Tuesday, May 7, 2013

Income Options (Part 2)

I knew about commercial junk bond funds that invested in high yield bonds issued by companies that were in serious trouble. I wondered if there were municipal bond funds that invested in bonds issued by municipalities or states that are struggling with their debt loads. Although at least one county and several municipalities have declared bankruptcy rendering their bonds worthless, the municipal bond market taken as a whole has remained pretty stable in spite of the fact several states are looking into the jaws of death as their underfunded pension liabilities come due. Such funds exist. It is a little difficult to find much information on these funds. They appear to be thinly traded specialty items. Last year they racked up about 10% returns. I don’t know how they might do this year. Local and state governments are pretty good about paying their debts since they want to borrow more money at the lowest rates possible---until they can’t. What really scares me is what might happen to this market if a state defaults. That has never happened not even in the great depression, but Illinois, New Jersey, California, and Rhode Island are in trouble. What would the default of an entire state do to the municipal bond market?

Here is the standard formula for Comparing the Yields of Taxable and Tax-Exempt Bonds, from the article By Matthew DiQuollo with the same title.

Taxable Equivalent Yield = Tax-exempt yield / 1 – [tax bracket]

For example, if the tax-exempt yield of the municipal bond you are looking at is 4% and you are in the 25% tax bracket, this is how the formula would work:

4%/1-0.25 = 5.33%

Do you need something else to worry about? The current administration has proposed a cap on tax exempt bond income. If that idea passes, which I doubt, it would certainly raise the interest rates paid by municipalities trying to build schools, roads, and sewer systems. Such a change in the law would probably benefit privately owned water companies as well as private builders looking to fund the so called “Lexus lanes” (low traffic volume toll lanes for those who can afford it) that are growing in popularity around big cities.

Oh, commercial junk bonds? The well known SPDR Barclays Capital High Yield Bond ETF sold under the ticker symbol (JNK) is paying 6.35%. But I have to ask the obvious question. Do you really want to own very much of something that advertises itself as JNK?

Over recent years, master limited partnerships (MLP) have been a way to juice your income a bit without too much risk. These entities enjoy a tax favored status similar to REITs. They are pretty much restricted to the oil and gas pipeline business. These are the people who build and operate our fossil fuel infrastructure including pipelines, storage facilities, terminals, and refineries. As long as Americans buy gasoline for their cars or heat their homes with natural gas, pipeline MLPs will survive in some form. Unfortunately from year-end 2012 to now, the yield on the group has gone from 6.4% to 5.6%. Also they typically have pretty high price earning ratios. That is usually an indication that you are betting their businesses will continue to grow at a pretty exorbitant rate. That may be true if environmental regulators allow the current oil and natural gas boomlet in places like western Pennsylvania to continue. There are still some MLP funds that pay some pretty high yields. Typically they invest in foreign countries that could be considered not all that safe.

There is one more thing to think about when investing in pipeline MLPs. They require a form K when you submit your income tax return. These things are issued pretty late in the tax season and add many pages to your tax return. If you insist on doing your own taxes, you might think twice before investing in something that might get you in over your head. There are also tax considerations that might require consultation with your CPA when and if you decide to sell your shares.

For the record, I own shares in the depressing G fund (government securities), the F Fund that matches the performance of the Barclays Capital U.S. Aggregate Bond Index, and lots of boring dividend paying stocks like Chevron (CVX). I do not currently own any preferred shares but I enjoyed a good run with General Electric until they recalled my shares at par. I own Plum Creek Timber (a specialty REIT), shares in Vanguard’s Intermediate Term Tax Exempt Fund, and Kinder Morgan Partners (KMP), a pipeline MLP.

People! Please! Let’s be careful out there today.

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