Category Archives: Finance

Finances, investing, and money management.

Taxable Investments: The Best Opportunities Now

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A good long-term investment plan does not change very often, but short-term cash and extra funds that you can dedicate to speculative opportunities should be constantly reevaluated.  The current markets present an extraordinary opportunity every individual should review.

If you are in a high tax bracket, tax-exempt bonds have historically offered a slightly better after-tax return than comparable taxable investments.  Over the last year, due to the liquidity crisis in the financial sector, tax-exempt bonds, a.k.a. municipal bonds or “munis,” have become extremely undervalued.  They now offer nominal returns that are roughly the same as taxable equivalents, which means that if you are in a high tax bracket you will end up with a lot more money if you put it in munis.

Clouding the situation has been the fact that bond rating agencies have historically put municipal bonds on a separate but identically named risk scale.  The Wall Street Journal notes, “[I]nvestment-grade corporate bonds between 1970 and 2000 had a 10-year default rate of about 2.3%, far higher than the 0.03% default rate of investment-grade munis.”  I.e., the finance industry has historically pretended that munis are as risky as taxable bonds that in actuality have proven to be seven times more risky.

Munis are not without risk.  Municipal institutions can default on their bonds, and they will be more likely to do so during a recession.  Also, muni bonds are exposed to the same price risks as most other bonds: Their value will decline if interest rates or inflation rise above the levels currently anticipated by the market.  Nevertheless, the risk level of investment-grade bonds is considerably lower than that of stocks or real estate.

First Action Item: If you are in a high tax bracket, this is definitely the time to move any non-retirement assets that you would normally invest in bonds into muni bond funds.  Your after-tax risk-adjusted earnings will be far higher with the munis.  Examples of good funds are Vanguard’s VWLTX, or USAA’s USSTX.

This is also a good time to consider a speculative angle on munis: Not only are they underpriced relative to taxable bonds, but they are also close to “support” levels where even non-taxable entities would start to buy them.  As soon as their nominal yields exceed those of comparable taxable bonds they will be bought by large investors that don’t benefit from the tax exemption — pension funds, endowments, etc.  I.e., they are below their historical and intrinsic price (which is the price a high-tax-bracket investor would pay to own them), and they are so low that they cannot fall much further relative to taxable fixed income.

Buying large amounts of municipal bonds with taxable funds could produce not only an attractive current yield, but also significant capital gains if they revert to their historical price levels relative to taxable bonds.  The best way to speculate on this dislocation is with leverage, and it turns out to be easy to leverage exposure to municipal bonds using Closed-End Funds (CEFs).  A typical leveraged muni CEF will employ leverage of 30% — which means you get roughly 30% more dividends and 30% more exposure to price swings than you would have from a conventional muni fund.  There are literally hundreds of CEFs in the municipal bond sector.  I look for high-yielding CEFs that are trading at a discount to their historical discount.  (There are a number of reasons why CEFs trade at a permium or discount to their NAV.  Without getting into those nuances just follow the rule-of-thumb that the practical “discount” for a CEF is defined with respect to its historical discount.  I.e., you’re getting a bargain if you buy a CEF at a discount to its discount.  Visit ETFConnect to look at the historical discount for any CEF.)

Second Action Item: This is a great time to speculate on munis using leverage.  Just realize that like all speculative strategies this is subject to greater risks: I.e., you can lose more money if things go wrong.  If you have speculative capital to put to work, look for a high-yielding muni CEF that is trading at a discount to its historical discount (I consider the average 52-week discount for this purpose).  Current examples would be:

  • BFK (6.5% current dividend yield, and trading at a 6% discount to average discount)
  • MVF (6.2% current dividend yield, and trading at a 3% discount to average discount)
  • NZF (6% current dividend yield, and trading at a 2% discount to average discount)

Before You Talk to a Real Estate Agent (or “Realtor”)

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Real estate brokerage in America is a terrible industry. A naive consumer intending to buy or sell a house will probably sign a long contract with a state-licensed broker (a.k.a. “Realtor”) that traditionally involves forfeiting up to 6% of the transaction value in exchange for questionable services. Before you even talk to a real estate broker, please consider the following:

Buyers

As a buyer, you will be encouraged to sign a contract enlisting a “Buyer’s Agent” to help you find a house. In spite of all the industry obfuscation to the contrary, “Buyer Agents” do not work for the buyer. Their incentive is to close a sale with as little work on their part as possible, and with a seller who will give them as high a commission as possible. Hence, as a buyer working with a Realtor you must keep in mind the following perils:

  • They do not have an incentive to show you the best house for your needs. Rather, their incentive is to show you a smaller set of houses you are likely to buy that pay the largest possible commission to them. This means they will typically show you full-commission houses listed for sale with them or their coworkers. Then they will show you full-commission houses listed elsewhere. They may show you cut-rate commission houses. It is very unlikely they will show you “FSBO’s” or other homes with low or zero commissions, or that would require a lot more effort on their part to close.
  • They do not have an incentive to help you negotiate the best price on the house you want. Their only incentive is to help you close a sale with as little effort on their part as possible. If you buy a house, it doesn’t matter what they do or don’t do: they get paid the same rate. (In fact, it may be small but technically their incentive is to have you pay as much as possible, since any commission on a higher price is still a little more.)

Agents may proclaim that they are licensed and that they have a fiduciary duty to their clients. However, in practice this fiduciary duty guarantees you absolutely nothing. So what service does a Buyer’s Agent actually provide?

  1. MLS searches. They will also ask you for your search criteria and will print out listings that meet those (and their) criteria. However, you can now do this yourself on the internet (and can circumvent their filters on low-commission houses). Thus, value to you of this service: Zero.
  2. Local expertise. They will be familiar with the communities in your search area. But no more so than anyone else. If you are moving somewhere new you will probably know people at the new place you are going to work, study, or recreate. Ask them instead.
  3. Market expertise. Skip it: When you’re buying they always tell you it’s a very tight market and you have to bid high and close fast. When you’re selling they always tell you it’s a soft market so you should be eager to accept the first offer that comes along.
  4. Referrals. They will refer you to home inspectors, appraisers, title insurers, and any other service provider you may want. There is no guarantee that these referrals are based on quality instead of kick-backs or other conflicting interests. Value to you: Zero.
  5. Chauffeur service. They will setup appointments to view homes and they will drive you to them. However, you could just as easily make an appointment directly with the listing agent and drive yourself.

Nevertheless, even if you don’t value the chauffeur and appointment services, it still pays to enlist buyer agents if only because most sellers offer them a commission. And most of that commission should go into your pocket. Did you know that it is standard practice in the real estate industry for brokers to give 40% of their commission on any sale to a referring agency? This is why there are so many banks and other services out there offering rebates if you work with a broker to whom they refer you. If you take no other advice from this article, you should at least demand up front that your broker share 40% of their final commission with you.

As a buyer, how can you avoid getting ripped off by a real estate broker?

  1. Do not commit to work with only one agent. Every broker will ask you to sign a contract in which you commit to giving them the buyer’s agent commission on any house you buy within a given period. This is absurd – and unnecessary. The industry has a glut of Realtors hungry for your business. Visit multiple brokers and tell them you will pay them if you buy a house that they show you. Working with multiple agents can mitigate many of the risks and hazards on the buyer’s side.
  2. Negotiate a share of the commission for yourself. Since the standard referral rate is 40%, make it clear that you expect to receive at least 40% of any commission. Negotiate your share upward based on the amount of work they actually do to help you find and buy a house. (Note that in a traditional sale of a $2MM house they will walk away with a $60k commission. What’s a fair wage for driving you to a few houses and sitting at your side during the closing?) Note that in 12 states commission “rebates” are illegal. So in those states don’t call it a rebate; call it a subcontracting fee, partnership share, or something else.
  3. Align the incentives. If you aren’t doing your own legwork in the MLS and FSBO sites to find houses you want to look at, then ensure that your broker has an incentive to show you houses that pay low or no commissions. For example, offer to pay them an hourly rate in lieu of commission for their work. Or offer to pay them some minimum compensation if the seller of a house you end up buying does not.

Sellers

People who want to sell a house are in a less flexible position than buyers. It is practically impossible to list your house for sale with more than one agent. (It is possible to list it with no agents, but even today that all but guarantees that 95% of potential buyers will never see your listing.) Furthermore, unless you offer Buyer Agents a 2-3% commission then many potential buyers will never be shown your property (due to the Buyer Agent conflicts of interest noted earlier).

Compounding the situation of the seller is the fact that a good Seller’s Agent will invest a significant amount of time and money marketing the house. This results in better visibility and, statistically, a higher selling price. Agents deserve to be compensated for this work (if they do it). But there are still many bad agents who will make you sign a contract for them to list your house – often for 6 or more months – and then do nothing to market it. And why not? Even if they don’t do anything there’s a chance someone will offer to buy it during that period, at which point they get their full commission.

Seller Agents face most of the same perverse incentives as Buyer Agents: Namely, they would rather close a deal with less work on their part than with more. Though they get a higher commission from a higher sale price, on a 6% commission listing each agent is only seeing at most 3% of the upside. Suppose you’re selling a $1MM house. How much harder do you think your agent will work to get you $1.1MM if at most $3k of that extra $100k ends up in their pocket?

As a seller, how can you avoid getting ripped off by a real estate broker?

  1. Do not sign a long-term listing contract. An agent might invest significant time and money marketing your house. They deserve to be compensated for that. However, I know top-rated agents who offer listing contracts with a 15-day opt-out. I.e., no matter what they have invested to sell a listed property, the seller can choose to opt out of their contract with 15 days notice. A good agent should offer a contract like this, since if they are doing a good job you have no incentive to take your business elsewhere. An alternative contract would allow you to terminate if you pay their sunk costs. I.e., if you want to take your listing elsewhere make them hand you receipts and time-logs of what they have invested, pay them for their work at a pre-agreed rate, and move on.
  2. Negotiate a share of the commission for yourself. Remember the 40% referral rate and use that as a starting point. You could even insist that the listing be free of any seller’s commission, and instead offer them a fixed fee, or a time-and-materials contract, perhaps with a performance bonus based on how much the selling price exceeds a fair appraisal.
  3. Do offer a full 2-3% commission to the Buyer Agent. Unfortunately, due to the Buyer Agent hazards there is a good probability that if you don’t offer this incentive you will have fewer lookers, fewer bids, and ultimately a lower selling price. However, this is not necessarily unfair: If your buyers are savvy (as suggested above) then they will be pocketing a large part of the Buyer Agent’s commission. In essence, you can look at the buyer’s commission as a built-in discount to the selling price. I.e., if your property sells for $1MM with a 3% buyer commission then everyone involved knows that the buyer is really only paying about $970k. (Of course, this isn’t optimal since taxes and fees are typically a function of the selling price. Ideally everyone would agree on the sale and then just reduce the price by 3%. But this is the best we can do in the present conditions.)

The market is overflowing with real estate agents. Some are very good. Many are just out there playing the lottery – hoping to pick up a listing or a buyer on a big sale and walk away with a single commission that they could live on for an entire year. The good agents will not mind contracting with you on terms like those outlined here.