In the crazy investment world in which we live, bonds yielding nothing or less are bought for capital gains, while stocks, the historical engine of capital appreciation, are bought for income. Bonds with negative yields can provide positive returns—if those yields plumb ever deeper negative territory, boosting the securities’ prices, as explained here several weeks ago.
In a world with $17 trillion of bonds with subzero yields, such desperate maneuvers are needed to eke out a return. The obligations of the government of Italy yield less than 1%, even though Italy scarcely has a government. Only when compared to 10-year German Bunds with a minus 0.7% yield can it be explained. No wonder the world rushes to the U.S. bond market for top-quality fixed-income investments for yields with not only a positive sign but an integer.
In the Treasury market, most maturities yield 1.5%, or less, out to the benchmark 10-year. And, last week, the 30-year bond yield traded at a record low under 2%. As international impacts have depressed U.S. Treasury yields, fixed-income investors have been seeking higher-yielding alternatives, as Alexandra Scaggs details in the Income Investing column.
But global influences are felt less in the sector of the U.S. bond market most domestically oriented: municipal securities. Their primary attraction is that their interest payments are exempt from federal income taxes, and, in some cases, state and local income levies. That makes munis relatively uninteresting to global investors, such as sovereign wealth funds, and tax-exempt investors, such as pension funds or endowments.
But munis have been left behind in the headlong plunge in yields. Some top-grade, tax-free long-term municipal bonds provide a higher yield than the taxable 30-year U.S. Treasury, David Kotok, the chairman and chief investment officer of Cumberland Advisors, writes in a note to clients.
Reached on one of his famous fishing retreats in Maine, Kotok suggests that U.S. individuals should take advantage of this anomalous situation by opting for some munis with credit quality comparable to Treasuries, but with higher yields.
Among them are the Irion, Texas, Independent School District bonds with a 4% coupon and maturing Aug. 15, 2044, which are priced to yield 2.09%, based on the worst-case assumption that they will be redeemed early, on Aug. 15, 2024. They have triple-A ratings because of their backing by the Texas Permanent School Fund, whose unique status was discussed in Barron’sthis year.
Kotok also likes Minnesota House Finance Agency 2.75% coupon bonds, due July 1, 2044, and providing the same yield to maturity. The bonds are rated Aa1 by Moody’s Investors Service and AA-plus by Standard & Poor’s, both a single notch below the rating agencies’ respective top grades. But the Minnesota bonds are backed by Ginnie Mae securities, which carry the federal government’s guarantee. For an investor in the top federal tax bracket, that 2.75% yield is equivalent to 4.37% on a fully taxable bond.
Even higher tax-free yields can be found in another relatively obscure part of the fixed-income market, closed-end muni funds. CEFs differ from open-end mutual funds in two important respects: They issue a set number of shares, which aren’t redeemed, but instead trade like stocks at prices that may be above or below their net asset values, and they often borrow money to leverage their portfolios. That increases both yield and risk.
The main danger is that their cost of borrowing can rise, cutting distributions, and, in turn, the share price. That typically happens when the Fed is raising its policy rates. The current likelihood is that those rates will fall, however; federal-funds futures put a 95.8% probability on a quarter-point cut at the policy meeting ending on Sept. 18, according to the CME Group’s FedWatch site, as of midday Friday.
Kotok also points out that muni closed-end funds tend to have limited liquidity, because most are most small- or microcap stocks. That should be less of a problem for individual investors looking to buy or sell the bigger funds. And the rewards are tax-free yields over 4% in many cases, equivalent to 6.35% on a taxable fixed-income investment to an investor paying 37% federal taxes.
But investors should look beyond just yield and take into account valuation. For instance, Pimco Municipal Income Fund II (PML), yields 4.9%, but trades at 23.97% above its net-asset value, according to CEFconnect.com. Paying $1.24 for a dollar’s worth of assets isn’t exactly a value play.
Slightly lower yields are available at significant discounts from the Nuveen Quality Municipal Income fund (NAD), with a 4.42% yield at a 10.36% discount, and Nuveen AMT-Free Quality Municipal Income fund (NEA), 4.47% yield at a 9.52% discount. These funds have respective market capitalizations of $3.2 billion and $4.1 billion, which should make for better liquidity than smaller funds.
Investors looking for a return of capital at a future date, similar to a bond, can consider the BlackRock Municipal 2030 Target Term Trust (BTT), one of Barron’s top income picks for 2019. Its lower yield of 3.14% reflects less risk from possible rising yields and falling bond prices, owing to the fund’s shorter effective duration. It also is among the larger muni CEFs, with a $1.8 billion stock-market value.
To be sure, these tax-free returns look attractive mainly in the context of the headlong plunge in global yields. But for tax-paying Americans, muni bonds at least provide a positive yield, all of which they can keep.
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