by Alexander Green, Investment U’s Chief Investment Strategist
Thursday, February 10, 2011: Issue #1447

In my last Investment U column, I made the case that fears of cash-strapped cities, counties and states causing a near-term collapse of the municipal bond market are overdone.

Yes, there will be defaults, perhaps 100 or more this year in small municipalities. That’s big in a market where the historical default rate is just .07%. But it won’t cause a domino effect or drive rates sharply higher. (Although rates could rise for other reasons.)

Why will the much-predicted municipal bond crisis fail to occur?

With Muni Bonds, Falling Supply Props Up Prices

You’ll notice that the most dire predictions always begin with the words, “If nothing is done…”

But of course, things will be done. Listen to New Jersey Governor Chris Christie and Ohio’s Governor John Kasich. They’re telling the public employee unions and others, with their hands outstretched, that the money simply isn’t there to fund their laundry lists. And there hasn’t been any political backlash. Their poll numbers are rising. In addition…

• Revenue for U.S. municipalities is increasing in this recovery, not falling. That’s putting many on a sounder footing.
• Because Obama’s Build America Bond program ended in December, municipal bond issuance will drop by 10% to 20% this year. Falling supply firms up prices.
• Tax-free munis now yield more than taxable Treasuries. Bargain-hunters will eventually swoop in to take advantage.
• The extension of the Bush taxes cuts will end in December next year. Does anyone seriously believe – with our federal deficit – that Congress will lower tax rates in the years beyond that?

Ok, let’s assume you agree that the sell off in municipal bonds is overdone and they’re due for a rebound. How do you play it?

Three Ways to Play the Muni Bond Rebound

You have three primary choices…

1. Buy a low-cost municipal bond fund.
2. Invest in a closed-end bond fund.
3. Buy individual tax-free bonds.

Let’s take the last one first. If you buy individual bonds, you’ll see their price fluctuate. But if you hang on – and there’s no default – you’re guaranteed of receiving $1,000 per bond at maturity.

Thirty-year AAA and insured tax-free bonds are currently yielding 5.1%. If you’re in the 35% tax bracket, you’d have to earn almost 8% taxable to receive that kind of after-tax return. Not bad.

Worried that the municipality and the insurer could both default? (Unlikely but not impossible.) Then buy only tax-free bonds insured by Berkshire Hathaway Assurance Co., a subsidiary of Berkshire Hathaway with a stellar AAA-credit rating. You can’t get much safer than that.

And if you don’t want to select individual bonds?

The Low-Cost Muni Bond Option

Option #1 above includes investing in a low-cost fund like the Vanguard Long-Term Tax-Exempt Fund (VWLTX). The current yield is 4.21% and the average maturity is just over 10 years.

Sure, it yields less than some individual bonds and there’s no guarantee of principal. But it will be less volatile than 20- or 30-year bonds and you can reinvest monthly dividends if you’re so inclined. (Those in high-tax states will want to choose a state-specific Vanguard fund, of course.)

Want to play a potential muni-bond rebound more aggressively, with a higher yield and greater capital appreciation potential? Go for Option #2…

Why You Should Pick Up Tax-Free Bonds Now

Consider the Nuveen Insured Municipal Opportunity Fund (NYSE: NIO).

This closed-end fund also holds a portfolio of high-grade tax-free bonds. The annual expense ratio is 1%. Although this is higher than Vanguard, it’s actually cheap by closed-end fund standards. Many closed-end funds have expenses that total more than 2% per year.

This fund currently yields 6.5% and the income is exempt from federal taxes. If you reside in the top tax bracket, you’d have to earn 10% to get this after-tax yield. Why is it so high? Because the fund is using 41% leverage, the equivalent of buying bonds on margin. If muni bond prices recover, however, this fund will really jump.

But will they? I don’t have a crystal ball. But recognize this: The yield on the benchmark index of 30-year AAA municipal bonds is higher now than in the depths of the recent credit crisis.

If you’re any kind of contrarian, now looks like a good time to pick up some tax-free bonds.

Good investing,

Alexander Green

by Alexander Green, Chief Investment Strategist
Monday, July 26, 2010: Issue #1309

The brickbats are starting to pour in.

For months, I’ve warned readers about the bubble developing in long-term Treasury bonds.

Yet what was the top-performing asset class in the first half of 2010?

You guessed it: Long-term Treasury bonds, with a total return – price gains plus interest – of 13.2%.

Why is this happening? Two reasons…

• U.S. stocks performed poorly over the first six months of 2010 – down 5.6%. That’s driving many to the perceived safety of Treasuries.
• The anemic euro is making U.S.-dollar-denominated securities attractive to international investors. And Treasuries are the traditional choice for those fearful of equities.

So does this mean there isn’t a bubble after all? Hardly. In fact, the risk now is greater than ever…

1999: An Internet Odyssey

In the fall of 1999, I belonged to a ritzy tennis club – a time when Internet and technology stocks were all the rage.

My playing partners knew I was in the money management business, so there was plenty of chatter among them about “the New Era” and how “the Internet changes everything.”

Occasionally, one of my buddies would ask which Internet stocks I was buying.

“None,” I said. (I was early to get into the sector and early to get out.) The valuations were outrageous and I didn’t think it would end well.

They were surprised by this view, but kept enthusiastically buying and trading Internet stocks like almost everyone else. And, indeed, those stocks kept right on going up.

As the weeks went by, a familiar ritual developed. I’d walk up to the group and – knowing I didn’t own any – they’d ask how my Internet stocks were doing.

Laughs all around.

This went on week after week, month after month. And judging by the guffaws, the question was funnier each week than the week before.

Until one day it wasn’t funny at all.

2000: Nightmare on Wall Street

In March of 2000, the Nasdaq started coming apart and Internet stocks nosedived. As I approached their courtside table one morning, they abruptly stop talking.

“Morning, guys,” I said. “How are your Internet stocks doing?”

Funny… that line was hilarious before. Now it generated obscene gestures, as well as various suggestions for me and “the horse you rode in on.” Hmm.

What is the lesson here (other than that we shouldn’t laugh at the misfortunes of others)?

It’s that you cannot make a rational judgment about when irrational behavior will end.

The “Twin Demons in the Distance” For Treasury Bonds

Internet stocks went up longer than any logical analysis would predict. So did home prices a few years ago.

And the situation with long Treasury bonds right now also defies analysis. Unless, of course, we’re headed into a massive, deflationary period. But if that’s the case, why are gold and inflation-adjusted Treasuries (TIPS) moving up, too?

Either buyers of gold and TIPS are wrong – or buyers of long-term Treasuries are wrong. I think you know where I stand.

As The Wall Street Journal reported on July 6: “The huge stimulus the Federal Reserve and U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat isn’t imminent, it’s not too early to take steps to protect the bond part of your portfolio from those twin demons in the distance.”

Consider yourself warned.

Good investing,

Alexander Green

by Alexander Green, Chief Investment Strategist
Monday, June 21, 2010: Issue #1285

Tens of millions of investors have a ticking time bomb in their fixed-income portfolios.

Are you one of them? If so, there’s still time to defuse it.

A few weeks ago, I wrote an Investment U column entitled, “Why the Safest Investment is Now One of the Riskiest.”

I noted that investors – frustrated by the microscopic yields on money market funds and certificates of deposit (CDs) – have poured money into longer-term Treasury funds.

Their thinking is simple. Too simple: “These funds yield over 5%, not bad in this environment, and the bonds they hold are guaranteed by the full faith and credit of Uncle Sam. What’s to worry about?”

Plenty…

Aren’t Treasury Funds Free of Risk?

Unlike individuals, corporations, and municipalities, the federal government can simply create money to meet any obligations. U.S. Treasuries are thus free of credit risk. But they aren’t free of interest-rate risk.

When interest rates go up, Treasury bond prices go down. Yet investors are comforting themselves that inflation isn’t currently a problem and that long-term rates remain near historic lows.

Don’t be fooled. There is a monster on the horizon – and he makes Beowulf’s Grindel look like Barney.

• Over the past 18 months, the federal debt has surged from $5.5 trillion to more than $8.6 trillion.
• Two years ago, it was 38% of GDP. Today, it’s 59% of GDP. And by the Congressional Budget Office’s own estimates, it’s going much higher still.

This is dangerous. Yet inflation has remained remarkably subdued so far. But understand that if the government opts to stimulate the economy further – especially if some emergency action is needed – short-term rates are already at zero.

Having already thrown the kitchen sink at the slowdown from a monetary standpoint, the federal government will almost certainly opt to spend even more dramatically.

The bond markets will not take this news well. Long-term rates are likely to spike. And when they do, it will get real ugly, real quick.

Investors always think they have time to move out of longer obligations before that happens. But that is not likely to be true…

The Triple Threat to Treasury Funds

Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points, driving a stake through most people’s bond portfolios.

Making matters worse, millions of Mom-and-Pop investors have unwittingly plunged into leveraged bond funds in recent years, often on their brokers’ recommendation.

Leveraged bond funds borrow money in the short-term to buy more longer-dated issues and enhance the funds’ yields. This is all well and good when rates are flat to lower. But when rates spike higher, look out below. The same thing will happen to these funds as to a margined stock portfolio in a correction.

In fact, leveraged closed-end bond fund investors could get hit with a triple-whammy…

• The bonds in the fund will drop when interest rates rise.
• The drop will be compounded by the fact that the portfolio is leveraged.
• The fund could plunge to a deep discount to its net asset value, too.

Become a Bomb Disposal Expert… On Your Portfolio

Not pretty. So what to do?

• First, check to see what percentage of your portfolio is in long-term bonds. It shouldn’t be more than 10% as a maximum (as protection against a deflationary scenario).
• Second, visit www.etfconnect.com and type in the symbols for your fixed-income ETFs or closed-end funds.

Then look at the number beside the fund’s “effective leverage.” Zero means the fund is unleveraged. But some may be leveraged up to 40% or more. (That’s how these funds are able to yield more than the bonds they invest in, even after expenses.)

In sum, this is a time to pare back your long-term bond holdings and eliminate most of your leveraged holdings.

Don’t take these words lightly. There is danger on the horizon. But if you act now, there’s still time to get that ticking time bomb out of your portfolio.

Good investing,

Alexander Green

by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271

U.S. Treasury bonds are the safest investment in the world.

However, that doesn’t mean they can’t be dangerous. Far from it.

Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”

Talk about jumping out of the frying pan and into the fire…

Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.

It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.

If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.

Of course, I don’t expect inflation like that. And neither should you.

But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?

Why U.S. Treasury Bonds Could Bulldoze Your Portfolio

That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?

Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.

But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.

On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.

I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.

But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.

They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.

Don’t Let the Government Trick You into Speculating

Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.

How?

“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

Of course, most people aren’t exactly in a speculating mood right now.

So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.

Except that’s not a safe investment – as many will eventually learn to their chagrin.

Good investing,

Alexander Green

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by Alexander Green, Chief Investment Strategist
Monday, April 19, 2010: Issue #1241

A recent Communiqué column of mine, in which I recommended Treasury Inflation-Protected Securities (TIPS), outraged a number of readers.

Why was it so upsetting? Because – and don’t ask me what they’re smoking – 17% of Americans actually approve of the job Congress is doing.

Taking both parties to task, however, I wrote:

#1: When George W. Bush and his fellow Republicans came to power a little more than nine years ago, they promised to cut wasteful spending, limit the size of government and move closer to a balanced budget.

Instead, they…

• Created a Medicare drug entitlement that will cost nearly $1 trillion in its first decade…
• Started a string of expensive financial bailouts that continues today…
• Passed a record number of earmarks…
• Increased federal spending 58% faster than inflation…
• Presided over a $2.5 trillion increase in the public debt.

#2: Then, last November – anxious for change – voters threw the bums out and put the Democrats in charge. The Democrats promised to change this reckless course and restore fiscal sanity to the country.

Instead, they tripled the budget deficit in their first year. The White House and the Congressional Budget Office now estimate that this year’s deficit will explode to $1.56 trillion – a post-World War II record at 11% of the overall economy – and add $9.7 trillion in debt over the next decade.

Facts vs. Opinions

Here are the other points I made…

#3: The Obama Administration’s own projections see the federal debt hitting $18.5 trillion by 2020. However, that was before the passage of the healthcare reform bill – the biggest new entitlement since the creation of Medicare in 1965.

#4: Unfunded liabilities for Social Security, Medicare, Medicaid, the prescription drug benefit and the new federal healthcare program have now jumped to $108 trillion, nearly eight times our annual GDP.

#5: Moody’s has threatened to downgrade the Triple-A rating of U.S. sovereign debt, perhaps within three years. A drop in our credit rating would both decrease the perceived safety of Treasury securities and increase the interest that Uncle Sam – excuse me, you, your children and your grandchildren – will pay on the deficit.

#6: Credit Suisse recently produced a report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath – the United States. (If you believe a picture is worth a thousand words, try this: http://www.usdebtclock.org/)

#7: Down the road, Washington – with the reluctant consent of the Federal Reserve – could opt to solve this problem the way so many governments throughout history have – by inflating our way out of it.

Inflation: The Bane of Debt-Holders & A Godsend to Debtors

Inflation is the bane of debt-holders, of course. But it is a godsend to debtors – and Uncle Sam is the biggest of them all – as they can repay fixed obligations with increasingly worthless currency.

What surprised me was not that some readers had a difference of opinion. I always welcome that. It was that respondents uniformly barked that they didn’t want to hear my “political opinions.”

Opinions? Go back through these seven points and tell me which one contains an opinion. Even the last one modestly states that Uncle Sam “could opt” to inflate our way out of this problem.

As Jack Nicholson reminded us in A Few Good Men, some people can’t handle the truth. Especially when it’s something they don’t want to hear.

For example…

• When we warned 11 years ago about the massive bubble in Internet stocks, the majority of respondents gushed about the New Era and insisted we “just didn’t get it.”
• When we warned six years ago about the ominous housing bubble, many scoffed and insisted that home prices “always go up.”
• When we talk today about the threat to your financial security that Washington is creating with its Ponzi-style entitlement schemes, a lot of investors don’t want to hear that, either.

Believe me, I hope I’m wrong. I don’t want high inflation any more than you do.

Fortunately, inflation today is as tame as a kitten.

The Benefits of Treasury Inflation-Protected Securities & Three Ways to Buy Them

I only suggest that you buy Treasury Inflation-Protected Securities ( TIPS) as an important insurance policy. (Because when inflation – the thief that robs us all – rears its ugly head, neither stocks nor bonds do well.)

You can purchase inflation-protected Treasuries (TIPS) in three ways…

• Directly ( http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm).
• Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
• Through the ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

There are several advantages to buying TIPS…

• TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
• The interest you receive is exempt from state and local (but not federal) income taxes.
• TIPS are less volatile than traditional bonds.
• They’re also excellent diversifiers.

Some investors complain that these securities haven’t done anything exciting lately. Of course not. We’ve been in the grip of disinflationary forces, not inflationary ones – and that won’t change next week or next month.

Protection Against The Government “Doing Something”

But as the deficit keeps expanding and the electorate grows increasingly unhappy, pressure will mount on the government to “do something.”

That “something” could be a decision to inflate our way out of this mess, rather than risk the kind of deflationary spiral that Japan has endured over the past two decades.

Bear in mind…

• The Fed has already taken interest rates close to zero…
• Congress has already tried a massive fiscal stimulus…
• The Federal Reserve has already created trillions out of thin air to mop up worthless securities.

If the economy stumbles again and further government action is taken, it could be even more reckless, resulting in inflation.

In the interest of full disclosure, however, that’s just my opinion.

Good investing,

Alexander Green

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