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Fed’s Move Backfires as T-Notes Plunge

Municipal bonds are due for a nice rally


I’m sure Ben Bernanke never reckoned on this. Hardly had the Federal Reserve chief announced his newest “quantitative easing” program earlier this month when bond prices began to fall. Even Treasuries, the stuff his buying was supposed to lift!

From November 2 (the day before the Fed announcement) through Monday, the price of a long T-bond plunged seven points.

Happily, though, the panic subsided today as investors began to realize that sharply higher bond yields will slow the economy for the rest of this quarter and into the first quarter of 2011. During the afternoon session, bond prices rebounded — a turnaround worth playing, in my judgment.

Municipal bonds, in particular, look hugely oversold and due for a nice rally. Yes, it appears increasingly likely that Congress will extend the Bush-era tax rates for another year or two. But if so, the top tax bracket will remain at 35% — certainly high enough to make today’s tax-exempt yields very attractive.

Build America bonds, are taxable munis that receive a 35% interest subsidy from the federal government. At the current monthly distribution rate, BAB yields an annualized 5.4%.

Unless Congress extends the program, issuance of Build America bonds will stop Dec. 31. That could give existing bonds a scarcity value, pushing up prices. So, in addition to the generous yield, BAB may generate some capital gains for us.

I envision BAB as a three- to six-month trade. Because Build America bonds are typically issued with long maturities (more than 10 years), I don’t expect to hang on to them once the interest rate cycle starts to move up in earnest.

Pay up to $25.50 for BAB. Suitable for retirement accounts as well as regular taxable accounts. For more background on the fund, click here.

If you’re in one of the upper tax brackets (28% or higher), you might consider a closed-end muni fund like Nuveen Quality Income Municipal Fund (NYSE: NQU). As the name implies, NQU emphasizes better-grade bonds, with 87% of the fund’s holdings carrying a single-A or higher rating.

Current tax-free yield: 7.1%, which translates to an after-tax equivalent of 11% for a taxpayer in the top federal bracket. Monthly distributions.

Note that NQU uses leverage (borrowed money) to magnify returns. This feature also heightens the volatility of the fund’s share price. Buy at $13.50 or less.

Over on the stock side, yesterday’s 178-point tumble in the Dow helped restore a lot of value to a previously overextended market. Best buy at today’s closing price: Total (NYSE: TOT).

Shares of the French oil titan have backtracked 10% in less than two weeks, providing a bargain entry point at only 7.7 times next year’s estimated earnings.

Current yield: 6% (before French withholding tax, recoverable via a credit on your 1040 if you own the stock in a taxable account). Pay up to $55.

Article printed from InvestorPlace Media, http://investorplace.com/2010/11/feds-move-backfires-as-t-notes-plunge/.

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