The Safe Asset Class You’ll Want To Own Before The Election…
Last week, when I wrote about the very real possibility of a tax hike after the election, I expected a bit of a backlash. After all, we’re in the height of campaign season during one of the most contentious periods of American history.
Frankly surprised by the lack of negative comments. That’s a testament to you, our readers. But it’s also probably because rather than complaining, I spent the bulk of the article offering a concrete solution for investors in the form of one of my favorite asset classes.
I’m talking about municipal bonds (or muni-bond funds to be exact).
If you missed that piece or want to learn the basics, I strongly suggest you go back and read that piece.
So today, I thought I’d follow up with some comments on the finer points of muni bonds.
Forgive me in advance if this is a little on the dry side. Muni bonds aren’t exactly sexy to most investors – but keeping more of your hard-earned money is pretty appealing if you ask me.
Not All Munis Are The Same
First, it’s worth talking about the characteristics of muni bonds.
When you invest in corporate bonds issued by companies like General Motors (NYSE: GM) or McDonald’s (NYSE: MCD), the proceeds are often used to buy new equipment or build stores or factories. When you buy a municipal bond, you are lending money to state or local government agencies to help build roads, bridges, schools, sports stadiums, water treatment plants, or other public works projects.
There are two main classifications.
The first category is called general obligation (GO) bonds. These securities are backed by the full faith and credit — as well as taxing power — of the state, city, or school district that issued them. That means the issuer can increase property or sales taxes if necessary to ensure the timely repayment of principal and interest due on the loans.
Then there are revenue bonds, which are issued to help finance infrastructure projects such as airports and toll roads. The revenue produced by these projects is then used to repay the bondholders. This type of muni bond carries a bit more risk but generally offers higher payouts in return.
One Of The Lowest-Risk Asset Classes Around
In either case, the risk of non-payment is exceptionally low. While corporations become insolvent all the time, government bankruptcy is rare and typically makes national news. Yes, it can happen. You might recall the high-profile bankruptcy of the city of Detroit, which filed chapter 9 in July 2013 with an estimated $20 billion in debt. The city was crushed under the weight of employee pensions.
That event rattled investors. But on average, over the past four decades, there have been just two or three of these situations (most far smaller in scale) in any given year, among thousands of issuers. Even in the relatively tough year of 2012, for example, there were nine municipal bankruptcy filings worth a total of about $2 billion in value — or less than 0.06% of the total municipal debt outstanding.
Prior to that, there was just one GO bond in default over the prior three years, out of 9,700 rated issuers. Even then, muni creditors eventually recover about 65 cents on the dollar, versus 49% for corporate notes.
So not only does this asset class shield you from the IRS, it also has a well-deserved reputation for being among the safest of all investments, suitable for “widows and orphans.” Some of these obligations are even underwritten by private insurance companies that guarantee the full repayment of principal and interest — so they carry top-notch “AAA” credit ratings.
The Bigger Picture
I should note that municipal bonds aren’t well-suited to IRAs and 401(K)s, since these accounts already offer tax-deferred growth. Furthermore, lower-income taxpayers may not find them advantageous. Finally, while most muni income is tax-exempt, there are certain issues (typically from airport and housing bonds) where a portion of the income may get ensnared by the alternative minimum tax (AMT).
That being said, this is a massive $3+ trillion asset class teeming with opportunities. And it’s currently enjoying some of the best conditions in years.
We’ve seen more than a few muni credit upgrades. In fact, the number of state ratings upgrades has doubled the number of downgrades in recent years. Much of the credit goes to a strong housing market rebound, which has inflated property taxes — putting more money into municipal coffers. Healthy job creation has also boosted consumer spending, leading to the collection of more city and state sales taxes.
More revenues mean a lower risk of default and increased investor appetite. I should add that munis are also less vulnerable to the whims of the Federal Reserve than rate-sensitive Treasuries and high-yield corporate bonds, holding their ground better in each of the past three rate tightening cycles.
As I mentioned in my last article, I recently recommended a muni-bond fund that offers a diversified exposure to this corner of the income world. I strongly encourage investors to look into this before it’s too late. If the polls are right and a tax hike does happen, you’ll be a step ahead of the crowd.
Speaking of, don’t worry, I’ll address all of the election ramifications in the weeks ahead, regardless of which candidate wins.
In the meantime, another thing I encourage you to do… And that’s tune in for my colleague Jim Fink’s event later this week…
If you’re like most traders or investors, then you’re probably a little nervous about the upcoming election. But our colleague Jim Fink says he’s found the closest thing to a “sure thing”. In fact, he says this trade is completely “election-proof”.
And on Thursday, Oct. 29th, at 1pm EST, he’s going to give it away, for free.