Not long ago a prospective client inquired about Apollo’s views of the fixed income markets and, specifically, muni bonds. It was a simple discussion – one we’ve had with our clients a number of times since the ‘market meltdown’ of 2007-2009. We explained that with ‘risk-free’ 10-year Treasuries yielding 2% and the questionable balance sheets of Federal/state governments the best risk/return tradeoff is in corporate bonds. With attractive yields (even if only on a relative basis) and solid balance sheets there’s no other game in town.

Unofficially the first rule of bond investing is ‘make sure you get your money back.’ A bond is a loan after all – a contractual obligation where the seller (except in the instances of ‘zero-coupon’ bonds) agrees to pay interest and, at maturity, repay principal. All other facets of bond investing while important are secondary to this most obvious of notions.

It’s a notion so obvious that many people (un)willingly forget about it. That’s unfortunate.

This prospective client was adamant that she wanted to invest in muni bonds. When we asked why she replied, “Because they’re tax-free.”

OK, that’s partially true. The interest on muni bonds is free from Federal income taxation. They may be free from state/local income taxation dependent upon several factors.

Our argument was that AFTER-TAX return is what matters most. If a 5% bond loses 40% to taxes then the net 3% return is still better than a ‘tax-free’ muni if the latter does not return 3%.

The return argument while important was secondary. We brought the conversation back on track by reminding this prospective client that return of capital is paramount. Governments have questionable balance sheets (is it not annually we hear of service cuts and tax hikes to balance budgets?), can play games to defer making payments and although unpopular/uncommon can file for bankruptcy. We’re not using scare tactics when we point out Detroit, Harrisburg, Orange County, etc.

Look no further than the latest announcement from Governor Walker of Wisconsin for proof that governments play a different game than their corporate competition in the bond market.

To be sure corporations can file for bankruptcy. We’re not suggesting otherwise. That’s where security selection becomes important – choosing PepsiCo’s balance sheet over Joe Shmoe’s fly-by-night lemonade stand for example. Unfortunately when an investor chooses the balance sheet of the Federal/state government over a rock-solid corporation they’re opting for that most summertime of businesses.

Lessons learned:

If you’re going to invest in fixed income make sure you understand that return of capital is paramount. Taxation, diversification, fixed vs. variable rates, call provisions, etc. are important but secondary discussions.

If you’re going to work with a financial planning and/or investment advisory firm seek one that has a fiduciary obligation and must act in your best interest. Any firm can agree to act as you instruct (“You want muni bonds? Sure, we’ll buy ‘em for ya.”) but how many will tell you what you need to hear instead of what you want to hear?

Don’t let preconceived notions and ideologies get in the way of doing the right thing. (That’s precisely what happened with this prospective client.)