The Wall Street Journal-20080212-R-O-I-- For Investors Seeking a Secure Haven- Closed-End Munis Offer Advantages

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R.O.I.: For Investors Seeking a Secure Haven, Closed-End Munis Offer Advantages

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If you're looking for secure long-term income and are investing in a taxable account, consider this: Thanks to the craziness going on in the markets, long-term municipal bonds are paying almost exactly the same rate of interest as Treasurys.

Top-quality 30-year municipals pay on average 4.33%, compared with 4.37% for 30-year Treasurys.

Yet the munis come with one enormous advantage. The income they generate, with a few very minor exceptions, is exempt from federal tax. Which means, for those paying the top 35% tax rate, each $1 earned on a municipal bond is worth as much as $1.54 earned from a regular bond. That figure will rise to $1.67 if the 2001 tax cuts expire. Events of the past week, including a potential revolt by the right wing of the Republican Party, make that more likely.

Sometimes investing is incredibly complex and no trade looks comfortable or easy. Other times, though, it's obvious. And that's the case right now.

Typically, municipal bonds have yielded a lot less than Treasurys to reflect their tax advantage. The gap, which should be 35%, has actually been closer to about 15% for much of the time. Only very occasionally -- like now -- has it vanished altogether. Such a situation doesn't last for long.

The main reason for this illogical state of affairs is the panic in the credit markets. Many municipal bonds come with insurance policies signed by Ambac and MBIA -- companies in crisis because they also insured all those disastrous mortgage-backed securities.

But Bob McIntosh, economist at Eaton Vance and a specialist in municipal bonds, says investors rushing to sell munis are overlooking one small factor: Very few of the truly risky municipal bonds were insured.

"They couldn't get insurance," he said. "The insurers only insured credits that didn't need the insurance to begin with."

And how risky are munis anyway? It's true that some have defaulted. These have tended to be so-called revenue bonds, which means they are backed only by the revenue from a new project -- a toll bridge, say, or the water utilities in a new neighborhood. If the bridge never gets the traffic, or the neighborhood collapses, bond investors can take a haircut. This is a reason to tread carefully when it comes to revenue bonds based on a deserted condo-flipping neighborhood out west.

On the other hand, "general obligation" municipal bonds are backed by the full faith and credit of the municipal authorities. Instances of default are very, very rare. And it's usually taxpayers, not the lenders, who lose their shirt. Taxes tend to rise to meet obligations.

Any credit crisis bad enough to threaten a wave of defaults by local governments nationwide would inevitably produce a proportionate intervention by the federal government anyway -- because it would have to.

Meanwhile, consider the big hidden risk in all long-term bonds, including Treasurys. While Uncle Sam has never defaulted on his debts, he has occasionally done the next best thing, which is to slash their value by unleashing inflation. Those lending the government money for 30 years, with the promise to earn no more than 4.37% a year, are taking an enormous gamble. You might call it, "faith-based investing."

The problem, though, is the market reflects the knee-jerk reactions of big institutional money managers at pension funds and other investment vehicles.

No money manager ever got fired for buying Treasurys in a crisis, even if investors end up losing money through inflation. On the other hand, few of these people ever get rewarded by their committees for making big contrarian moves at times of stress, even if they end up turning a big profit.

Bottom line: Money managers are watching their own backs, not your wallet.

Frankly, I wouldn't buy any long-term bonds at these rates. I think they offer poor compensation for the risk of inflation. Nonetheless, if I were offered 4.37% subject to tax or 4.33% tax-free, I know which one I would take.

The simplest approach for the ordinary investor may be to buy a closed-end fund that invests in municipals. Closed-ends are like ordinary mutual funds, except they issue only a limited number of shares and one buys and sells them on the stock market.

Closed-end investors have a big advantage, because they can boost their returns by borrowing cheaply at short-term rates. An example is BlackRock Municipal Income Trust. At $15.31 a share, it yields 6.1% tax-free, according to an analysis by Nuveen Investments. For a top- rate tax payer, that's the equivalent to 9.32% in a taxable bond.

The fund has typically concentrated on bonds rated A or above, although it also has some rated BBB or below. At $16.28 a share, BlackRock Investment Quality Municipal Trust, which invests in a more- conservative portfolio of bonds, yields 5.9% right now, or nearly as much. The equivalent for a top-rate payer: 9.1%.