by Bryan Perry | August 28, 2012 12:07 pm
It seems that every time Warren Buffett gets away from his bread-and-butter strategy of picking great companies, he gets burned. This was true when Berkshire Hathaway (NYSE: BRK.A, BRK.B) dabbled in currency trading and credit-default swaps a couple of years ago; now it’s municipal bonds that are getting dumped by the “Oracle of Omaha.”
State and municipal debt has just been getting a bad rap overall, as the past month saw a wave of bad press in this area that’s sent investors fleeing from just about every muni-bond fund in the sector. In Buffett’s case, the issue was timing: His firm rang the bell at the top of the market in 2007 when municipal tax receipts were strongest — and now he wants out.
But I’m here to tell you that dumping muni-bond funds altogether isn’t the way to go. There are some great names in this area that have weathered the storm by sticking with solid, investment-grade bonds. And despite the impression you may have gotten from the media, there are plenty to go around.
Sure, states like Illinois have gotten a lot of attention lately, as it has the lowest credit rating of them all — and the rating may go even lower soon. However, many other state governments are virtually guaranteed to maintain a great credit rating because of their constitutional budget requirements.
States such as Virginia, Maryland and Georgia carry AAA ratings by the three major rating agencies — Moody’s, Fitch and Standard & Poor’s — thanks to their fiscal discipline during every major economic downturn.
For that reason, they’re some of the most coveted for seeking out tax-free income. A resident of Virginia who invests in a Virginia municipal bond is exempt from both federal and state taxes. A 6% municipal bond yield is equivalent to a 10% taxable yield for high-income residents. It doesn’t get much better than that!
So, despite all the negative buzz around muni bonds, keep in mind that we’re talking about tax-free debt here. With higher income tax rates just around the corner, I expect that the top 1% of wage earners will keep on buying in, especially for the higher rated paper. So I say buy the dip — it shouldn’t last long.
I recommend you start with Dreyfus Strategic Municipals (NYSE:LEO), an investment-grade fund focused on areas that are absolutely essential: transportation, health care and education. Its holdings consist of general obligation bonds (GOs) issued by state governments.
GOs are any state’s premier credit and are senior to all other state-issued debt. In many cases, GOs are voter-approved. If a state is facing the risk of default, holders of GOs are always paid first, which is why they’re so coveted by informed buyers of municipal bonds.
Now, I will give Buffett one thing: In tough times where budget cutbacks are the norm, there is inherently more risk investing in certain municipal bonds. Given the current economy, these areas of state debt should be avoided unless they’re issued within an AAA-rated state, so it pays to do your homework on these funds and make sure that its holdings are investment-grade.
LEO is one such muni-bond ETF that’s at a great entry point in the current market. The fund sports a solid 6% dividend yield and cuts its investors a monthly check.
I expect U.S. Treasury yields to rise incrementally going forward, which will send investors back into the state bond markets as they gain confidence in these governments. The yield on the benchmark 10-year Treasury note surged from 1.40% in late July to 1.80% in mid-August, and has hovered in that area ever since. This bodes very well for municipal bond ETFs in general, and at current prices, LEO is a Buy under $10.
Bryan Perry is editor of Cash Machine, a newsletter focused on dividends and income investing.
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