I think the folks at Agora Financial staged a bit of an upgrade for their Lifetime Income Report last year when they brought on Neil George to manage it — not that he’s infallible, of course, or that the prior editor Jim Nelson was terrible (I don’t know his record) but George has been a pretty consistent and generally sober recommender of more conservative income strategies in the past, particularly when he ran Personal Finance for a few years, so he’s got some background in recommending more boring stuff like fixed income that’s ignored by most newsletters (this is the same letter that, under Jim Nelson, pitched Statoil shares as “Scandinavian Income Certificates” … and they’re still pitching MLPs as their “10-86 Plan” in an ad that has been running for almost two years, so the silly marketing lingo is not going to stop anytime soon).
So now that George is aboard (and he wears a bowtie, so he must be a smarty, right?), what are they hyping for us today?
It’s a special “Box 8 Dividend” that they say is even better than 401(k)s, IRAs and Roth IRAs — there are no limits on how much you can invest (as with Roth IRAs), and the income is genuinely tax free (not just “tax deferred” like most retirement accounts or like other frequently touted income investments like MLPs and some Income Trusts or REITs.
Here’s how the pitch begins:
“The rich ex-talk host I want you to meet is not a terrorist.
“He collects wine — and Porsches — not weapons. And when he was still on CNBC and CNN with his weekly show, he talked mostly about how to make more money in the markets.
“So why might he end up as the next ‘tax enemy #1’ for IRS bullies?
“Because right now, this man is ready to show millions of Americans a perfectly legal way to get paid piles of income every month — 100% tax free. As in, ‘the IRS can’t touch a nickel.’
“And it’s not just a little bit of income, either.
“So far, we’re talking about as many as three tax-free checks a month… for a total of 36 tax-free checks per year… and that’s just the tip of the iceberg.”
So … monthly checks, tax-free. Sounds exciting, no? How about some more details?
“… any income that someone calls ‘tax-free’ has to come with a catch. It either has to be illegal or risky, right?
“But it turns out there’s not a thing that’s sketchy or illegal about it.
“There’s even a Supreme Court ruling from 2008 that makes this possible.
“In fact, that’s where the “Box 8 Dividend” gets its name — from a phrase in the tax code that makes these specific payouts 100% free of federal income tax.”
Notice that in those paragraphs they did say it’s not sketchy or illegal, but they carefully did NOT say it’s without risk. More on that in a minute.
Some more from the ad? I thought you’d never ask! Here you go:
“You DON’T Have to Be Rich to Benefit
“‘Box 8 Dividend’ income checks are easy enough for anybody to collect, even if they’ve got a more modest bank account.”
And the ad cites a few outside sources, too, to buttress George’s assertions:
“AOL Daily Finance recently said…
‘[The ‘Box 8 Dividend’ strategy] has actually gotten more attractive… yet because it’s perceived as being strictly for rich people, many ordinary Americans never think twice about it…’
“Then listen to this, as they go on to say…
‘[‘Box 8 Dividends’] could be the answer for many folks trying to make their money work harder for them.’
“And then there’s this in USA Today, which is even more blunt…
‘You don’t have to be rich to cash in on [‘Box 8 Dividends’]…’
And then the big promise — what’s the yield? It sounds huge:
“once you’ve factored in the tax-free boost, we’re talking about three moves with equivalent yields that run as high as 10.72%… 10.81%… and 11.04%, respectively.”
That means they’re citing the taxable-equivalent yield, not the actual yield, but it’s still impressive. This is a calculation you do by calculating how much this yield would be worth before taxes, if it were taxed at your top marginal tax rate. And given that they’re trying to impress, they’re probably using one of the higher tax rates between 30-40%. So the actual cash yield is probably about 6-7%.
And they do mention the low risk of these “plays” with Box 8 Dividends, saying that the risk of default is dramatically lower than corporate bonds, low enough to be almost nonexistent.
And that these “plays” often act defensively in bear markets, so that sounds pretty exciting. But what exactly is George pitching?
Well, I hate to break it to you that the big picture answer is so, well, boring, but the broad statements about defaults and “box 8 dividends” refer to … Municipal Bonds. Which have indeed been extremely unlikely to default over the last several decades, and which do indeed pay coupons that are free of federal tax (you may have to pay state or local taxes on them, depending on where you live and which bonds they are).
But George clearly isn’t just pitching municipal bonds — no matter how high your tax bracket is, you’re not going to earn 10 or 11% tax-equivalent yields from a plain vanilla muni bond. The highest-grade municipal bonds, those that carry a AA or AAA, have yields of slightly higher than US Treasury bonds (quite a bit higher on a taxable-equivalent basis, but only about 50 basis points higher on a cash basis). So those high-rated bonds going out, say, 10 years will average about a 3% yield versus the 2.5% 10-year Treasury Bond. If you’re curious, corporate bonds of similar credit quality are slightly higher still (average about 3.5%).
So how do you get those 10-11% dividends, paid monthly? With leverage. Or more specifically for individual investors who don’t want to borrow money to buy bonds, with leveraged closed-end bond funds. And there are a bunch of these that are run by reputable asset managers and which pay their distributions on a monthly basis. Here’s how George describes the three “plays” he’s recommending (he doesn’t, of course, let the cat out of the bag and tell us even that they are closed-end funds):
“Even Better Than 11% Dividends
“Not only does this first ‘Box 8’ move offer nearly an 11% equivalent yield, but it also offers gains — just like a stock — and some pretty impressive gains too.
“From its very start, this first move has gone up 817%.
“The second ‘Box 8 Dividend’ also offers out a tax-free equivalent yield that’s as good as getting 10.81% on the dollar. But looking back over the last 10 years, it’s also up 112%.
“That’s more than double every dollar, piling up equivalent tax-free yields at a rate that’s more than triple your average income-paying stock on the Dow.
“And then there’s my third ‘Box 8 Dividend’ move. As I said, this one offers an equivalent yield of 11.04%. You’ll have a hard time finding that kind of income anywhere.
“But this move has also shot up 13% over the last year… with a 65.5% gain over the last five years… and it’s up 143.9% over the last 10 years.
“You could follow just one or two of these moves. You could follow all three. Either way, you could just watch the income pile up every month. It’s a great combination.”
So what are they? Well, I haven’t scoured through every single municipal bond to try to match up exactly those returns with specific funds — it’s an inexact science at this point, since closed-end funds can be evaluated either by market price or by NAV, and those big numbers (like the 817%) must, I think, be cumulative returns including dividends over time, I’m pretty sure that there are no closed-end muni funds that have recorded a 800% gain in their net asset value over even a very long time period. They do not, after all, keep the coupon payments and reinvest them in new bonds, they pay out the income to shareholders. You can search the CEF Connect database of funds here, and you’ll find that if you include all of the leveraged tax-free bond funds you get a list of 83 closed-end funds, with most of them having distribution yields that range from 5-8% and leverage ratios in the 30-40% range.
But if you’re interested in specific funds, we can refer to the man himself — Neil George in past free articles, including this one, has recommended three specific closed-end bond funds as favorites this year, and I’d bet that if those were his favorites six months ago they’re still at or near the top of his list today. Here’s an excerpt from that free article where he named the three investments:
“First is Nuveen Quality Income Municipal Fund, Inc. (NQU). This is run by one of the best in the municipal market management businesses. It yields a current rate of 5.3 percent and is up more than 14 percent for the trailing year. Even better, over past five years (including all of the supposed crisis years), the fund is up more than 53 percent. And for the past 10 years, it’s enjoyed a return of more than 109 percent, or an average annual return of 7 percent.
“Second is AllianceBernstein National Municipal Income Fund, Inc. (AFB). This firm has had some issues on its equity fund side. But when it comes to bonds, it has some of the best investment pickers; and the numbers prove out. It has earned investors 17 percent over the past year alone, while paying a monthly dividend like the other two funds of 5.6 percent.
“And like the Nuveen fund, Alliance has performed well. It generated returns of more than 58 percent for the past five years and of 127 percent for more than 10 years, for an average annual return of 8.6 percent.
“Third is BlackRock Municipal Income Trust II (BLE). The monthly dividend is currently yielding 6 percent. And the return for the trailing year is 19 percent, with the five- and 10-year returns running at 63 and 129 percent, giving a 10-year average annual return of nearly 9 percent.”
Right now, according to CEF Connect, NQU has a distribution yield of 6.1% and a taxable-equivalent yield of 9.4%, with effective leverage of 36%, and trades at a discount to NAV of about 10%.
AFB has a current distribution yield of 6.8% and a taxable-equivalent yield of 10.4%, with effective leverage of 39%, and it trades at a 5% discount to NAV.
BLE is the highest yielder of the three, with a distribution of 7.2%, taxable-equivalent of 11.1%, leverage also at 39% … and it trades at a 1.5% premium to NAV.
You can look at the detailed data on each of those at CEF Connect if you’re curious — see which are their largest positions, whether they have more tax-backed general obligation bonds or more utility or corporate-backed bonds, what allocations by state or by credit quality are, etc.
I don’t own any municipal bonds or bond funds myself, but bonds are overwhelmingly owned by individual investors who want the safe and tax-free income these bonds offer — clipping the coupon and planning, one presumes, to hold the bond in perpetuity or, if they expect to live that long, to maturity. As long as municipal bonds remain such a steady bet, and bankrutpcies remain very rare, they’ll probably continue to pay those coupons and to repay principal at maturity — these bonds are backed by valuable assets, like municipal utilities or the ability to collect taxes, and it’s hard to picture the federal government not helping if there were a wave of bankruptcies. There have been a few high profile municipal bankruptcies in the last few years that have made muni bond holders nervous, including Stockton, CA and Jefferson County, LA, all of them are listed here, but certainly the default rate is still minuscule.
That’s individual bonds, though, not bond funds. With a bond fund you don’t have the option of just holding until maturity and collecting your principal back, worrying just about inflation and about possible defaults. When you invest in one if these funds instead of buying individual bonds you also get management risk and interest rate risk on top of those concerns, with potential for capital losses if the fund sells bonds that are marked down or if you have to sell the fund at a time when investors dont’ want it. Unlike a bond that you have socked away in your safe deposit box, which may fluctuate in value without you knowing much about it as you collect those coupons, a closed-end fund will report every day what the current net asset value of its assets are, and the price of the fund will rise and fall with sentiment about the current and future value of those assets.
And lately, all bond funds have been in trouble — thanks to the overreaction to the Federal Reserve last week, everyone is suddenly convinced that the Fed is about to stop pushing interest rates down (that’s the current “QE” program, where they buy bonds to keep prices high and rates low). Whether or not it was an overreaction, though we did see mortgage rates move up from about 3.5% to 4.5% in the space of just a couple months, and the most important barometer for all other interest rates, the 10-year US Treasury bond, went from about 1.6% to 2.5% in the span of two months, with most of that move happening over just a few days. That might not seem like a huge deal, but if you bought a 10-year bond in early May at the face value of $1,000 when the rate was 1.6%, the value of that bond would have dropped to $858 if you needed to sell it last week when current rates hit 2.5%. You might not have to sell it, sure, but that’s a big loss of value to stomach. That’s effectively the same thing that happened to every interest-rate sensitive investment recently, including REITs, many dividend-paying stocks, and, yes, municipal bonds and bond funds.
So … now that the latest GDP numbers have come out indicating that the economy is growing more slowly than we thought, and now that we’ve seen so much chatter from the Fed watchers that indicates maybe we all overreacted to the possibility of an end to quantitative easing (there’s a good NY Times article about that here), maybe we’ll see interest rates drift back down. I don’t know.
But I do know that long-term bonds are extremely sensitive to interest rate changes. And all of these funds are dominated by long-term municipal bonds, with probably a minimum of 75% of their portfolio in each case committed to bonds that have maturities in excess of ten years away. So these funds have generally seen their net asset values drop by at least 10% over the last 4-6 weeks, and since they’re closed-end funds you often see the price move in a leveraged way to those changes — the NAV drops, and investors want to get out so the discount widens (or, as in the case of AFB, a premium turns into a discount — AFB was at a 10% premium to NAV in January and dropped to a 5% discount now, so the fund ha performed much worse this year than even their falling NAV would indicate). The reverse is true as well, when folks get excited about muni bonds these discounted funds can spike to a premium valuation, so both joy and despair are amplified.
That doesn’t mean that their distribution is necessarily at risk — that depends on their borrowing costs and on the actual performance of the bonds in their portfolio, which may well be perfectly fine and manageable. All leveraged closed-end funds took a massive tumble during the financial crisis because their access to easy re-funding of their leverage needs dried up overnight, but unless we have a similar type of crisis it will be the price, not the availability, of leverage that might hurt returns in the future — if it costs them 1, 2 or even 3% to borrow money and increase the size of their portfolio they can easily lever up their asset base by 35% and boost the income they can distribute by owning more bonds, but if the cost of that leverage approaches the actual coupon yield of their bonds then the leverage stops providing any, well, leverage.
Like the mortgage REITs, they generally get the benefit of being able to borrow short and lend long, so they may need to refinance their leverage annually or even more frequently, either through money markets or through bank debt or preferred shares, but the bonds they hold are long-term and fixed-rate so one risk is that their borrowing costs squeeze their margins if short-term rates rise rapidly. The fact that they are closed-end means that they at least don’t have to liquidate if investors sell shares, so they may not have to sell bonds at bad prices during bad times to redeem shares like an open-ended bond fund would, but any such bad times are certain to be reflected in a falling NAV and falling share price.
And of course, a bond fund is a managed portfolio — it has no maturity, so you can’t could on getting your specific principal investment back at the maturity date. You’re buying the ability of a manager to manage the portfolio for interest-rate risk, impairment/default risk, and income. These kinds of investments have generally done pretty well at generating above-average yield for a long time, particularly if you’re willing to ignore that 2008-2009 period as a fluke, but it’s also worth noting that we’ve been in a sustained bull market for bonds for decades now as interest rates have generally been in a long, slow decline — if that’s turning, as some folks believe it is, then almost all bond funds of every stripe will be fighting an uphill battle. If, alternatively, we’re going to see an economy akin to Japan’s lost decade, or more near-deflation, then rates could keep dropping, unbelievable as that may seem sometimes, and bond funds would have a tailwind again. Those larger cyclical issues, which no one can predict very well, particularly with the huge amount of manipulation of interest rates by governments, will have a much larger impact on the performance of these funds than will the specific portfolios or management strategies each fund is working with.
But yes, if you’re in the 35% tax bracket then those three funds do each have current taxable-equivalent yields of near or slightly over 10%.