Back in February Fortune ran a nice article as to why non-taxable municipal bonds "muni's" were a buy NOW:
Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis' tax advantages. Throw in munis' microscopic default rates, and you've got an ideal landing spot for investors weary of the stock market roller coaster.In theory I agreed with all the points. The article even pinpointed the danger of investing in muni close-end funds, which trade like stocks:
With a fund, given the vagaries of interest rates, bond prices and net asset values, there's no way of knowing what price you will get when you decide to sell your shares.However, the author did not understand how large a risk this really was in an environment where returns of stocks and close-end funds become highly correlated, which is what happens when EVERYONE is deleveraging (i.e. selling) at the same time. Throw in the bad press many of these close-end funds had after the auction-rate security debacle and you get an investment (in a high-quality muni close-end fund) down as much as 35+% since February (of which about 10-15% is due to the underlying muni bond exposure).
Forced Muni Selling by Banks / Hedge Funds:
Broker-dealers and hedge funds were forced (and continue) to unwind major muni positions, shedding as much as 20% of all the outstanding issues held at brokerages, in an attempt to delever and raise capital.
Frozen Credit Markets:
There are currently no natural buyers of any risk in credit markets and muni bonds are no exception. Fear has driven many traditional investors to the safety of Treasuries. Thus, anyone selling muni's gets a significantly lower price, which in a mark to market and illiquid world becomes the new price. Long dated muni's currently trade at a yield 1.45x that of Treasuries (with the tax savings associated with muni's, this should be at or below 1x given conservative assumptions).
No Demand for Close-End Funds:
Muni close-end funds traded at a roughly 5% discount to the net asset value of the underlying holdings as recently as May of this year. The recent market turmoil has caused this discount to spike to 20+% in many instances as owners are unloading close-end funds, along with their equities (i.e. throwing the baby out with the bath water).
muni's have survived many brutal economic environments in the past, but did see high levels of defaults during the great depression (unlike many bears on the blogosphere, I do not see us approaching anything near that level - hopeful news here).
To be extra safe, I would sacrifice yield for additional credit quality, although in an environment in which a AA rated municipality is in trouble, it is highly likely a AAA one will be as well. However, in a low yielding environment (such as this one), I am happy to take on the risk associated with a AA rated muni-close end fund, at the current 20% discount, which yields MORE THAN 8% AFTER TAX in many cases. That is the equivalent to a before tax yield of 9.4% (if your tax rate is 20%) and a whopping 10.5% (if it is 35%). Considering the risk embedded in the S&P 500, and an average return on the S&P 500 (including reinvestment of dividends) of only 8% over the last 20 years BEFORE taxes, I like the risk-return profile.
obvious hope is the market rebounds significantly, but even if the underlying asset values and close-end continue to sell off due to continued selling pressure, I'll collect my boring 7.5% tax free coupon until the cows come home.
Note: Before any investment, please do your own research. 'Muni X Close End Fund' is "based" on a real fund (i.e. it's real).