There is no better time to invest than when lots of other investors need their money back.  During market crises like the present the premium on liquidity skyrockets.  I.e., if you have cash on hand that you can commit to investments for an extended period then the people who don’t will let you scoop up assets at firesale prices.  Hence, the rules for investing in a market crisis:

1. Don’t abandon investments unless you need cash.  If you sell during a liquidity crunch you become one of the people paying the liquidity premium.

2. If you buy during a liquidity crunch you collect the liquidity premium.  Therefore you should revisit your asset allocation and consider reallocating your investments to increase your exposure to distressed assets.  (Don’t try to pick stocks or sectors — the information premium during a market crisis can also skyrocket, which means if you don’t have extraordinary information you are at a heightened disadvantage.)  For example, last week a lot of institutions needed to move into short-term treasuries.  They were dumping corporate bonds, stocks, and just about anything else to do it.  Demand for treasuries got so high that buyers were literally paying out for the right to own them (i.e., interest rates went negative).  If you held treasuries and didn’t need the exceptional margin of security they provide it was a good time to cash them in and buy the things everyone else was selling.

In general your portfolio should reflect your investment time horizon and risk aversion — i.e., how long you can keep your money invested, and how much interim “pain” you can tolerate.  The more pain, the more (potential) gain.  During a liquidity crisis you may perceive that risks have gone up and thus be inclined to sell risky assets and move to more liquid assets.  That is exactly the wrong course of action, because it turns you from a liquidity provider into a liquidity demander.  If you succumb to the urge to pull money from the markets you will find yourself in the notoriously underperforming pool of retail market timers who always buy near the top, when everything seems great, and sell near the bottom, at the point of “maximum pain.”

When you see falling asset prices during a liquidity crisis do not think, “Shoot, those assets are riskier than anyone thought, I had better get out too.”  Instead think, “Wow, the market is willing to pay me even more to move into those assets.  Last time I considered those I didn’t think the extra return was worth the risk.  But since that return potential is even higher maybe now it is worth owning them.”

How can you collect the handsome liquidity premium that exists in the current market?  If you own CDs, consider paying the early-withdrawal penalty and putting the money into corporate or muni bonds, whose spreads over treasuries have spiked to record levels.  If you already own bonds consider moving to higher-risk asset classes, or else consider leveraging up using bond CEFs.

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)