A Big Bond Buy Today
March 12, 2020
With COVID-19 fears ripping up markets, investors need to focus on what they can trust—not just for return on capital but return of capital. Bonds are delivering on both fronts right now.
And while the financial media are focusing on US Treasury bonds, I want to draw your attention to another government bond market in the US—municipals.
Municipal Bond Bargains
Municipal bonds have been a big success for the model portfolios of Profitable Investing.
In early 2018, I added three closed-end municipal bond funds, including the BlackRock Municipal Income Trust II (BLE), the Nuveen AMT-Free Municipal Credit Income Fund (NVG) and the Nuveen Municipal Credit Income Fund (NZF).
Since then, the three funds have generated an average return of 18.9%. That outdistances the general municipal market return of 11.9% and the overall return of the entire US bond market of 15.7%.
S&P 500 Index Intra-Day—Source: Bloomberg Finance L.P.
The arguments I made back then are similar to today.
First, the US economy has been growing and becoming ever healthier (even including the recent COVID-19 mess). That aids the credit standing of municipal issuers and issues, making the bonds more valuable.
Next, municipalities have been issuing fewer and lower amounts of muni bonds because rising tax revenues have lowered their need to issue new bonds and lessened the desire by taxpayers to authorize new issues. This means less supply in a better market.
Then add in lower inflation. The US core Personal Consumption Expenditure (PCE) Index is sitting at a barely-there rate of 1.58%. The entire bond market gets a low-inflation boost.
Finally, add in the 2017 Tax Cuts & Jobs Act (TCJA) that limited state and local tax (SALT) deductions, and the demand for more tax-free income, particularly from high-tax states and localities, made for further demand for muni bonds.
The BlackRock fund and the two Nuveen funds also offer taxable equivalent yields that average 7.6%, which is compelling for income on top of the gains in the market.
All three remain buys today in taxable accounts, particularly as closed-end bond funds have been needlessly sold to raise cash by some despite the underlying muni market attractions.
Now, I want you to expand your investment universe into another part of the municipal bond market that is one of the best bargains in a heated market looking for a haven.
Taxable Municipal Bonds
The US Federal Tax Code allows most state and local authorities the power to issue bonds that are free of Federal income tax. And the states that issue them also allow local taxpayers to avoid having state tax liabilities.
In addition, the code has some provisions that allow private entities, including companies and property developers, to issue tax-free bonds under certain state and local issuing authorities.
But not all issuances come under the tax-free allowances of the tax code. This is where many municipal bonds are issued as taxable municipal bonds. They can still have the backing of state and local governments for credit, but their interest/coupons are taxable.
Taxable municipals yield more than tax-free issues, but they can still be an attractive source of capital for issuing authorities. And with the exception of the TCJA limits on SALT, taxable munis have all of the other advantages in the past and current market.
But taxable munis have some additional advantages over tax-free munis. To start, the TCJA also had provisions that limited the ability of tax-free muni issuers to pre-refund existing issues with new tax-free muni bonds.
Pre-refunding is when an issuer has a bond with a higher-than-the-current-market yield and is not callable by the issuer or the call is out into a future date.
Issuers would issue new tax-free bonds at lower yields and use the proceeds to buy US Treasuries or other allowable securities to fulfill the interest and principal payments of the older more expensive bonds.
And in the process, they would not only save interest costs, but also pocket additional cash proceeds.
The TCJA limited this double-dipping by issuers. Instead, issuers can now only issue taxable munis to pre-refund older tax-free bonds.
This, along with the lack of issuance of tax-free munis, means that the taxable market is more attractive for investors wanting to buy into the market, which continues to be tighter in supply.
And with US Treasury yields down, the market for taxable munis has been rapidly expanding. In 2018, there was $7.5 billion in issuances. In 2019, there was $49 billion.
Since taxable munis are really like higher-quality corporate bonds in the eyes of institutional investors, including insurance companies, pension funds and, more importantly, foreign investors, there is a whole new and expanding world of eager buyers for taxable munis.
It comes down to the yield advantage over some parts of the traditional corporate market as well as the US Treasury market that makes taxable munis very attractive.
Add in the very long history of munis and the near-zero level of default without recovery by investors, and taxable munis are exactly what the market wants right now.
In the past trailing three years, particularly through 2019 to date, taxable munis are easily outperforming tax-free munis. Taxable munis returned 38.6% compared to the return of tax-free munis at 16%. And that outperformance is accelerating in 2020.
US West Texas Intermediate (WTI, White) & Brent Crude (Green)—Source: Bloomberg Finance L.P.
BlackRock at the Ready
BlackRock has the closed-end BlackRock Taxable Municipal Bond Trust (BBN), which is one of the leaders in closed-end taxable muni funds, along with Nuveen. The fund pays a dividend distribution monthly, which currently yields 5.5%.
That yield is taxable. But this has two advantages.
First, the taxable muni-bond market is advancing above the tax-free muni market. This will provide the opportunity to up the gain potential while still providing a strong taxable yield.
But what makes the fund a bargain buy is that, thanks to silly selling of closed-end bond funds, it is now trading at a discount to its holdings by 9.2%.
That means you can buy this fund at nearly 10% off. That’s the kind of bargain buy I’m always looking to recommend to my Profitable Investing subscribers.
All My Best,
Editor, Income Investor’s Digest & Profitable Investing
Author, Income for Life
PS—It’s that time of year again! Our annual Diamond Club meeting is right around the corner, and I’m busy preparing to get together with my subscribers to discuss my outlook for the stock and bond markets and how to best position our portfolios for the remainder of the year.
This exclusive in-person meeting is only available for Diamond Club members. But don’t worry… If you’re not already a lifetime member of my Profitable Investing research service, there’s plenty of time to sign up and save a ton on your subscription. Click here for details.