We recently covered (graphically, anyway) the relationship between the Ten Year Treasury Yield, Shiller's CAPE (inverted) and the S&P 500 Index.  Although it was sort of possible to estimate the returns that followed, we'd be a bit uneasy if we forced you to do too much squinting - truly, you don't want your eyes to end up like mine.  If that was "Risk Free Rate 101" course, consider this the 201 course: let's look at Shiller CAPE versus the risk free rate, represented by 10 Year US Treasuries.

Shiller's CAPE Versus the Risk Free Rate

Let me refresh your memory on the last article by reproducing its key graph, summarizing Robert Shiller's data on the S&P (not just the 500 - he also has the pre-500 and a synthetic measure back to 1871).  Shiller's CAPE measures the inflation-adjusted last 10 years of earnings on the market versus the current S&P 500 index price, a very conservative way of looking at earnings that generally includes all stages of the business cycle.

We 'invert' CAPE, turning it into a measure of how much of the price is made up by the average earnings.  This allows us to compare it to the rate on the Ten Year Treasury, like so:

Shiller Inverted CAPE and CAPE versus the Risk Free Rate (10y Treasuries)

The relationship between CAPE^(-1) and GS10 (the ten year treasury yield) is the one we are most concerned about.  I want to turn your attention to the points when the relationship 'inverts', or when the ten year treasury is greater than the ten year earnings to price ratio.  The following table details those times.  We've added ten year returns from our dividends included S&P return calculator (not inflation adjusted - remember, the Treasury isn't).  Adjacent rows mean you're looking at the first and last months of the inversion, single rows mean the inversion lasted for a single month:

Note that, again, these don't account for inflation nor do I attempt to factor tax rates (or transactions on reinvestment of dividends) into the equation.

Still... interesting, isn't it?

A municipal bond, often termed a “muni”, is a fixed-income instrument  issued by a local government, city, township or agency.

What are municipal bonds?

Municipal bonds are debt securities. When a municipality needs money for a specified purpose such as an infrastructure project, long-term investment or general financial and cash flow management they can issue a bond.

Municipal bonds have various maturities ranging from:

• Short-term,
• Less than 1-year
• Long-term issues that can be 30-years or longer.

Like any loan, borrowers receive cash and the lenders (the bond investors) receive a promise of repayment at a specified time, as well as periodic payments.

In the U.S., interest income received by holders of municipals bonds is typically exempt from federal income tax and from state income tax.Tax-exempt status is one of the most attractive features of municipal bonds from an investors’ point of view.

When should you hold municipal bonds in your portfolio?

Municipal bonds make the most sense for an individual that has already maximized all other tax-efficient investment options.

In other words, if you have contributed the maximum permissible annual amounts to:

• A pre-tax 401K plan
• 529 College Savings Plan
• IRA/Roth IRA
• HSA
• Or other tax advantaged investment (e.g. other deferred income or real estate investments)

then purchasing municipal bonds or municipal bond funds might make sense. When you reason through the other accounts, you'll find high new worth investors are the ideal target for municipal bonds.

Why are municipal bonds best for high net worth or affluent investors?

It's ridiculous to hold municipal bonds in your tax-deferred IRA. The main advantage of municipal debt is its tax-free advantage. If you hold the bonds in a tax-advantaged account, you are effectively “wasting” the tax-advantaged status of a security that's already tax-exempt.

Let me clarify with an example: Your tax-deferred 401k has an annual contribution limit. That limit serves to promote your own retirement savings... while balancing the government's need to fund everything it needs.

The government does not tax income received from interest, dividends and capital gains in your 401(k) until you retire and actually withdraw money. As an investor, tax-deferred accounts are powerful savings tool. The annual limit is in place to constrain that special benefit they give you.

The bottom line: your objective is to use your tax-deferred 401(k) capacity wisely. The wisest thing you can do is fill your tax-deferred 401(k) with taxable securities, such as equities and corporate bonds.

On the other hand, since the interest you receive from municipal bonds is tax-free there is no need to shield these securities from income taxes!

It's wise to hold your municipal bonds in taxable brokerage accounts because of this benefit. And, as stated above, it's best to do that after you've exhausted the limits on all your taxable accounts.

Should I buy municipal bonds directly or buy municipal bond funds?

Our view is that if you are new to municipal bond investing, purchase a municipal bond fund. Municipal bond funds come in a variety of forms such as mutual funds, exchange-traded funds, closed-end funds, and other, more exotic types.

The key benefits to investing in municipal bond funds are:

• Outsourced management: Fund managers select the portfolio, and manage the purchase and sale of municipal bonds. Managers collect any interest payments and r-distribute income to investors in exchange for the fund's fees.
• All-in-one diversification: Purchasing a single fund can provide exposure to municipal bonds issued by various cities or agencies across the U.S. Even without a ton of money, you can receive diversification by issuer, tenor, purpose, interest rates, credit ratings, repayment sources, collateral, and other metrics.
• Less initial capital requirement: Municipal bond mutual funds usually have a minimum purchase amount of $1,000 to $10,000 for a portfolio of bonds. Municipal bonds are issued and traded in $5,000 denominations.
  
  You would need at least $50,000 to buy 10 different municipal bonds directly in order to build a portfolio. ETFs or Mutual funds give you diversity for less.
• Funds (specifically ETFs) are traded on an exchange: Exchange traded funds unds can be sold easily and electronically through a discount broker just like placing an equity trade.
  
  However, if there was a material liquidity event in municipal bonds, your ability to execute fund trades would be impacted.

Should you buy municipal bonds now?

Like oh-so-many questions the answer is: “It depends on your situation and knowledge”.

Before you buy municipal bonds, here are some things to consider:

• Spreads and prices have an inverse relationship; when spreads decline, bond prices normally increase.
• If you expect increasing interest rates, they will decrease bond prices, thus deflating the value of fixed income holdings.
• Municipal bonds and bond funds generate tax-exempt income, which is attractive even while yields are low.
• In addition, municipals feature an extremely low default rate. They also have a distinct advantage over corporations in raising money: the ability to increase taxes.