Fat 5% dividends are hard to come by as stocks continue to climb. But you can actually still get those high yields – and take on less risk – by looking to the municipal bond market.
Munis also offer something else truly wonderful: tax-free dividends. That’s right, the income from most municipal bonds is tax free for most Americans. However, choosing individual municipal bonds is difficult. High minimum buy-ins force many retirees to concentrate too much of their capital in one project or municipality.
While muni defaults are rare, it’s never safe to concentrate too much money in one place, which is why municipal bond funds are a much safer alternative. Plus, there are still some muni funds that are trading at a discount to their intrinsic market value while paying dividends over 5%. This means you’re buying these bonds for 95 cents on the dollar or so, while still benefiting from the tax advantages of individual muni bonds.
I’d buy them soon, though – because other investors are waking up to these deals and are starting to buy these funds aggressively. As Bloomberg reported in April, municipal bonds have seen the biggest inflow of investment since 2010—a time when every market was recovering from the worst financial crisis in a generation.
Munis Gather Billions in Cash
With that in mind, we want to get into the muni market now before prices rise further – and yields decline. As we’ve seen with the National iShares Municipal Bond ETF (MUB) – it’s up 4% over the last year, while its dividend yield has plummeted.
As MUB Got Popular, Its Yield Plummeted
MUB tracks the municipal bond market and has no active management. While some believe in passive investing – which can have benefits in the stock market – the bond market is an entirely different animal. The complex dynamics between par value, yield-to-maturity changes, the relationship between Treasury and bond market yields and the limited liquidity in bond markets mean that they are much less efficient markets than equities. For this reason, active management tends to outperform in bonds, even if active investment doesn’t work as consistently in the stock market.
Actively managed bond funds can identify high quality, high yielding municipal bonds and often bid on them before smaller retail investors even know they exist. This is another big reason to look for actively managed funds—they provide expert analysis and access that leads to lower risk and higher payouts. That’s a rare combination.
So which actively managed bond funds should we look for now?
Building a Discounted Municipal Bond Portfolio
There are a few municipal bond funds yielding over 5% with discounts to their net asset value (NAV), and four of them are particularly high quality with well-covered dividends. These are Invesco Municipal Trust (VKQ), Invesco Quality Municipal Income Fund (IQI), Nuveen Enhanced Municipal Credit Fund (NZF), and Putnam Managed Municipal Income Fund (PMM).
Muni Funds on Sale, Yielding 5%
A quick look at the chart above shows that these funds remain discounted to their intrinsic value, which actually makes it easier for them to pay out their distributions. This is especially true because these funds have access to leverage at very low costs (thanks to the low interest rates that seem to never go away), which the managers can use to boost their returns.
Leverage scares many investors, but it shouldn’t—not in this case. The biggest fear is that over-levered portfolios will result in a margin call. Could that happen to one of these funds? Unless there’s some calamity like a nuclear war, probably not. VKQ is the most levered fund at 39% leverage, while PMM is the least levered at 24%. For one of these funds to see its NAV go to 0, we would have to see the vast majority of the funds in its portfolio default or be downgraded to junk. Not only has that never happened in history, but the default rate for municipal bonds is less than 0.1% and has been so for decades. Additionally, the highly diversified portfolios of these funds provides an extra cushion of safety that offsets the leverage.
These funds also avoided Puerto Rico, thanks to their quality holdings. As a result, their NAV has grown—as has their market price:
Muni Funds Rally…
…And Their Yields Fall
Still, it isn’t too late to lock in 5% yields. But you need to act fast, because you’ll soon find it impossible to get even 5%.
If you’re searching for high yields, you’ll need to combine your municipal funds with a collection of other high quality bond funds that yield even more—in some cases, much more. A group of funds that billionaire hedge funds have recently been snapping up offer yields of 7% or more, and they have the potential for capital gains of 10% and above.
Still, these funds are relatively thinly traded because they’re unknown by many retail investors. That is changing as a result of rising inflows from institutional investors, so investors will need to learn about these funds and act fast if they want to secure these high yields and get in before inflows eradicate their capital gains potential. Click here to learn why billionaire investors have called them one of the best options for 2016 and I’ll reveal the names, tickers and “buy” advice on the three best.