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Summary

  • 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:

Bond A

  • 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%

Bond B

  • 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%

Bond C

  • 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

Muni

Yield

Taxable

Equivalent

(at 28%)

Treasury

Yield

Spread

Bond A - 2017

2.00%

2.78%

0.95%

183 bps

Bond B - 2019

2.62%

3.64%

1.70%

194 bps

Bond C - 2021

3.44%

4.78%

2.20%

258 bps

If the call option is never exercised:

Bond / Maturity

Muni

Yield

Taxable

Equivalent

(at 28%)

Treasury

Yield

Spread

Bond A - 2030

4.14%

5.75%

3.10%

265 bps

Bond B - 2033

4.24%

5.89%

3.25%

264 bps

Bond C - 2038

4.31%

5.99%

3.40%

259 bps

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.

Source: Waiting For The Call: Muni Bonds For Safety And Yield, With A Sweet Little Kicker To Boot