Tax-Free Income on Your Safe Money

This opportunity shouldn't exist. It's in a safe investment that you've probably never considered before. But now is the time to consider it.

The opportunity is easy to understand. Stick with me here, let me explain it...

When a state needs to build a new toll road, it borrows money. It promises to pay back the money it borrows through the revenues from the toll road.

Specifically, when your local government borrows to build a toll road, it raises the money by selling municipal bonds. Big investors buy these municipal bonds. Again, these investors get paid back through the revenues of the toll road. Now, here comes the good part...

In order to entice investors to lend money to local governments, the U.S. government makes an offer they can't refuse: Investors don't have to pay income taxes on the interest they earn on their municipal bonds.

So investors in high tax brackets love municipal bonds. Rich guys simply buy these bonds and hold them to maturity.

And recently, Bill Gross of PIMCO said tax-free municipal bonds "yield just as much, in most cases, as taxable Treasuries... When you can get a non-taxable security at the same rate as a basically taxable security, then you've got a bargain."

"A bargain" is an understatement here. This is a freakish opportunity...

Right now, tax-free bonds are yielding about as much as taxable Treasury bonds. This makes no sense.

Think about it... If you had two choices – to earn 4% tax-free, or 4% and pay full income taxes on it, which would you choose? Of course you'd choose tax-free. At a 33% income tax rate, you'd have to earn 6% in a taxable account to earn 4% after tax. So all things being equal, tax-free bonds should never pay the same rate of interest as a taxable bond. But right now, they do...

This anomaly always sorts itself out in one of two ways: 1) Either regular government bond prices must crash while municipal bonds stay flat. Or 2) Municipal bond prices must soar. Either way, you'll do extremely well by holding a portfolio of municipal bonds.

Incidentally, there are guys on Wall Street (arbitrageurs) who will ensure that the relationship will return to normal. These guys earn a fortune making it happen. As the normal relationship returns, pushing bond prices up, investors should see nice capital gains...

And municipal bonds are pretty darn safe... According to the huge bond firm, PIMCO, the cumulative default rate on municipal bonds from 1970 to 2000 was 0.04%. That number is for all municipal bonds, not just AAA-rated ones.

But lately, municipal bond prices have fallen, creating our opportunity. I think the main reason for the fall is bond insurance companies... Bond insurance companies got into insuring subprime bonds. Now the insurers are in trouble. But this doesn't concern me with municipal bonds, which almost never default.

Between the tax-free interest, and the capital gains I expect as the anomaly sorts itself out, you should be able to pick up double-digit total returns here. The Fed cutting interest rates will further help our gains.

It is a unique opportunity. It won't make us 100% profits. But our timing is perfect: The anomaly and the Fed are both in our favor.

Municipal bonds are a great place to stash some "safe money" for the next few years until the interest-rate anomaly sorts itself out and the Fed stops cutting rates. Take advantage of it.

Safe, double-digit annual returns on your cash for two years... It's hard to beat.

Good investing,

Steve

P.S. One way to take advantage of this is through a simple municipal bond fund. Van Kampen (www.vankampen.com) offers many of them. So does Vanguard (www.vanguard.com).