Shoot Par With Muni Housing Bonds

by: Alexander Anderson
Summary

Generating extra yield in the municipal bond market is easier than you think.

Hiding in plain sight, municipal housing bonds offer an edge.

Plus, do-it-yourself investors have first dibs.

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Today's tax-free investors hunting for yield face the same intimidation as their most feared golf course. Picking up extra yield is no easy task. New tax laws have driven investors into tax-frees, especially those in high tax states where state and local tax deductions are no longer an option. This surge in the popularity of municipal bonds has reduced supply and tanked yields.

If your search for tax-free income has been stuck in the bunker, fear not. There's a relatively unknown sector of the muni market that offers extra yield. Tax-free state housing bonds issued at par offer a great investment opportunity with extra yield and low risk. They are a safe and stable alternative to municipal ETFs and mutual funds. Funds carry "redemption risk," meaning they will lose value during periods of large outflows. Tax-free state housing bonds don't suffer from this.

State-issued housing bonds raise money to finance low-cost mortgages for homebuyers. Most bond issues are made up thousands of government guaranteed (GNMA/FNMA) pooled home mortgages. That's why they are highly rated and low risk for those hunting safe tax-free income.

So, the obvious question is: why the extra yield versus other similar quality municipal bonds? The answer is that mortgages can be prepaid, which can allow portions of the bond issuance to be extinguished prior to maturity. In other words, the bonds can be redeemed early at par value ($1,000). This can occur at any time and on short notice. Because of this redemption uncertainty, the bonds are offered with extra yield versus other similar rated municipals. For the tolerable risk of early redemption, you are paid handsomely versus the typical water/sewer, general obligation, or airport municipal bond.

Below are two examples showing housing bonds as alternative to your typical municipal issuer. First, we compare two similar recent new issues: a Washington, D.C., Airport Revenue bond and a Tennessee Housing bond. Here's how the yields sized up:

TN HOUSING

DC AIRPORT

BASIS POINT

(Aa1/AA+)

(Aa3/AA-)

PICKUP W/HOUSING

1 YEAR

1.45%

1.37%

+8

3 YEAR

1.65%

1.41%

+24

5 YEAR

1.80%

1.47%

+33

10 YEAR

2.35%

1.81%

+54

Notice how the Housing Bonds yield rise over the airport bonds the farther out on the yield curve. Clearly, Housing Bonds offer more bang for the buck.

Housing bonds also benefit those in high tax states where municipal yields are particularly low and the need for tax savings is high. New York municipals offer some of the lowest yields in the country due to the high tax rates. Since every basis point matters in Bondland, it's apparent that this New York Housing deal beats the socks off the national alternative.

NY HOUSING

TUCSON WATER

BASIS POINT

(Aa2/AA+)

(AA)

PICKUP W/HOUSING

2 YEAR

1.40%

1.39%

+1

3 YEAR

1.50%

1.41%

+9

5 YEAR

1.65%

1.46%

+19

10 YEAR

2.30%

1.86%

+44

Risks

Price Risk: This is the most significant hazard with housing bonds. Never pay above par. Housing bonds are frequently called early at par ($1,000). If you pay a premium (over $1,000) and the bonds get called at $1,000, you will lose that premium and suffer a loss.

Interest Rate Risk: Forecasting how these types of bonds will perform is straight forward. If interest rates decline with the economic slowdown continuing to take shape, tax-free housing bonds will appreciate. On the other hand, if rates unexpectedly go up, these bonds will likely go down but will still outperform tax-free ETFs and mutual funds reeling from outflows. With rising rates, the early redemption provisions on housings provide opportunity for reinvestment in a higher and more attractive yield environment.

Paydown Risk: Because portions of municipal housing issues can be redeemed early, there is risk that most of your bonds are called leaving only a small amount remaining. A reduced position size of $5000 or $10000 will be harder to sell.

Credit Risk: These bonds are very safe but reflect the general creditworthiness of the states they are issued by. States that are highly reliant on one industry (e.g., Alaska-Oil) carry more risk. Therefore, we recommend states with diverse revenue sources.

The easiest way to acquire housing bonds is when they are newly issued at par. New issues come frequently and are offered by most states. Orders from retail investors get priority, particularly if you are a resident in the state of issue. Individual investors can buy or sell Housing Municipal bonds with the help of a broker/dealer or asset manager. They are not offered on the stock exchanges or in any kind of trading vehicle.

Actionable Steps for Individual Investors to Buy Housing Municipal Bonds

Search the new issue calendar for housing deals coming to market. The calendar may seem voluminous, but a careful search will likely yield a number of housing deals. This website lists the upcoming calendar of new issues. Alternatively, brokerage companies like Fidelity can get you setup to receive email alerts when new issues are occurring. They also post new issues they are involved in on their website.

Next, contact your broker or asset manager and let them know which housing deal interests you. They should provide you with a scale listing the yields for the various maturity dates.

Then, submit an order for the maturity date/yield you desire during the retail order period. This order period is specifically set aside for individual investors and makes sure they have a fair shake at getting bonds versus the institutions. The retail orders have the highest priority to receive bonds. You will be notified about your allocation in one to two days.

Individual investors can also buy housing bonds in the secondary market with just a point and click on a financial institution's website. Unfortunately, most secondary housing offers are above par ($1,000), so we don't recommend it.

Newly issued municipal housing bonds priced at par are a great portfolio addition in a low yield environment. They offer juicy yields versus other tax-frees. They are a simple alternative to maneuvering the muni bond market without ending up in the rough.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Alexander Anderson and Envision Capital Management are not a broker/dealers, and therefore do not sell bonds. However, they are registered investment advisers and will buy and monitor fixed-income securities on behalf of their clients in managed accounts.