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October 15, 2009

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Sound Mind Investing has great advice. Good detailed look at finances. Great post.

As a serious student of stockmarket trends, particularly the summations of New Highs vs New Lows and the summations of Up Volume vs Down Volume for the NYSE and the NASDAQ I started to see the writing on the wall months before it happened and moved everything into money market funds (MMF).

By October 2008 the yield on MMFs was pitifully low so I loaded up my taxable account 100% with individual muni bonds. Since growth is no longer an issue for me and I don't need capital gains I was looking primarily for Federal and AMT tax exempt income. At the time it was easy to find good quality bonds with a 4.5% to 5% coupon at prices beween $950 and $990/bond. I laddered them out between 2010 and 2021 and intend to hold them all to maturity. This way I can generate tax free income (Avg. 4.9%), far higher than keeping my money in a MMF, avoid the AMT tax, still make a little profit on them as they reach maturity and not worry about market volatility and fluctuations. Currently, one year later, muni bonds have appreciated to the point however where it's almost impossible to find a 5% coupon at par value, and if you pay the premiums that the sellers are asking it makes little sense to buy them if you intend holding them to maturity since you would be buying at $1100 - $1150/bond and have a substantial capital loss when they mature at $1000/bond.

Even though my brokerage shows them to be worth a lot more than I paid for them I use the value at maturity in my own accounting. There are no account fees or other expenses, it's just a matter of reinvesting the income that each bond pays every six months. I am accumulating the income in a good, tax free muni bond mutual fund so that I can raise some cash in a hurry should I need to.

You talk about inflation in your article however some eminent economists are predicting a deflationary environment in the future. We will just have to wait and see who is right. Currently the American consumer seems to have tossed away his credit cards, is saving money or paying off debt, and not in a buying mood. Inflation usually requires that companies can keep raising prices - I don't see that happening. Even restaurants seem half empty and are offering lots of 2 for 1 deals. The unemployed and the underemployed are eating at home and not frequenting the shopping malls.

I honestly honestly think the bond market is OVERPRICED right now with the 10 yr yielding only 3.35%.

That said, I feel the stock market is also overpriced, hence one should be getting defensive and raising cash.

Don't get greedy folks!

@Old Limey -- good thinking buying individual bonds during the credit crisis. I did the same, though I was a bit cash-short at the time: I needed to either break CDs or sell stocks at low prices to raise more money, and I didn't want to do either. So I only spent cash I had - enough for a couple issues of AA and AAA munis and a couple issues of corporate bonds which were seriously undervalued (Goldman Sachs and Wells Fargo). The rate was 5 and 5.25% municipal bonds, but because I bought at a discount, the actual yield to maturity is 5.5%. On corporate bonds, the rate was 6%, but I bought at very large discount, so yield-to-maturity is between 8 and 9%.

Now all of these bonds are up in value, so this is a dilemma. Like you, I use their face value in my calculations. But if I look at the current price, the actual yield on the current value of the bond is much lower. I.e. if I were to sell it, and pay capital gains tax, would I get more or less on this new amount. I plan to keep doing this calculation and sell (at least corporate bonds) if I feel that the return is no longer good or if I feel the time the interest rates would go up is close. Not sure about munis - tax free income is very attractive.

" if you pay the premiums that the sellers are asking it makes little sense to buy them if you intend holding them to maturity since you would be buying at $1100 - $1150/bond and have a substantial capital loss when they mature at $1000/bond."

Yes, but isn't this already reflected in yield-to-maturity column? So shouldn't you simply compare yield-to-maturity with the return you can be getting elsewhere? Especially when you talk about municipal bonds, buying a bond at a premium may still be attractive in your tax bracket: the years of tax free return may well compensate the loss in principal. Especially if you deduct the loss on your tax return.

I am not saying bonds are a good deal now - same reason that Financial Samurai mentioned. In fact, I plan to move money I have in bonds in my 401K (where we can only have funds, so no option to wait till maturity) into stable value probably next week. I am also seriously considering selling my corporate bonds (after doing some calculations). May wait until next year with individual bonds though -- too many capital gains this year and no immediate risk of rate hikes.

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