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Investment Guide

Supercharged Munis

From Forbes: Bernard Condon 06.02.08, 12:00 AM ET

Conventional wisdom says buy muni bonds in cautiously staggered maturities. Jimmy Klotz says put everything into long bonds—and get an extra point of yield.

Popular tactics with brokers selling municipal bonds: ladder your portfolio. You buy a bond due in a year, another due in three, then six and end with one due in nine years. As each matures, you put the principal into a nine-year bond. The rolling redemptions provide some protection against rising interest rates, which of course kill the market value of bonds. As bonds are redeemed, you redeploy the money at the new higher rates.

This is Wall Street propaganda, says James A. Klotz, 60, the president of brokers FMSbonds of Boca Raton, Fla. Reason: Your yield will be less than it could be. Better to put all your money in long bonds, he says, and take your chances on interest rates.

“Everyone wants to tell you how they’re so sophisticated,” says Klotz. “But bonds don’t need to be managed. Just buy and hold.”

As a 35-year veteran of the bond business, Klotz knows all the tricks. Brokers love laddering for two reasons, he says: It gives them a lot of work scaring up medium-term bonds every two years; and it protects them— against angry phone calls. If interest rates shoot up, people holding long-maturity bonds can see 20% or even 40% losses in market value. Indeed, Klotz remembers the bond collapse of the early 1980s, when munis from some solid issuers traded at 50 cents on the dollar.

What makes him so sure that won’t happen again? The interest rate spike of a generation ago, he says, was due to the Fed’s desperate battle against inflation. Next time it will tame inflation early, Klotz figures.

The problem with a ladder that reaches out only nine years is its skimpy yield. A California general-obligation muni due in 2017 yields 4%, versus 5.1% on a GOdue in 30 years. (Both of these get A+ ratings from Standard and Poor’s—good, but not great.) If you won’t need the money until 2038—if you are 40 and investing for retirement, or 65 and planning bequests—you and/or your heirs can afford a stretch of high interest rates. Provided the agency borrowing the money doesn’t default, the full principal will come back in 2038, even if it has had a bumpy ride in the meantime.

“If you’re going to panic when you see the monthly statement, you shouldn’t buy munis,” Klotz says. “Buy a money market fund.”

Klotz says laddering might make sense with U.S. Treasurys: These (taxable) bonds have a flatter yield curve, so you don’t give up as much by going short. The muni yield curve is steeper. Time diversity costs real money there. Klotz does, to be sure, advocate diversifying across issuers by putting, say, $100,000 into four different tax-free bonds.

What if inflation creeps up and muni interest rates climb by two points? That would take the market value of a $100,000 bond due in 2038 down to $78,000. You could sell and take a $22,000 long-term capital loss, usable against any amount of capital gains and against up to $3,000 a year of salary and other income. (Unused losses carry forward.) But do get back into the market for the new 7% rate.

There are two ways to do that. Put your $78,000 into newly issued 7% bonds at 100 cents on the dollar. They would return only $78,000 of principal at maturity but pay $5,460 a year, instead of $5,000. Or you could, with the same $78,000, buy $100,000 (par value) of a 5% bond trading at 78 cents on the dollar. These would pay $5,000 a year but repay $100,000 in principal in 2038.

The risk with the former strategy is that the new, high-coupon bonds could get called. That is, if rates fall again to 5%, the sewer authority that has your $78,000 could force an early redemption and end your $5,460 income stream. You can prevent that by putting cash from a tax-loss sale into discounted bonds.

That’s what Klotz and his partner, Paul Feinsilver, did for clients when the Fed was working its magic in 1982. They sold 6% bonds trading at 50 cents on the dollar and reinvested in different 6% bonds trading at 50 cents. Their clients came out even, earning over time the same 6% they had bargained for. Had they switched into new bonds paying more like 12%, those bonds would have been called away as interest rates subsided in the late 1980s, and the investors would have suffered a permanent erosion of capital.

Alas, the tax-loss game has got a little trickier because of a law change. Now if you buy a “tax-exempt” muni at a discount the capital gain realized at maturity is taxed as ordinary interest income. (It’s not fair, but that’s how the tax laws work.) Switching to highercoupon bonds finesses this problem but at the risk that rates subside and you get whipsawed by a bond call. Klotz’s advice: Don’t take that tax loss unless it’s really big and you can make use of it. Otherwise sit tight.

If you don’t need the coupon payments to live, reinvest income from going long in new 30-year bonds, Klotz advises. Make sure you have 10-year call protection and consider possible tax changes. Don’t buy double-tax-free bonds if you plan a move across state lines.

Before buying, it also pays to check price quotes against the securities industry Web site, www.investinginbonds.com, to avoid getting gouged by brokers. Or buy newly issued bonds. The table below displays a sampling of high-quality munis that Klotz likes.

If you have less than $100,000 to invest, or need liquidity, you’re better off in a muni bond fund.

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Staff Editor, FMSbonds, Inc. Email the Author05/15/2008