How to get 7 percent tax-free income from your portfolio

 George W. Karpus, The Daily Record Newswire

Getting 7 percent tax-free income from a municipal bond portfolio seems like something from the late 1980s, when interest rates were much higher. However, due to somewhat unusual circumstances, that 7 percent tax-free return is available today.

Interest rates bottomed in June of 2012 and have been rising for the last 1 ? years. This causes bonds to decline in value with long-term bonds declining the most. Simultaneously, the Federal Reserve has kept short-term interest rates near zero to help stimulate the economy. This has resulted in the yield curve becoming extremely steep (i.e., long-term interest rates are high relative to short-term interest rates).

Municipal bonds (especially longer-term muni bonds) have dropped the most in price in 2013. The drop was primarily attributable to individuals becoming afraid of longer maturities and the fact that they have been taking tax losses in their municipal portfolios. Also, the implementation of the Volker Rules has caused many banks to sell their tender option bonds.

As a matter of fact, long-term municipals are now selling at yields that are above their 20-year average. For purposes of comparison, a 30-year A+ municipal is now selling at 138 percent of the yield of a similar maturity U.S. Treasury. This is one of the most attractive yield spreads in history. In addition, the municipal bond’s yield is tax-free where the yield on the U.S. Treasury is not.

Fundamentally, municipal bonds are very safe. Since 1970, the default rate on an A rated municipal bond is about the same as a AAA rated corporate bond. However, after a default the A rated municipal bond holder has recouped about 50 percent more than the AAA corporate bond holder.

Spooked by the news of the Detroit failure, the problems of Puerto Rico, and the defaults in some California communities, retail inventories have been selling municipal bonds creating what I believe is an outstanding opportunity. This selling has also occurred in municipal closed-end bond funds, causing funds that were selling at premiums to their net asset values a year ago to now be selling at significant discounts (12 percent or more) today. 

The question you are probably asking is, “How can you get a 7 percent tax free yield when an A+ rated 30-year municipal is yielding 5.4 percent?” The question you have to ask yourself is: “Would you borrow a modest amount of money at 0.3 percent in the short end of the market and invest it at 5.4 percent tax free in long-term municipal bonds that are A+ rated?” Unlike open-end funds, this is what closed-end municipal bond funds do with about one-third of their portfolios.

Here is how you get the 7 percent tax-free current yield:

2/3 of portfolio invested in A+ rated municipals       

 =          5.4%

1/3 leverage 5.1% (5.4% - .3%) x 1/3              

=          1.7%

Tax Free Yield

=          7.1%

Less 1% Expense                              -1.0%

After Tax (Current Yield)

=          6.1%

Now, if we buy this fund at a 12 percent discount, or $0.88 for $1 worth of assets, our current yield is a whopping 6.93 percent tax free.

Beyond this, if we find closed-end municipal bond funds that own premium bonds we can easily drive our after-tax return to over 7 percent tax free. This is because when premium bonds are amortized in a fund, an investor can realize a loss when the fund is sold. This allows them to harvest short-term losses and delay capital gains where necessary. 

Looking forward, my worst case estimate would be for a 75 basis point rise in the 30-year U.S. Treasury. If this happens, the 30-year municipal market should see about a 50 basis point rise. That would drop the after-tax total return to about 2 percent over the next year, which is still a very good return. A more realistic scenario is to see a 9 percent after-tax total return, which should be greater than the expected return in the stock market with only half of the statistical risk.

If you have questions on how closed-end municipal bond funds could help you achieve your portfolio’s objectives, contact your financial professional to learn more.

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George W. Karpus is chief investment strategist and chairman of the board of Karpus Investment Management. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

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