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Despite Talk of Bond Bubble, There's Opportunity in Mispriced Munis

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Some reasons to consider fixed income investments now, and why individual bonds may have the edge over bond funds and bond ETFs.

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MINYANVILLE ORIGINAL It seems almost certain that taxes on dividends, capital gains, and most likely ordinary income will rise in 2013. This is based on a read of the tea leaves of discussions surrounding the fiscal cliff and on the simple math of what it will take to fix our budget shortfall and deficit, as well as our mounting debt. Further, I expect the current low interest rate and monetary policies to continue, thereby necessitating a closer look at the fixed income portion of your portfolio.

The current fiscal environment will ultimately bring (if not sooner, then later) higher taxes on dividends and ordinary income, and drive a rotation out of investment grade and high-yield corporate bonds and into municipal bonds. I view it as unlikely that these fixed income investors will move their cash into equities, so municipal bonds remain one of the few viable options.

For all the talk of a bond bubble, I still see some opportunities in the space. Specifically, I think that the short-term high-yield (one- to five-year) and in intermediate-term municipals (three- to 10-year) are attractive. This is because: 1) wealthier investors will want to shield their fixed income returns from higher taxes – this bodes well for municipal bonds; and 2) corporate and high-yield bonds have appreciated significantly over the past two and a half years, much more than munis, and institutional investors and money managers will likely rotate out of corporate bonds first.

If I'm right, it will indeed take a village -- or a city, or a port authority, or a state agency -- to make the most of your fixed income investments. Additionally, I also feel confident suggesting that if you are looking at fixed income, it would be prudent to consider individual bonds over bond funds and bond ETFs.

Here's the risk in funds. First, should rates climb, bond values will fall; therefore, the risk of capital loss is real. I feel this risk is exacerbated when bonds are held in a mutual fund or ETF, rather than individually. Specifically, because bond fund managers rotate in and out of bonds as rates climb, the risk of capital losses never, ever goes away. With an individual bond, this isn't a risk (or at the very least it's limited). That is, the value of the bonds may fluctuate as rates rise and fall, but at the end of the day – assuming there is no default – that bond is going to pay out at par, generally 100%, and that means you get all your money back.

This leads me to the other advantage of bonds over bond funds: You can pick the maturity date and know with a high degree of certainty when you are going to get your money back. Funding tuition? Retirement? Home improvement? Buying individual bonds can keep you on track. While bond funds will help you reduce risk in your portfolio relative to the risks in stocks while you wait out the arrival of a future date, you only get your money back when you decide to sell. And if tuition or retirement arrives and your bond fund is underwater by a lot, or even a little, you may be reluctant to take the loss.

The second and more likely risk, really to bonds as an asset class, is that should all of the Fed's quantitative easing come home to roost in the form of inflation, the purchasing power of bonds will erode.

Purchasing individual bonds can be a little tricky, though. About the best you can say about the process is that it's not quite as easy as buying stocks.

If you are convinced that buying individual bonds is right for you, I would recommend two resources. The first is a very good treatise offered by the American Association of Individual Investors (AAII) called How to Buy Individual Bonds: A Fixed-Income Toolkit. It's free on AAII's website by searching for the above title. The second resource is investinginbonds.com, a site run by SIFMA, the Securities Industry and Financial Markets Association.

Finally, as some parting advice, stick with insured general obligation bonds, or (highway) toll revenue bonds. The general obligation feature carries with it the taxing authority of the municipality, which means there is a more assured source of repayment. The same principal applies to highway bonds. Most drivers don't like higher tolls, but they rarely slow down to argue about them.

Follow Oliver Pursche on Twitter: @opursche
No positions in stocks mentioned.
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