August 2004 TeraDime Newsletter
Topic: Investment choice for the rest of 2004 - municipal bonds!
If you have been reading my
newsletters lately, you would realize that I am bearish on the
But �sitting in Cash� is the problem. The FOMC (Federal Reserve Open Market Committee) or �the Fed� with Mr. Greenspan at the helm are telling us that there is no inflation, and we should not be worried. I disagree based on the price of milk at my local supermarket and the price of gas at the pump. I believe that sooner or later these price increases will work their way into Mr. Greenspan�s indicators and inflation will officially be here. So, if you sit in cash you will not be losing nominal money and may be even gaining 2.1% at ING Direct; but the real buying power of cash is being reduced every day by the price of energy and the price of raw materials (check out the prices of sheetrock and wood at Home Depot � they have increased by 50% over the past 2 years).
In my June newsletter, I indicated that the yield on 10-year US Treasury bonds had increased from 3.7% to 4.7% effectively reducing the price of a 10-year note by nearly 20%. So, if you thought that it was a good deal to buy a 10-year note this past March, it must certainly be a great deal to buy the same thing now at 20% off the sticker price J
I actually think that for the
short term, a 10-year bond may provide a good investment opportunity, though it
doesn�t excite me much to be �locked� in at a 4.7% return for the next 10
years. So, while I was looking for
alternatives to stocks and US bonds I realized that the municipal bonds sold
off even more during the months of April, May and June. Their effective yields on average, for a high
quality rated municipal bond of 10 year maturity, have moved up to yield
between 6.5% and 7.5%. That is 2 points
higher than US treasuries! The nice
thing about Munis is that interest on
the bonds is exempt from Federal, State, and Local taxes if you buy from within
your state of residence. Effectively, if
you are in the 28% federal tax bracket and 3-5% state bracket, you need to find
a safe investment that will yield you over 10% taxable to match 7% from the
municipal bond. The next question that I
had to ask was why did municipal bonds sell off more than US treasuries? Usually, high quality (AAA or AA rated) municipal bonds command a premium (cost more
and yield less) vs. US treasuries, but this time around we have the opposite
effect. The answer:
How can an average investor buy into municipal bonds? Given the fact that most municipal bonds are issued in denominations of $100,000 each, the average investor wouldn�t be able to buy them easily. Institutional investors, High Net-Worth Individuals (AKA, the stinking rich), and Mutual funds own the majority of these bonds. Buying an Open-End Mutual Fund is therefore one way of participating; however, the problem is that the funds hold different maturities of municipal bonds and even though they provide a wide diversification, the fees eat a lot of the interest payments. Another way of buying in is via a Closed-End Mutual Fund.
These investment products are also called C-ETFs for Closed-End Exchange Traded Funds. There are many varieties of these, which trade like stocks, and you can buy them through your discount broker for minimal fees. Their typical expense ratios (fees) are very low, just like an ETF, but�.yes, there�s always a �but��. C-ETFs have some unique risks proving that everything in this world comes with a price.
To learn more about closed-end funds, how they work and what
are the risks involved, go to ETF Connect:
http://www.etfconnect.com/. The information contained on the site is
excellent for anyone trying to learn more about this investment strategy. It also provides a screening tool to figure
out what kind of closed-end fund is right for you. Just click on the �Find a Fund� tab to get to this
screening page. A screening example: If
you live in NY State, you probably do not want to by NJ Municipal bond, because
the interest payment will be exempt from Federal tax, but will not be exempt
from NY state tax or City tax if you happen to live in
Use the following link to find all the risks associated with buying a closed-end fund:
http://www.etfconnect.com/education/fundamentals_cef.asp#Investment%20Risk
I strongly recommend you become
familiar with each of the risks associated with C-ETFs and also review the
useful topics in the �
It should also be noted that due to tax advantages of municipal bonds it only makes sense to hold them in your taxable accounts since earnings and dividend/interest payments in your 401K, IRAs, and Roth IRAs are either tax-deferred or tax-free.
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�By the end of 2004, over eight thousand McDonald�s
restaurants will be accepting credit cards. This will allow Americans to
combine their two favorite pastimes, going deeper into debt and getting fat.�--
Jay Leno