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    Still Stinging From Tax Day? Here’s Your Solution

    On April 15, Tax Day, we got to celebrate our privilege of paying Uncle Sam a big chunk of what we earned in the prior year.

    Many folks say that if you’re paying taxes (especially on your portfolio income), that’s a good sign that you’re actually making money, which has been challenging to do in the general stock market over the past decade.

    The stock market indexes have recovered so far this year, but many people are now thinking that perhaps the gains aren’t sustainable. Wall Street veterans look at seasonal trading patterns and say “sell in May and go away,” leading some to seek a refuge for their investment cash.

    I’d like to help soothe the pain you felt from writing a check to the Internal Revenue Service, show you a refuge from the potential pains of the Standard & Poor’s 500 index selling off and bolster the dividend income from your portfolio with a favored part of the market that you need to buy into.

    This market pays a dividend income yielding nearly three times the average dividend yield of the S&P 500 and is tax-free at the same time.

    As for safety, this part of the market kept paying ample dividends and consistently gaining value over the past decade, through times of stock market disasters, credit crises, wars, terrorist attacks and rioting around the globe.

    For those who invested in this part of the market for the past 10 years through all the turmoil of the markets, the return of more than 118.8 percent was more than double the money invested.

    This means the average annual return was more than 8.1 percent for all of those years. And remember: While investors would pay tax on the capital gain, the qualified dividend income has been and will continue to be tax-free from Federal taxes.

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    Buy My Favorite Tax-Free Investments

    The municipal bond market is one of the safest and most lucrative markets in which you can get regular checks every month and capital appreciation as well.

    Municipal bonds are so safe that the $3.7 trillion worth that made up the market last year saw only 63 issuer bankruptcies. That was down more than 22 percent from the prior year, and the trend is lower from 2009 to date.

    And while some doom-and-gloom pundits have made their prognostication of a tsunami of defaults, the reality has been a drop in the bucket of this vast market.

    Moreover, if you look at the long-term averages — including during times of deep recessions — over many, many years, the default rates for munis are very low. In fact, they are much, much better than for most other bond markets and light-years better than for corporate bonds.

    According to reviews by the leading rating agencies, the average for defaults for muni bonds is very low. Indeed, the fail rate for the entire muni market is less than .2 percent.

    It’s important to understand that muni bond defaults involve recovery. Just because a muni issue delays or misses a payment doesn’t mean that the investors get squat. In fact, for most muni issues that have defaulted, the recovery rate for decades has been 100 percent. That’s right: 100 percent of principal was paid to investors.

    Do you know what corporate bond investors have been getting for decades when their bonds default? The long-term average recovery rate is only 40 percent, or 40 cents on the dollar.

    There’s even more proof that the safety of the muni bond market isn’t determined just by how well it’s done but also by how well it’s supposed to do in the years to come.

    For institutional investors that participate in this lucrative market, there is a form of insurance that can be bought, sold and even traded in the financial markets against munis failing for the next 10 to 20 or more years.

    The insurance comes in the form of credit default swaps (CDS). A CDS gives the buyer the protection that if a muni bond defaults, then the seller of the CDS will pay the interest and principal of the muni bond.

    This is perhaps the best credit barometer of how the market prices potential trouble. The higher the price of CDS on muni bonds, the greater the risk of the munis having trouble. The lower the price is, the less the risk.

    Over the past three years, the general CDS market has dropped more than 44 percent, meaning the institutions see a whole lot less risk in the muni bond market.

    With more tax money coming in across the Nation, muni bond issuers from coast to coast are ever better able to keep paying their muni bond interest and principal.

    Uncle Sam likes to keep tabs on how much State and local authorities are raking in via the U.S. Census Bureau. The most current quarterly report shows that the overall tax receipts of State and local municipal authorities continue to climb. The report shows gains of more than 5 percent.

    This was the 12th quarter in a row in which State and local taxes were rising.

    Not only are bonds safer, but they pay more than the U.S. Treasury. In many cases, they are rated higher than the U.S. Treasury.

    So it’s no wonder the muni market is faring well. For the past year alone, the muni market as tracked by Standard & Poor’s is up more than 5 percent, continuing a trend that’s been working well for the past five years straight with an overall return in excess of 33 percent.

    (The chart below is the total return for the S&P Municipal Bond Market Index.)

    S&P Municipal Bond Market

    The general muni market is and has been working well. But the segment of this market that I want you to buy is paying more now; and it has done even better, as noted above, with more yield and positive performance through thick and thin over the past decade.

    I want you to buy all three of my selected closed-end municipal bond funds that trade nice and easy on the New York Stock Exchange (NYSE).

    What sets these three apart is that they have well-chosen collections of good, well-paying muni bonds that are chosen for their own merits rather than due to pure ratings or special insured deals.

    And again, this isn’t just about recent performance; it’s about performance for years and years. I’ve been following these and recommending them for many years and in this column for investors who want and need safe, higher income with less risk than the general stock market. That they are tax advantaged makes them even better.

    The first is AllianceBernstein National Municipal Income Fund (AFB). When it comes to bonds, this management company has some of the best muni investment pickers; and the numbers prove out. It has earned investors 113 percent for the past 10 years and a 9 percent return for the past year. Meanwhile, it’s paid a monthly dividend yielding 5.7 percent. Assuming a tax rate of 35 percent, that equates to an effective yield of 8.8 percent.

    The second is BlackRock Municipal Income Trust II (BLE). The monthly dividend is currently yielding 6.2 percent. Adjusted for taxes, that equals a tax equivalent yield of 9.5 percent. The return for the year is 12.6 percent. The 10-year return is running at more than 143 percent, giving a 10-year average annual return of more than 9 percent.

    The third is Nuveen Quality Income Muni Fund (NQU). It yields a current rate of 5.2 percent, giving a tax-equivalent yield of 8 percent; and it is up more than 7 percent for the year and nearly 100 percent for the past 10 years.

    You might be tempted just to buy one of these three (perhaps the one with the highest current dividend, such as BlackRock), but that wouldn’t be the best means to earn more with less market risk.

    You need to buy these three together for the stability and safety that the three bring. Each owns a different mix of muni bonds. AllianceBernstein has the lowest amount of lesser credit rated bonds at less than 1 percent of the fund, while Blackrock and Nuveen have a bit more. This means that combined you’ll get an even safer allocation of bonds that give you the right mix of credit and higher yielding muni bonds inside these funds when bought together.

    If you’re concerned about a backup in muni bond yields, the three balance with different average maturities for their muni bond portfolios. AllianceBernstein has the shortest average effective maturity, followed closely by Nuveen; BlackRock has a bit longer average effective maturity. So again, buying the three together reduces your risk in the overall bond market while getting the most yield by buying them together.

    If you buy the three together, you’ll get an average yield of 5.7 percent, which equates to a taxable equivalent yield of more than 8.7 percent. In addition, you’ll have less credit risk and less overall bond price risk if market yields go up in the muni market.

    You will also have a hedge against the stock market taking back its recovery, as well as some gains over the coming years. And all the while, you will pay Uncle Sam less tax.

    — Neil George

    Neil George is the editor of By George, an investment advisory publication. George was the editor of Personal Finance for many years. In addition, he served as editor for a collection of other investment journals published in the United States, Germany and other selected nations. Prior to his career in media, George worked for more than two decades on six continents in senior positions with a select group of financial institutions in investment banking, bond trading, brokerage and asset management. The institutions included Merrill Lynch International Bank in Europe, Asia and the Americas, as well as U.S. Bank and British- and Chinese-based Investec PLC. In addition, George worked to build a collection of independent public and private brokerage and fund-management companies in Los Angeles and New York. He also currently serves as an adjunct professor and board member of Webster University's Walker School of Business and Technology. George earned an MBA in international finance from Webster University in Europe and a bachelor's degree in economics from Kings College.

    | All posts from Neil George

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