The Fascinating World of Municipal Bonds

I was fortunate to catch the muni bond wave this year with my recommendations to buy the funds in this sector, the (NCP) and the (NVX) (click here for “California Municipal Bonds Are a Steal” at ). I turned negative on bonds of every description in August, fearing that the popping of the government bond bubble could take down the rest of the fixed income universe down with it (click here for “The Great Bond Market Crash of 2010” at ).

However, there may be some circumstances unique to certain individuals where hanging on to you muni bonds may make some sense. Treasury bond investors are not being compensated for their risk at current yields, but muni bond investors are. Ten year tax free munis are now yielding 2.58%, delivering an effective taxable rate of 3.97% for those in the top end 35% tax bracket.

If the Bush tax cuts are not extended, that yield jacks up to 4.27% for top earners. In the 30 year arena, the effective taxable rate is 6.38%, and a very generous 6.87% without the Bush cuts. That’s a lot in this zero yield world we live in. And let’s face it, taxes are going up a lot, no matter who won the election, making these bonds even more valuable in the future.

The risk of an outright default on this paper has been vastly overblown by the media. California’s $70 billion in general obligation debt, which is used mostly for infrastructure spending, is at the very top of the seniority structure, followed by $150 billion in retirement benefits debt. These claims are untouchable.

All of the budget cuts going forward will take place with the junior claims in the obligation structure, mostly schools and social services. That is why we are seeing rioting at the University of California at Berkeley and demonstrations at welfare offices. And with the stock market up 78% in 20 months, capital gains will start kicking in, which in peak years account for 40% of total state tax revenues.

For those who would rather leave slugging it out in the markets every day to the younger crowd, who despair at figuring out the “new normal”, or who don’t want to deal with the harsh reality that “buy and hold” is dead, this may be a good option. Sure, you almost certainly will have to take some ugly marks down the road. But if you are willing to hold this paper to maturity, it might be worth it.

To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.