How to Play Municipal Bonds When Investors Fear Inflation

Note from Editor Sara Nunnally: On Monday last week, I wrote to you about how government bonds could be weighing down your portfolio. My friend and fellow editor Joey McBrennan, contributor to Taipan Daily, tapped me on the shoulder at our two-day editorial meeting last week and said, “I want to send you a recent article I wrote for Taipan Daily about bonds. Might be useful to your Smart Investing Daily readers.”

Later that afternoon, he sent it over, and I have to say, Joey really debunks some of the myths investors have about how the bond market is doing.

That’s not to say that long-term government bonds are where you want to be right now… But read through Joey’s article to find out how you can play the bond market when inflationary fears are gutting government bonds.

It’s longer than many of our Smart Investing Daily articles, but it’s worth every word.

The Underappreciated Municipal Bond

Social Security won’t be there for many of us — so here’s how to build a “replacement retirement” with safe municipal bonds.

Last week, readers nearly sunk me with their heated responses to my call for the end of Social Security. (Thank you for your replies.) Today, we’ll focus on buying tax-exempt bonds to replace that coveted Social Security check once the program implodes.

Meredith Whitney, the analyst who correctly predicted the fall of Citibank and the other megabanks, more recently pounded the table about a coming wave of municipal bond defaults.

Nouriel Roubini discussed the same not long after, and while his numbers were substantially less painful than Whitney’s, they were still triple the historical default trends.

Even if Roubini is correct, municipal bonds are still remarkably safe. Using his numbers, the default rate could climb to 3.7%. (That’s not 37%, but three point seven.) This number also includes ALL bonds… even bonds that should never have been sold, for things that nobody wanted.

Adding to municipal bond woes, on Friday [April 7] we were greeted with this front-page news in The Bond Buyer:

“Fitch Ratings Friday downgraded $4.6 billion of Detroit water and sewer revenue bonds, citing weak financial performance and future challenges, including looming capital needs and risks associated with derivatives.”

So why do I think it’s time to consider municipal bonds?

Forget the fact that I’ve been working with every size municipal borrower across the United States. The reason I like bonds now is because they are currently out of favor, and the prices have dropped. They are also talking about eliminating tax-exempt bonds all together — making any tax-exempt bonds I currently hold worth that much more.

Municipal Bonds Create Your Own Safety Net

It is unlikely Social Security will be there for anyone under the age of 40 — or at least not in its present form. If you agree, then along with playing around in the stock market, you had better start considering creating your own safety net. I would suggest that municipal bonds offer a perfect replacement for our government’s Ponzi scheme.

However, like any investment, you better understand what you’re buying. Which is the point of today’s piece.

As much as I’d like to impress you with advanced knowledge, my side of the investment banking business doesn’t require an advanced degree. If you can read and do a little math, you’ll understand bonds just fine. In a few short paragraphs, I’ll provide you with a few keys that will help you more confidently invest in municipal bonds and increase your returns over what a broker would try to sell you.

(By the way, sign up for Smart Investing Daily and let editors Sara Nunnally and Jared Levy simplify the stock market for you with their easy-to-understand investment articles.)

Buy a (Municipal) Monopoly

The fastest way to get rich is to secure a monopoly on a product everyone must have. The waterworks and sewage waste in most cities, for example, are not optional services. In other words, the law of the land forces everyone to buy water or sewer services from the municipality. In most cases, federal regulations also force you in the direction of this sole provider.

In effect, when you buy a muni water and/or sewer revenue bond, you are participating in a monopoly.

Ensuring captured clients for your bonds is a great first step in analysis, but it isn’t foolproof, as the earlier Detroit news demonstrates. The news clipping mentioned “looming capital needs” and “risks associated with derivatives.“

Now, all cities older than a few decades have ongoing “capital needs.” The derivatives problems, however, are exclusive to larger cities. Add unfunded pensions and angry unions into that mix, and you’ll quickly understand why I gravitate toward small-town USA.

The Municipal Investment Hidden Under Your Nose

The financials of large municipalities can be pretty complicated. There are just too many layers for you to comfortably do any DIY (do it yourself) investing.

However, just outside most metro areas are plenty of small towns. Most of these municipalities have escaped the recent economic bust, in large part because they never really participated in the boom that went awry.

These overlooked municipalities — and there are hundreds or even thousands in almost every state — are where I suggest you consider investing for your Social Security replacement.

Like their big-city cousins, smaller municipalities have capital needs and need to issue municipal bonds. Unlike their big counterparts, though, it is a rare small municipality that has any derivatives exposure, unfunded pensions, or similar type problems that plague the larger cities.

In short, they pay their bills. They treat each dollar in spending like it was their own. In most cases, they treat their budgets like responsible elected officials that care about their neighbors.

There is also one thing you can easily do that most would never think of when investing. You can pick up the phone, contact the city administrator or city clerk, and ask how their bonds are getting along. They will actually tell you!

What a novel idea when investing: Talking to the people who are running the show. They are available, honest and accessible… and they’ll talk directly with you, regardless of whether you are buying one bond, or 1 million bonds.

Before you rush in and start buying, though, there are four important questions that must be asked. These are for your broker, but the city may know the answers as well:

1. Is it a water or sewer revenue bond?

Not a lease, lease purchase revenue bond, or certificate of participation (COP). The question isn’t complicated. You’re looking for a monopoly and nothing else. We’re also not looking for a gas revenue bond. Why no gas? Because most cities don’t require citizens to hook up, and there are alternative energy sources that compete with gas. Again, we’re looking only for a monopoly.

2. What is the coverage?

This is my favorite. It will sound like you really know your stuff. All that the “coverage” question asks is, for every dollar of debt after all expenses (except depreciation), how many dollars are available to pay off the bonds?

Here is a simple example: The city has $100 in income and $40 in expenses (before depreciation). They will have $60 available to pay their bonds. Now their new annual payment, plus any old debt, comes to $38 per month. So the coverage would be 1.57x, because $38 in payments x 1.57 roughly equals $60.

A broker should be able to tell you that this bond’s coverage is “one point five seven times.” I’m no longer surprised when a stockbroker has no clue what coverage means, but now you’ll be the one who knows. Teach him.

You need to be careful for any coverage number under 1.25x.

3. How many connections and what are the monthly rates?

Obviously you don’t want a system with only a few connections and water or sewer rates that rival rents or mortgages. While it’s great to have a monopoly, it doesn’t do much good if all your customers move.

4. Do they have good reserves established for these bonds?

You want a debt service reserve account to be completely funded. Typically, these are about the amount of one year’s principal and interest, and may be used only for the emergency payment of principal and interest.

I can’t stand bond ratings. I believe them to be nearly useless. They also make the investor lazy. Too many times an investor will fear looking stupid and hesitate asking questions (like these four), instead relying on the rating to make him feel all right. Bad idea.

Never forget, the largest municipal default in U.S. history was for an “A” rated bond… and Greece, at one time, was given investment grades by the rating agencies.

Skip the Bond Rating — Do Your Own Homework

By purposefully looking for municipal bonds that were too small to get bond ratings, and choosing to skip the hefty fees associated with those, you can potentially increase your returns dramatically.

How much more can you make? Well, how does more than twice the return of a comparable bank CD sound? Right now these sit at about 2.5%, and that is before you pay taxes.

Five-year double-A rated bonds yield about 2%. A non-rated bond will give you approximately 3.75%. A 20-year double-A rated bond will yield approximately 4.63%, while a non-rated would be around 6%.

In other words, by skipping the problem-plagued big cities and doing your own homework in smaller locales, you can dramatically increase your long-term return without taking on a great deal more risk.

And with a little math, your yield improves even more. A 3.75% increase doesn’t sound like much to some, but when you consider that you pay no taxes on this amount, you’ll see that return jump further. Divide your yield by the sum of one minus your total tax rate [3.75%/(1-42%)= 6.46%] to get the comparable taxable rate.

Now, try to find a five-year bank CD that matches 6.5% with this little risk. I’ll save you the time; you can’t. And so that 20-year bond taxable equivalent yield turns into a whopping 10.34%.

Practice First

I don’t expect you to feel like an expert after only few short paragraphs and my words of encouragement. Like anything, practice first. Contact a broker, tell him what you’d like, and ask him the questions we’ve outlined. Write down everything he says, even if you don’t understand it, and ask for an official statement.

Nobody expects you to buy right away. Get accustomed to the jargon and learn to pick apart the offering documents. You’ll come to realize that municipal bonds hold a great deal of opportunity, and truly are one of the most uncomplicated investments available.

The choice is yours to make. You can rely on your government to secure your future, or you can create your own safety net with municipal bonds.

I Can Help

The legal department won’t allow me to provide specific investment advice. However, I may provide general explanations if there is a concept you don’t understand, or if you need a little help understanding the bond jargon thrown out by your broker.

Feel free to email me anytime at [email protected] and I’d be happy to translate, or answer any question you may have.

Editor’s Note: He was called the nation’s most prominent bond trader by The New York Times. So what investment does he think is “better than bonds,” right now? Find out in this exclusive investment report.

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