Daniel Lippincott, The Daily Record Newswire
2013 will be known as one of the best years for the stock market, as the S&P 500 Index was up over 29 percent through the end of November. While this great performance has many investors considering an increase in their stock allocation, other investors are thinking that stocks have run too far and are overdue for a correction. Given these conditions, where can a “cautious” investor put their money when there are seemingly no palatable alternatives to stocks?
One answer, from Pimco’s bond guru Bill Gross, is to favor short-dated U.S. Treasury Notes, particularly the 5-year maturity range. However, the problem with this preference is that the 5-year note currently yields a paltry 1.37 percent; which, after taxes and inflation, would leave an investor with little, if any return.
Another alternative, posed by Doubline Capital’s Geoffrey Gundlach, is to invest in emerging market bonds denominated in U.S. dollars. While emerging market bonds certainly offer a more compelling yield often in the 6 to 7 percent range, they also expose investors to significant risks and increased volatility.
Given the downsides associated with these two bond managers’ preferences, my suggestion would be to invest in closed-end municipal bond funds. While Gross and Gundlach are not able to effectively utilize closed-end funds in the multi-billion dollar mutual funds they manage, both have utilized these funds in their personal investment portfolios.
Closed-end municipal bond funds offer an astute investor the opportunity to purchase a professionally managed, highly diversified portfolio of high quality municipal bonds at a discount. To top it off, the discounted price at which muni closed-end funds are currently trading is akin to the recent “Black Friday” sales at your local mall. And better yet, this opportunity should last through the holiday season, as investors in these funds look to sell their shares in order to realize capital losses for tax purposes.
For an example of this sale, let’s examine a muni closed-end fund managed by Nuveen, which we were able to recently purchase for $12.14. The net asset value (or the value of all the bonds in the fund) is $14.03. This means that we are buying this fund at a 13.47 percent discount, nearly 9 percent wider than its 20-year average discount. Better yet, this fund is yielding 6.50 percent, all of which is tax free. To illustrate just how attractive this tax free yield is, an investor subject to the highest marginal tax-bracket would have to earn 11.48 percent on a taxable investment in order to match it.
In order to project the return on this fund, we need to look at the three components of a closed-end fund’s total return. The first and most reliable component of return is the 6.50 percent tax free yield. Second, we need to project which way the discount is most likely to move. Since the current discount of 13.47 percent is much wider than the fund’s 4.50 percent historical average (likely due to tax loss selling), it is very probable that the fund’s discount will narrow in 2014 as this selling pressure abates.
Conservatively, if the fund retraces half way toward the long-term average discount, that would produce 4.50 percent of additional return. The final, and most difficult component to predict, is the return on the individual municipal bonds within the fund. If you simply assume flat net asset value performance, this fund could return 11 percent in 2014.
However, many people believe that interest rates will rise next year as the Federal Reserve tapers its purchases of U.S. Treasuries and mortgage-backed securities. While U.S. Treasuries have been artificially suppressed to abnormally low levels by quantitative easing, a 30-year A rated municipal bond currently yield 5.88 percent, 2.07 percent more than the 30-year U.S. Treasury. Should interest rates rise, this indicates that municipal bonds offer a tremendous value and less downside risk than U.S. Treasuries.
In order to achieve a return, an investor must accept some type of risk. At current valuations, we believe closed-end municipal bond funds offer tax-sensitive investors a compelling “go forward” return with minimal risk. To learn more about how closed-end municipal bond funds could help you achieve your investment objectives, please consult with your investment professional.
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Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
