The Two Sides of Muni Bonds -- Part I

I invest in municipal bonds. They serve as a place to park my cash (very short-term munis used in money market accounts) and as a component of fixed income of my portfolio (longer term maturities).

But I also buy individual issues when they're mispriced. Nine to twelve months ago was a great time to pick up some bargains. Now, some bargains are back, but one must be careful, as munis have two sides, a reasonably safe one and an unsafe one.

The safe side

General Obligation municipal bonds (GO bonds) are typically tax-free obligations of the state, backed up by its taxing authority. That means that the state must do what it takes to pay them back, including raising taxes. So, unless a state becomes empty or some huge unheard of crisis hits, GO bonds should be a relatively safe investment.

But they typically don't trade much below their face value and as such good deals are hard to find. One must look constantly for temporarily mispriced issues or other inefficiencies in the market.

Not all GO bonds are "safe" since states can still default or issue IOUs.

The unsafe side

Revenue muni bonds are typically not backed up by the full-faith and credit authority of the state. They typically represent an investment by the state in a particular revenue-generating project such as a hospital, toll road, utility company, etc.

In most cases, these bonds are guaranteed only by the revenue generated by the project. In some other cases, they are backed up by special taxes imposed on certain people (residents of an area or district) or company or both. But these taxes can't be arbitrarily increased to back up the bonds.

While "unsafe" in nature, revenue bonds can be very safe investments if chosen wisely. There are opportunities lurking in plain sight in this area.

What to look for and how to tell them apart

When I search for muni bonds, I totally disregard credit quality (those letters such as "AAA", "B+", etc issued by Moodys, S&P or Fitch). Why? Because if I look at credit, I'll be delegating to the rating agencies the assessment of riskiness of the bond. After all, it's part of my job as an investor to find those "B-" or "B3" bonds that are really "AAA" in my assessment but that are mispriced by the market (because it blindly follows credit ranking).

Maturity, yield and price. I start my search by ranking muni bonds per maturity, yield and price. The higher the yield, the best. But I prefer to see the yield being high because the price is low, not because it was issued at high yield to begin with. This is because when projects are high-yielding from the start, it's likely to be a high risk project. But they're fine too, as long as I understand the risks. I like the price to be below par and the maturity to be as short as necessary for me to get a good yield-to-maturity.

Prospectus. Once I'm interested enough in the maturity, price and yield, I go read the prospectus. Just like a company's IPO prospectus, a muni bond has a similar document too. I look it up at the Municipal Securities Rulemaking Board's website. That's where I get to know for sure what the proceeds are going to be used for, what (if anything) guarantees my principal and my interest and all other terms that I'm looking for.

Who/What Guarantees My Principal. This is one of the first things I want to know, even if it's obvious from the description of the bond. The prospectus clearly says if the state guarantees it based on its taxing power (GO bonds) or not and if not, what, if anything, backs it up. Sometimes, there's nothing backing it up, just the full-faith and credit of some private company. Run from these unless you know something about the private company in question. If special tax revenues back the bonds, go find out how many people/businesses pay this tax and how much they pay per year and what's the situation in that specific area.

Insurance. Some bonds are insured by private companies. This sounds like a good thing but it really isn't necessarily and many investors miss this. First, in most cases, the insurance is for the interest, not the principal. If the state defaults, you may still lose your principal. Second, historically, the default rate on muni bonds has been low, and insurance companies know this, so they may take risks and insure more than they can realistically afford to. Now an investor has to look at the credit worthiness of the insurer and we don't trust the rating agencies, so it's more work.

Finally, (and here is the counter-intuitive part) if faced with the possibility of default, states would probably be more likely to stop paying interest on the insured bonds as opposed to the uninsured ones. Why? Because then no investor would be harmed by the state, right? After all, the state is paying for the insurance, it might as well use it when needed. That means, insured bonds are probably the first to be defaulted on and if too many of these cases happen, the insurer goes broke and the investor gets the bill. I try to avoid insured issues when other opportunities exist.

Sinking Fund. This is not as big a deal as it sounds. A sinking fund is cash set aside periodically to pay off the debt. It's typically a good thing to have, but is not a big deal in most cases. One must still look for it because it's possible in theory (though, rare) that in exchange for the safety of the sinking fund, the bonds are only redeemable at a discount of their face value. If that's the case, you need to readjust the face value and recompute the yield accordingly, if your broker or search site hasn't done so.

Call Feature / Redemption Provisions. Bonds can be called (paid for and terminated) prior to their maturities. This is typically seen as an added risk, because it limits the return an investor will get. When times are good, borrowers pay off their debt ahead of time and issue new bonds with less attractive terms. However, and here's the rub most people miss, a call feature can be a good thing if one buys a bond at a big discount. By redeeming my long-term bond before its maturity, I realize the capital gain upside earlier, because bonds are typically called at par. This means I don't have to wait until maturity and the price converges to par immediately as opposed to over time. For some of the bonds I buy, the capital gain portion can be a bigger upside than the interest paid over time.

Tax-Free, AMT Status. Believe it or not, some revenue bonds are not really tax free. I pass on those almost always since I can typically find better deals in the corporate world or elsewhere. The alternative minimum tax (AMT) status is something else to watch out for, since it can bite some investors and reduce their gains.

Putting it all together

Now you know more about muni investing than the next guy who is going by the Fitch credit rating and what his commission-hungry broker told him. So it's time to wrap up and choose your bond.

The tricky part is that there are no hard and fast rules. After reading the prospectus and assessing all the risks, one must be satisfied with the yield and maturity or not. That's a personal call.

My rule is to never buy bonds for any price above par, no matter how juicy the interest might be. I often screen them based on a maximum price of 90% of par and go down from there. This is because I want to have some upside and plus want to have a margin of safety in the case the bond gets called.

I also don't consider munis if I can get better yield somewhere else, for similar risk profile. Why settle for less? Also, if the yield is so low to be comparable to a CD or a savings or money market account, then why bother?

Next time, I will discuss current opportunities in GO bonds and a few risky issues I found on the dark side of munis.


Using Options to Enhance Returns

Options can be a valuable instrument for enhancing an investor's returns. Option investing must be done strategically or the risks and costs outweigh the benefits.

The two strategies are like are the simplest ones: covered call and put-write.

Covered Call

A covered call strategy is when an investor sells a call option, giving the buyer the right to buy the stock at a given price in the future, while holding the underlying stock. This strategy has the disadvantage of limiting the upside for the option seller, but provides current income.

I've used this strategy recently when volatility was high. I bought the Dow Jones Industrial Index ETF (DIA) for $85 back in January and sold call options expiring in March for a strike price of $86. In March, of course, the entire market dropped, so the call options expired worthless and I got to keep the $2.5 premium I was paid for the options.

I then replayed this strategy a few more times and eventually the call option expired in-the-money, at which point my DIA shares were called and I was paid $1 above what I had paid for each share, and still got to keep the premium. But I forfeited a few extra bucks the stock had appreciated when the options expired.

Put Write

Puts give the option buyer the right to sell a stock to the put seller in the future for a given price. I use put write when I want buy a stock for a price lower than the current one being offered by the market. In this strategy,  I typically sell out-of-the-money puts that are covered by cash. If the stock drops, I get to keep the premium and I get the stock for the price I established.

The downside is that if the stock drops even more, I'll be buying it for the strike price, which could be a lot higher than what the stock is trading for at the time of option expiration.

I've recently used put write to buy the DIA ETF I mentioned above for $85 back in January. I sold at-the-money January put options and a few days later I was assigned the ETFs for $85, and I still kept the $1.36 premium I was paid for the options.

I've also used put write to try to acquire shares of V and MA at lower prices. In both cases, the options expired worthless and I did not get the shares. But I still got to keep the premium.

Current Opportunities

With the market currently going up (mostly due to devaluation of the dollar, I speculate) I don't think selling covered calls is a good idea, as my shares could be called and I currently don't have temporary or speculatory positions.

On the put write side, currently I don't have many great ideas either because my entry prices for stocks are way below their market prices right now. But for someone willing to enter the dividend investing strategy, selling at-the-money puts on the Dividend Aristocrat Index ETF (SDY) is not a bad idea. One can get $0.45 for the November $45 puts or $1.45 for the December puts. SDY is currently at $45.50, so a slight drop and a premium on the puts could help one get started on a solid selection of dividend payers.


The bottom line is that there's money to be made with options. However, there are risks both in terms of loss and limiting upside. One should use options to enhance returns only when one can afford to lose in the worst case scenario.

It's important to note also that options are a zero-sum game: one investor wins at the expense of a loser on the other side. So, unless one has a clear advantage, odds are one'll be the loser just as often as the winner, or possibly more often, given that there are smart players with lots of resources and lower costs in this game.

Disclosures: Long V.


A Place for the Shiny Metal in a Value Investor's Portfolio

I'm often asked about whether I like gold as an investment medium.

Personally, I don't use gold and have never used. But that doesn't mean I don't believe there is a place for gold in one's portfolio. There is. Let me explain by stating a few true facts that can be confirmed with a bit of your own research:

Pros and Cons of Gold

  1. Historically, over long time periods, gold mostly retains its purchasing power.
  2. Gold doesn't go bankrupt, doesn't overstate earnings, doesn't write-down anything (its weight, for example).
  3. Physical ownership of gold cannot be confiscated by law or by electronic methods; force is required to take gold from someone.
  4. Gold is universally accepted.
  1. Gold doesn't pay a coupon or dividend.
  2. Gold can't cut costs, become more effective, increase earnings, expand market share or come up with a great new idea.
  3. Gold can't take advantage of acquisitions, market opportunities or low interest rates.
  4. Gold is hard to value. There's little industrial utility for gold, so demand is mostly speculatory and fear-driven.
Basically,  what this all tells an investor is that 1) gold provides little in terms of a decent, predictable, long-term return but that 2) gold is a good store of value for times of political and monetary uncertainty.

Let's break it down in parts.

Little upside

As a commodity, the price of gold depends on "the market" and there is little in the way of assigning it a fair value. Bonds, on the other hand, can be assigned a value given a discount rate, inflation, maturity, credit quality and coupon rate. Stocks, though harder to value, can be valued independently of their market price too. Gold cannot.

As such, how can one "invest" in gold and expect returns from it, without having a crystal ball?

Store of wealth

On the other hand, gold has historically(*), in modern times (last 100 years or so) held its value over time.  Due to its fungibility and international acceptance it's a good medium of exchange ("currency") to have in times of trouble, war, economic instability, inflation,  and maybe even deflation. This mostly applies to physical gold held close to the investor, not in a vault or via proxies.

Gold is, then, a good hedge against inflation over long time periods.

How to use gold?

So how should an investor use gold? To me, it only makes sense to have gold as part of one's cash reserves. As I've said before, every investor, experienced or not, should have at least six months worth (more for increased safety) of living expenses in readily available currency such as money markets and savings accounts. And in my view, part of this reserve can be held in physical gold (other commodities may also qualify, but let's focus on gold here).

If one is fearful of high inflation, political or economic instability, then increasing this allocation to a year or more makes sense. It also makes sense that this extra reserve be in gold.

Currently, I don't own gold and have no intention of buying it anytime soon. The time to buy gold is when everyone is talking about prosperity, peace and low inflation. And even then, the role of gold should be limited to that half-year to a year reserve of readily available "currency", for emergencies.

* Appendix: How well does the value of gold really hold up?

I couldn't help but try to find what an ounce of gold could buy many centuries ago. Perhaps the historians could help? So, here's my uber non-scientific, back-of-the-envelope-ish analysis.

According to this site, prices in ancient Rome during the 6th century were as follows:

1 donkey = 3-4 solidii
1 lb of fish = 6 folles

Now, some units:

1 solidus = 1/72th of a half pound of gold = 226.79/72 g of gold = US$ 101 (@ 1 troy ounce = US$ 1000)
1 folle = 1/180th of 1 solidus = US$ 0.5626

Hence, we get the following prices in today's USD:

1 donkey in ancient Rome = US$ 303-405 today.
1 lb of fish in ancient Rome = US$ 3.375 today

But in reality, we see the following prices currently:

1 donkey today = at least US$ 500, sometimes close to $3000 (sources: http://www.equinenow.com/donkey.htm, http://www.littlefriendsranch.com/Donkeys%20for%20Sale.htm)
1 lb of fish today = US$ 15-20 (source: http://www.allfreshseafood.com/p-tilapia-fillet.htm)

The interesting thing is that the prices are in the general ballpark despite the centuries that have gone by. Neither the fish cost a tiny fraction of a penny nor the donkey was found to cost a trillion dollars.

So, if that's even close to correct (which I can't confirm), it means that gold mostly retains its value, but "inflation" can catch gold too -- after all, it can be mined and thus diluted.  Also, despite all the increased efficiency in farming techniques, raising donkeys and fish didn't seem to get much cheaper over the years but instead have appreciated in gold terms.

This analysis, however, is mostly for entertainment value as I can't verify the validity of the prices above. Take it for what it's worth.


Dividend Discount Model in Action -- LLY Stock Analysis

Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.

For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.

LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.

Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.

If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.

LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.

LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.

Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.

Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.

Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.

Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.

Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.

Disclosures: No shares of LLY held at the time of writing.