Buying Tax-Free Bonds? Avoid the Conventional Advice

Is there a reasonably safe way for you as a retail investor to put some money into tax-free bonds at a time when the Federal Reserve is raising interest rates?

There is. Provided that you’re willing to ignore the typical financial advice, to be seriously patient - and to ignore the bond market’s gyrations. And, of course, you have to be willing to do some financial analysis, and take some risk.

Let me explain.

The conventional wisdom is that retail investors should do their bond investing through mutual funds. That way, they get a diversified portfolio and professional management, and own a security that they can sell simply and quickly. By contrast, bond markets—unlike stock markets—are difficult for retail investors to navigate.

But bond funds have some problems: they carry management fees and other costs, and their net asset values moves up and down with interest rates. They move down when rates rise. (Which is what is likely to happen.) And move up when rates fall. (Which isn’t likely to happen any time soon).

I got around these problems—and you can, too—by buying carefully-selected newly-issued individual tax-free municipal bonds.

I have no fees to pay, and get to keep all the income the bonds generate. I locked myself into two to three decades of fixed payments—but at 5%, triple tax-free, I was willing to commit to holding the bonds indefinitely.

Please note that I was in a position to absorb losses if my home state of New Jersey defaulted on these Transportation Trust Fund bonds, which I considered highly unlikely. In addition, I was resolved not to whine if rates went up sharply and I found myself owning 5% bonds in a world in which new issues of NJ Transportation Trust Fund bonds carried rates of, say, 7%.

Here’s how I did it.

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I bought some of my bonds the day they were issued, paying a small commission because the brokerage firm with which I deal wasn’t part of the bond offering. If you deal with a firm involved in the offering, you get to buy commission-free.

I bought other bonds a day or two after they were issued—that brief period when lots of bonds change hands and the difference between bond dealers’ bid and ask prices narrows significantly.

What you don’t want to do is to go out in the market when the volume is thin, and try to buy or sell. That’s when the spread between bid (what the dealer will pay for your bonds) and ask (what the dealer will charge to sell you bonds) gets wide enough to eat up several months of interest payments

I am not telling you to buy individual municipal bonds if you can’t afford the risk, aren’t willing to settle for the interest rate on the bonds you buy, and can’t do research homework. But if you have time, patience, and the willingness to wait out markets, buying carefully-selected long-term munis can make a lot of sense.

Yes, of course long-term munis are subject to having their market prices fall if long-term rates rise sharply. But remember what I said about being willing to settle for the interest your bonds produce, and not worrying about their market price.

In fact, I think that the market values of long-term munis are less vulnerable to rising rates than long-term Treasury bonds or high-quality corporate bonds. Why? That’s a subject we can discuss the next time around.

A happy, healthy, and prosperous 2016 to you and yours.