Even worse, these bonds effectively tax you and me for projects we never voted on, may never benefit from, and never really ever wanted in the first place. (Again, see Part 1 for more detail.)
However, as awful as I believe these to be for our country, as best stock investments they are worthy of serious consideration, especially for IRA or other tax-deferred accounts.
Reviewing very quickly: A BAB is basically a municipal bond, except that it is NOT tax-exempt (while most munis are). Thirty-five percent of the interest cost is paid for by the U.S. government (read: you and me) in the form of a direct subsidy payment to the borrowing municipality.
(Please don't misunderstand me: This does not mean that 35% of the interest paid is guaranteed by our federal government. It is not. If the municipality defaults, i.e. stops paying principal or interest, then so too will the Feds.)
From long experience, I know municipal bonds to be outstanding stock investments in 2011. I've written about them extensively and, in next month's Wealth Legacy Advisory, my subscribers will be provided with a "how to" on analyzing municipal general obligation bonds (often abbreviated as "GO"). BABs are, again, municipal bonds with a twist.
When "New" Means "Opportunity"
The taxable nature of BABs means they will provide you with a substantially higher rate of return over a comparable municipal bond. (This is because the BAB owner must pay taxes on the yield – and thus the yield must be higher to compensate for that hurdle.)
There is yet another reason, however, why BABs pay an exceptionally high rate of interest. These bonds are relatively new – about a year old – and many provide exceptionally fat yields simply because the investing public is less aware of them, making the bonds harder
to sell.
We can exploit this "newness" opportunity by getting a good price on BABs (thus increasing the yield percentage we receive).
In addition to their young age and relative "newness," another reason for the high returns BABs offer is – and this probably won't surprise you – government interference in the marketplace.
Taking Advantage of Uncle Sam
In the government's desperate attempt to inflate most anything and everything to stave off a recession, they created this subsidy to lower the cost of borrowing to municipalities, increase the flow of funds to infrastructure projects.
The taxpayer-funded subsidy that supports BABs thus gives municipalities the advantage of below-normal borrowing costs. Unfortunately, precisely because of this subsidy, there is far less incentive for the borrower to get the lowest interest rate possible. Who cares about paying a little extra when you know the government is good for 35% of it?
In other words, when it's not your money, you're less careful with it. This laxness on the part of municipalities means potential higher rates of return for investors in BABs.
However, this yield "kicker" over a normal municipal bond investment is only part of the BAB opportunity…
The Hidden Sweetener
Alert readers may have spotted it already, but I'll now provide a second, hidden and completely unintended opportunity that was created right alongside BABs.
You may have picked it up. It has to do with the fact that, as mentioned in Part 1, BABs are the federal government's brilliant attempt at ending tax-exempt municipal bonds.
Municipalities across the United States are gladly handing over their ability to issue tax-exempt municipal bonds for the few coins the feds are throwing their way (that 35% subsidy).
Before long, instead of this being a "temporary government program," municipalities will demand it be made permanent – and there is already talk about it remaining after the succubus package ends.
What this means is that the more traditional, fully tax-exempt municipal bonds will become scarce. As normal munis get crowded out by the subsidized BABs, the various options for creating tax-exempt income streams will begin to dwindle. This, in turn, should increase the value of existing municipal bond issues. It's simple supply and demand: When supply falls as demand holds steady, perceived value increases – causing the price to go up.
In conclusion, BABs are a lousy deal for the American taxpayer and a potential threat to the sovereignty of state and local governments. Nonetheless, they are potentially fabulous investments that should find their way into your retirement accounts.
When properly selected, the right BABs can provide steady, reliable and, most valuably, higher than normal rates of return. Their issuance also provides a hidden sweetener for the value of any tax-exempt munis you currently own (or may be thinking of purchasing in future).
As with any anomaly in the best stocks market – and BABs certainly do qualify as one – the window of opportunity will only remain open for a limited time. The market will eventually adjust its pricing; when this happens, BAB yields will drop to a level on par with other similar quality investments. That's why investors should consider moving on this opportunity, and locking in more favorable rates of return, sooner rather than later.
The Moral Issue
One other quick comment: Reader Edward R. delivered an eloquent reply to Part 1 questioning the moral aspect BABs. As Edward put it,
Listen, I'm all for making money. But it must be made honestly. And just because something's legal doesn't mean that it's honest or honorable. Just look at what Pelosi and Co are trying to do with Obamacare with their "deemed" vote to pass.
If this country is to get back on the right track, it must start with each one of us doing the right thing. Buying bonds that make us money yet are tainted in their essence is just plain wrong.
Now, I admit Edward has a point. And his stance puts him in excellent company. Numerous financial advisors in Texas, for example, believe state sovereignty is at risk and are thus avoiding these types of bonds. (Bravo Texas!)
I would, however, suggest that BABs are a bit like the federal income tax, which is far worse than any new program, yet something we all must deal with.
I believe the current income tax regime, structured the way it is, is not only wrong but illegal (unconstitutional). In fact, I was so disgusted with the IRS and its system that at one
point – in protest of the system – I withheld, in escrow, an entire year's worth of income taxes (a big chunk!) that they said I owed.
I sent repeated notices to the Treasury Secretary and any other federal officials I could think of during that year of protest. I pled that my questions, at the very least, be acknowledged, if not addressed.
And what was the result? I was ignored, even though I sent everything via either FedEx or registered mail-return. (It all came back unsigned.)
My belabored point is, that while I fully agree with Edward's point that we need to take a stand against government evil, I also believe we are dealt, wrong or otherwise, certain cards that must be played. Like it or not, we must play the hands we hold. Wearing my investor hat, I see it as a fiduciary duty to generate the most attractive returns I can (while taking on the lowest risk). Bilk America Bonds, as questionable as they are, offer an attractive means of doing this. And like the odious federal income tax, they will probably be with us for a long while.
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