate “edge”,
  2. Their asset pools are fixed, which means they can (and do) trade at discounts to their net asset values (NAVs), and
  3. They get access to cheap money, which helps them lever up returns with minimal risk.

Add up these edges, and we have a superior long-term vehicle for muni returns. For example, since its inception in 2002, the Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund has returned 6.4% yearly to investors (before the tax break!).

It’s no surprise because Nuveen is so connected that it gets the first phone call on muni bond offerings. Portfolio manager Paul Brennan is in the catbird’s seat as he builds a tax-advantaged collection of investments for his shareholders. And Paul earns his paycheck. His Rolodex has doubled up the flashier MUB since the latter was launched by its marketing wonks!

I admit that NVG’s superior ride isn’t quite as smooth. Two of its major advantages are responsible for its higher volatility. (I’ll explain in a moment but let me add that this is actually a good trait, because price swings give us calculated contrarians great times to buy.)

Is right now one of them? Let’s consider three important factors.

NVG Trades at a 7% Discount to NAV

We can buy Paul’s muni bonds at a discount today – for 93 cents on the dollar, to be precise (using our 7 cent discount). This covers his management fee and provides us with a nice margin of safety while we collect our federal tax-exempt payouts.

It’s a good deal. Not quite a great one, because there have been times (and will be again) when NVG has traded at double-digit discounts to its NAV. But there have also been times (and will be again) when NVG traded for a narrower discount or even a slight premium.

Given that NVG is a great fund with a great tax benefit for certain individuals, I am fine with us paying a good price for it.

(And when great buying moments like we saw in December 2016 to arise, my subscribers are the first to know! I told my Contrarian Income Report readers to buy NVG then, and it’s delivered 14% pre-tax returns since.)

Rates Rising: A Problem for Munis?

Headline-following investors believe that rising rates are bad for muni bonds. But munis and long-term rates haven’t always had an inverse relationship. Last decade, they actually co-existed peacefully and tended to move in tandem.

This traditional relationship should eventually resume. If the 10-year yield (somehow) rolls towards 5% or 6%, municipalities will have to pay more to fund their projects. But their premiums should be modest, thanks to the tax benefits they provide.

Sure, leverage costs will creep higher for CEFs. But historically, this has been offset by the higher “coupons” our managers are able to collect.

Disclosure: none

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