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Municipal (“muni”) bonds tend to be a part of our overall allocation in client portfolios since they provide stable tax advantaged cash flows.  This post breaks down the basic of muni bonds.  For information on why rising rates are good for investors, read out blog post here (Why Rising Rates are Good for Muni Investors)

 

What is a municipal bond?

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good.

When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date.

What is taxable equivalent yield?

Taxable equivalent yield (also called equivalent taxable interest rate) is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The taxable equivalent yield is commonly used when evaluating municipal bond returns. Below are examples of the taxable equivalent yield for an investor in various tax brackets who buys a muni bond whose yield to call is 3.50%:

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Credit Risk

If the issuer is unable to meets its financial obligations, it may fail to make scheduled interest payments and/or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer’s creditworthiness, ratings agencies (such as Moody’s Investors Service and Standard & Poor’s), analyze a bond issuer’s ability to meet its debt obligations, and issue ratings from ‘Aaa’ or ‘AAA’ for the most creditworthy issuers to ‘Ca’, ‘C’, ‘D’, ‘DDD’, ‘DD’ or ‘D’ for those in default. Bonds rated ‘BBB’, ‘Baa’ or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.

Interest Rate Risk

The interest rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds. To compensate new investors who purchase the bond you already own, the value in fall in price until it’s yield is equal to the current interest rates.

Duration is the most common measure of interest rate risk for non-callable bonds while modified-duration is the most common measure of interest rate risk for callable bonds. For instance, if a bond has a duration of 8 and interest rates rise 1%, the bond will fall by approximately 8%. Time until maturity and coupon are the primary factors for calculating duration. A bond with a 2% coupon that matures in 20 years will have much higher duration than a 8% coupon bond maturing in 20 years.

What is a callable bond and why do you purchase them?

A callable bond is a bond that can be redeemed by the issuer prior to its maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at a lower rate of interest. In this case, the company calls its current bonds and reissues them at a lower rate of interest. Most municipal bonds in today’s market are callable bonds.

A long maturity bond with near term call feature (5-10 years) will keep the price lower since the bonds will be priced on a yield to call basis.  By having the call feature within a bond, the municipality has to compensate you for the fact that they can take it away (call it), which is why they yield more than non-callable bonds.  In my opinion, the callable bonds offer superior yields at better pricing than non-callable bonds. If interest rates rise and the bonds do not get called, they were purchased at a lower price than a non-callable bond and therefore wouldn’t fall in price as much. Furthermore, the price was lower and YTM is therefore higher than a comparable non-callable bond.

How are municipal bonds priced?

Most muni bonds are priced at a discount, at par or above par.  Par is the price that the bond will mature at.   Most muni bonds mature at 100.  Muni bonds tend to trade relative to US treasury bonds. For instance, a very high quality muni bonds (AAA rated) that yields 2.5% for 30 years has a yield today equal to a 30 year treasury bond. Since municipal bonds offer tax free income while treasury bond investors pay federal income tax, the muni bond actually yields more than the treasury bond in this example for a high income earner. Although, in periods of market stress like 2008, 30 year treasury bonds returned over 40% while the AAA muni bond earned around 5%. We buy muni bonds and treasury bonds for very different reasons, although they trade on a relative basis.

When buying individual muni bonds, there can be a bid-ask spread of around 1 point. The bid-ask spread is the difference between what you could buy or sell it for. For instance, a 5% bond callable in 2026 and due in 2046 may be offered for sale at 116 while it may have a bid to buy of 115.

What is yield to maturity?

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield, but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.

Calculations of yield to maturity assume that all coupon payments are reinvested at the same rate as the bond’s current yield, and take into account the bond’s current market price, par value, coupon interest rate and term to maturity. YTM is a complex but accurate calculation of a bond’s return that can help investors compare bonds with different maturities and coupons.

What is the pricing arc?

This is a term we created and helps us conceptualize the future movement of a bonds price with certain assumptions. If you assume interest rates stay flat during the term of the bond, the bond price will have a predictable pattern. In today’s environment, most bonds with a coupon over 4% are priced at a premium (over 100). Each coupon bond will have a different arc depending on its coupon and price. All bonds priced below or above 100 will be pulled to par either close to the time of the call date or maturity date.

 

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Yield to Call and Yield to Maturity Matrix

In the matrix below, 3% coupon bonds have the highest yield to call while they have the lowest yield to maturities.  5% coupon bonds tend to have the lowest yield to calls, but the highest yield to maturities.  These unique qualities makes it important that you customize portfolios clients since someone who’s using income from the bonds may require a different strategy than an investor who’s reinvesting coupons.

 

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Other Factors to Consider:

  • Total issuance size
  • Is the ratings outlook positive, negative or neutral?
  • If the bond has insurance, what is the underlying rating without insurance wrapper?
  • What is the interest rate outlook? Do we expect long term interest rates to rise, fall or stay range bound?
  • Are there any special redemption provisions?
  • Is the bond a general obligation, revenue based (utility, transportation, etc.) or hospital bond?
  • How has the pricing been trending the previous 6 months?

 

There are other factors to consider when purchasing muni bonds.  It’s important to work with an investment professional who has a deep understanding of your goals and overall investment strategy to ensure a particular strategy is appropriate.

 

Proper Wealth Management’s (“Proper”) blog is not an offering for any investment. It represents only the opinions of Jared Toren and Proper . Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest. Jared Toren is the CEO of Proper, a Texas based Registered Investment Advisor.   All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Information contained herein is believed to be accurate, but cannot be guaranteed. This material is based on information that is considered to be reliable, but Proper and its related entities make this information available on an “as is” basis and make no warranties, express or implied regarding the accuracy or completeness of the information contained herein, for any particular purpose. Proper will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter.  Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The material contained herein is subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Proper may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Proper Wealth Management is not responsible for any errors or omissions or for results obtained from the use of this information. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this material should not be acted upon without obtaining specific legal, tax or investment advice from a licensed professional.

 

Author: Jared Toren

Jared Toren is CEO and Founder at Proper Wealth Management. Proper was born out of frustration with the inherent conflicts of interest at big brokerage firms influencing advisors to sell products that were not suitable for clients but profitable to the firm along with a consistently mixed message of who’s interest was supposed to be put first; the clients’, the firms’, shareholders or advisors.

At Proper, our clients interests come first. We are compensated the same regardless of which investments we utilize so there’s no incentive for us to sell high commission products. Since we focus on a small number of clients, we are able to truly tailor our advice to each person’s unique circumstances.

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