Merry Christmas, my fellow contrarian! Did Santa bring you a tax-advantaged dividend this morning?
The municipal bonds funding the Las Vegas Valley Nevada Water District would have made a great stocking stuffer. They yield 5% and get a tax hall pass from Uncle Sam. Which means on a tax equivalent basis they actually pay 6% or 7% or more, depending on your income tax bracket.
Vegas is booming. And the town is in the middle of a hot desert that is increasingly arid, so this muni is rock solid.
Five percent, tax free. Why’d you forget this, Santa?
Well fear not, my fellow “naughty lister.” I have a backdoor way to buy the bonds that Santa forgot to stuff. Actually, even better because we can type in a simple ticker and boost that yield to a tax-free 7.9%.
Plus, the Federal Reserve’s fresh hawkish stance should support this bond fund’s price. As I write it trades at an 8% discount to the value of its Vegas munis and other safe issues in its portfolio. Which means we are paying 92 cents for a dollar of this fund.
We’ll get to specifics in a minute. But first, let’s talk about the Fed, which cut interest rates for a third consecutive meeting last week. Ten-year rates are now, ironically, 90 basis points higher than when the easing cycle began.
It’s true. The Fed eased and long rates went higher, not lower. When the Fed first cut rates in September, the 10-year Treasury yielded just 3.6%. Three “eases” later, the longer-dated yield ran up to 4.5%.
“Caution! Potential inflation ahead,” the bond market screamed as the Fed lowered its key rate for, it seems, no good reason.
The economy is fine. There are plenty of jobs. The market is not hurting for liquidity. Bonds, which trade opposite interest rates, have dropped into the holiday bargain bin as a result of these unnecessary rate cuts.
Jay Powell finally took the hint and delivered a hawkish statement alongside the cut. That’s a long overdue responsible move from the supposed adult in the room.
Powell’s parental guidance may very well set a ceiling on the 10-year yield. It has formidable resistance just overhead. That sure would surprise Wall Street, wouldn’t it? Just as long rates rose when the Fed began to ease, it would only be fitting if the 10-year topped when the Fed paused.
Bonds are despised right now. They have flopped since September. We, as card-carrying contrarians, are buying this dip.
This is the trickiest part of being a contrarian investor. It took me years (really, decades) to train myself to buy assets when (and only when!) they are hated.
Let’s watch bonds rally and surprise everyone except us. Bond prices, remember, have two drivers:
- Duration risk: The concern that higher future interest rates make today’s bond yields look lame.
- Credit risk: The chance that the bond issuer can’t pay us back in the future.
A hawkish Fed—or at least a halfway responsible one—helps with the duration risk because it puts a lid on long rates. Meanwhile credit risk is not a problem now with the economy still going strong.
To never worry about credit risk, we can buy US Treasuries. SPDR Portfolio Long-Term Treasury ETF (NYSE:SPTL) is a convenient vehicle that yields 4.8% today. SPTL will also enjoy price appreciation if 10-year rates relax from here.
Municipal “muni” bonds are another safe option. Muni default rates have been in the basement, below 0.1% since 2013. The biggest ETF is iShares National Muni Bond ETF (NYSE:MUB), which holds more than 5,600 individual muni issues.
One-click MUB is convenient and diversified, though income investors pay for it by sacrificing yields. MUB pays just 3.1%. Muni dividends are tax-free from Uncle Sam, though, giving MUB a boost (making it more than a noob!) The fund’s tax-equivalent yield can be up to 5.3%, depending on the holder’s tax bracket.
We contrarians prefer closed-end funds (CEFs). They pay more—up to 7.9%, and this is before we consider their tax advantages. For top-bracket earners, this can mean a 13.3% yearly payout!
Nuveen is our “go to” money shop in Muniland. They manage $429 billion worth of bonds! When municipalities issue bonds—or think about it—they call the big whale Nuveen. The muni giant throws its purse around to secure the best deals for its investors.
We like the ease of buying these funds—they trade like stocks. We love the dividends and tax benefits. And the discounts aren’t bad either—today we can buy these funds for just 92 cents on the dollar.
Why the Christmas gift from Mr. and Ms. Market? Bonds are on sale thanks to a wishy-washy Fed. Let’s be thankful—and buy the dip.
Disclosure: Brett Owens and Michael Foster are contrarian income investors who look for undervalued stocks/funds across the U.S. markets. Click here to learn how to profit from their strategies in the latest report, "7 Great Dividend Growth Stocks for a Secure Retirement."