- Interest rates are currently at abysmally low levels.
- Some fixed-income investors have chased yield by sliding down the credit-quality scale.
- High-quality municipal "cushion bonds" may provide a better answer, allowing the conservative investor to gain additional income while maintaining high credit quality standards.
As we all know, short- and medium-term rates for fixed income securities are abysmally low.
Care for a slice of Apple? How about a bond maturing in May 2016 with a 0.45% coupon priced slightly above par to yield .44%? Or maybe you'd prefer a juicy offering from Microsoft (NASDAQ:MSFT) maturing November 2017 with a .875% coupon priced to yield 1.07%.
If you are impatient with the interest rate environment, one option is to slide down the credit-quality scale to capture additional yield. (There's always Puerto Rico and Greece). But there is a class of high quality municipal bonds that may provide a better answer.
This article focuses on what I see as a sweet spot in the municipal bond universe. These are high quality, long dated, callable bonds with a high coupon and a first call date within seven years. These are a subset of a class of debt securities known as "cushion bonds." As explained by Investopedia:
A cushion bond is a type of callable bond that sells at a premium because it carries a coupon rate that is above market interest rates. (Its) call feature means that it will be priced on a yield-to-call basis (i.e. it can be redeemed prior to maturity), rather than on a yield-to-maturity basis (thereby) decreasing its sensitivity to changes in interest rates.
More specifically, I have been looking at issues:
- Rated AA+ or higher
- Maturities of 15 to 25 years
- Coupons of 5% or more
- Call dates in 2021 or sooner
My objective is to find better yields for the short to medium term (i.e. I hope the bonds are called) without getting stuck with an "undesirable" holding if they are not. In addition to benefiting from the resilience to interest rate fluctuations, which is a general characteristic of this type of bond, you can also gain a margin of safety from the currently high spread ratios between tax-exempt munis and government bonds.
Consider these recent offerings:
- Issuer/Rating: Florida Board of Education (AA1/AAA)
- Details: 5% coupon maturing 6/1/30 at $110
- First Call Date:6/1/17
- Yield to Worst: 2.00%
- Yield to Maturity: 4.14%
- Issuer/Rating: Palm Beach County Water + Sewer (AAA/AAA)
- Details: 5.25% coupon maturing 10/1/33 at $113
- First Call Date:10/1/19
- Yield to Worst: 2.62%
- Yield to Maturity: 4.24%
- Issuer/Rating: Massachusetts State GO (AA1/AA+)
- Details: 5% coupon maturing 12/1/38 at $110
- First Call Date:12/1/21
- Yield to Worst: 3.44%
- Yield to Maturity: 4.31%
Here is a chart comparing the muni yields with Treasuries of similar duration...
If called at the earliest date:
Bond / Call Date
Bond A - 2017
Bond B - 2019
Bond C - 2021
If the call option is never exercised:
Bond / Maturity
Bond A - 2030
Bond B - 2033
Bond C - 2038
Each scenario offers an advantage:
- If the bonds are called, you will have captured the higher yields and can then assess your reinvestment options in light of the prevailing environment.
- If held to maturity, you're "stuck" with taxable-equivalent yields of close to 6% for AA+ or better credits.
- And if you do decide to sell somewhere in-between, the selling price might be enhanced if the current spread ratios revert to their longer-term averages.
Have we found fixed-income Nirvana? No, not quite. But, all in all, this strategy should provide the conservative investor a bit more safety, a bit more yield and a cushion against rising rates.