The above is either some real funky math or I need to take a visit to Khan Academy–or both!

Regardless of what you’re hearing from the headlines (and talking heads) that encourage fear and being afraid to invest in the market, there is an asset class that has done pretty well despite the cognitive resistance.

What asset class?  Muni bonds.

Municipal bonds have performed well when considering what a reasonable investor might expect from an investment:

  • outpace inflation with some capital appreciation,
  • provide current cashflow,  and
  • provide a decent probability of return of the original investment.

Let’s explore each of these 3 points while explaining my math from above.

Outpace Inflation…

After speaking with hundreds of investors over my years in financial services one common concern is the erosion of purchasing power over their investment horizon.  Thus it is necessary to find suitable investments that not only fit a particular risk tolerance but also exceed the rate of inflation.  Municipal bonds fit these criteria even using a very high historical CPI number like 3%.  Although municipal bonds can pay lower than 3%, bonds with maturities of 10 years and longer typically pay more.

Provide Cash Flow…

Cash is king!  Let’s look at an example…

  • Original Investment = $25,000
  • Bond’s interest rate (e.g. coupon) = 5%
  • Bond’s yield at purchase = 5%
  • Annual Cash Payment = $1, 250
  • Tax Rate = 35%

If this bond pays tax-free income, the investor would receive more than the 5% return on their money every year.  How?  Since the cash payments are exempt from federal income tax, the taxable equivalent yield (or TEY) needs to be calculated, which is:

.05 /  (1-.35) = .07692 or 7.692%

So the municipal bond investment yields 7.692% when considering the 35% tax bracket. At this writing the 30 year US treasury bond yields just 3.137%–less than half of the tax free municipal bond! Need I say more?

Provide a Decent Probability Principal Return…

Without going into too much detail of statistics and standard deviation, I can tell you that there is a lot of research evidencing less than a 0.5% default rate for investment grade municipal bonds for the last few decades.  (For you quants, here is a study that you’ll like.) Which means that of all the bonds issued that are investment grade, there is about a 1/2 percent chance that you lose your original investment.  Even in cases where bankruptcy is involved (e.g. Detroit), there was recovery value of greater than 60% for some holders of the debt.

Needless to say, your choice of bonds or bond funds should be done after the following steps are taken with a qualified professional:

  1. review of your investment goals and objectives including risk tolerance;
  2. full design of an investment plan;
  3. thorough analysis of investment choices

Further Food for Thought:

www.investopedia.com

www.investinginbonds.com

The Bond Book (3rd ed.)