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Focus on yield when looking at premium bonds

Can you please explain why an investor won’t “overpay” or “pay a penalty” for premium bonds? Some investors seem to believe if you buy a municipal bond at 107, for example, they automatically are paying a 7% premium over a par bond right off the bat. Can you use bond price, coupon and yield to maturity to illustrate the comparison between premium and par bonds?
T.J., Florida
12/19/03

Mr. Klotz responds: The premium bond could be the most misunderstood security in the financial marketplace.

The premium bond derives its name from the fact that it sells for a price above 100.00 (par). Depending on the coupon rate, premium bonds can sell for as much as 110, 120, or even 130 cents on the dollar. This means an investor can pay as much as $130,000 for bonds that will be worth $100,000 at maturity.

You are correct in thinking that investors often have trouble with this concept. They have difficulty comprehending how a bond investment can return less money at maturity than was originally invested.

Most bonds trading at a premium today were probably issued at par or at a discount. They were issued, however, at a time when interest rates were higher. Instead of carrying coupon rates of 4.75% to 5.25%, as are being issued today, these bonds are paying 5.50%, 6.00%, 6.50% or more. Investors who have bought tax-free bonds over the last 10 years have bonds in their portfolio that now command a premium price even if they were purchased at 100.00. Since these older bonds are priced to approximate the current interest rate environment, 6% bonds would naturally sell at a higher price than the 5% bonds being issued today.

The most interesting aspect of premium bonds is that they usually provide the best value in the tax-free bond market. They invariably provide a greater yield to maturity than comparable quality, par or discount bonds. This makes them more defensive (less volatile) when interest rates are rising.

Their higher coupon rates generate greater cash flow, which can be reinvested while rates are rising. All bonds fall in value if interest rates rise, but the decline in a premium bond will be less severe. In the municipal bond market, premium bonds yield substantially more to maturity than other bonds of like quality and maturity. This is because the tax-free bond market is dominated by individual investors, rather than institutions.

Individuals are too often distracted by the dollar price of a bond, rather than focusing on yield. This causes them to shun premium bonds, which reduces demand for bonds with larger coupons. Like any other product or commodity, this softer demand lowers prices and subsequently causes the yield to maturity on these bonds to be as much as 50 basis points higher than for a similar discount or par bond. This yield advantage does not exist with corporate or treasury bonds because professional investors know that yield is the key factor when analyzing a bond investment.

Since the higher coupons on premium bonds make them more susceptible to being called prior to their maturity date, it is important that you know the dates that the bonds can be called. Your confirmation should show the "worst case" yield on the bond.

Finding the right premium bond is easy if you use the following rule of thumb: Make sure the yield to the call is higher than it would be if you bought a par bond that was maturing in that year.

For example, an insured par bond that is due in 2011 would yield approximately 3.25% in today's market. So if you are buying a premium bond that is callable in 2011, the yield to call should be at least 3.75%. The yield to maturity should also be higher than the yield available on a new issue maturing in the same year.

If you follow this rule, you are in a win-win situation. If your bond is called, you receive a higher return than if you bought a bond maturing in that year. If the bond is not called, your yield to maturity will be higher than bonds issued at the time of your purchase.

This is why purchasing a premium bond with a yield advantage to the call as well as to maturity will provide the best value in the tax-free bond market.

Keeping cities financially fit

In view of the downgrade to junk status of Pittsburgh, PA, muni bonds, will other major cities follow suit? Pittsburgh is a city with an aging population, corruption problems that those in political power have winked at, unfunded pensions etc., etc. The University of Pittsburgh and other "non profits" now exceed 30 percent of the taxable city space. Most don’t even pay for city services. Would you please discuss default rates, both historic and current? Has there ever been a book published about defaulting municipalities? Do you expect to see discounts of a very deep nature in Pittsburgh bonds and bonds of other shaky, aging rust belt areas?
F.C., Florida
10/24/03

Mr. Klotz responds:The historic default rates for general obligation bonds, like Pittsburgh's, have been extremely low. A municipal default risk study completed in 1999 by Fitch ratings noted that during the study period of 1979 to 1994, the total default rate for all municipals was 1.49% and for general obligations was a microscopic 0.44% (in terms of dollar volume). Defaults by major municipalities like Pittsburgh are rarer still.

Cities such as Bridgeport, CT, Washington, D.C., New York and Philadelphia have at one time or another been financially distressed, though none has defaulted on its long-term general obligation debt. In most cases, a financial oversight board is put in place by the state that has the power to levy additional taxes, which can be used to supplement any cash crisis, or be used to secure deficit bonds.

Philadelphia, another Pennsylvania city, went through this experience in the early 1990s. Over time, the state became very aggressive in providing financial assistance to its local governments. Act 47, also known as the "Financially Distressed Municipalities Act," empowers the Pennsylvania Department of Community and Economic Development to declare a community in financial distress and take strong actions to address the causes.

In Pittsburgh's case, the tools exist to help that city deal with the crisis at hand and the Commonwealth of Pennsylvania has a strong record of coming to the aid of its municipalities. Because it is in everyone's interest to make sure that Pittsburgh has long-term access to the municipal market, the likelihood of default is remote.

On "The Long and Expensive Wait"

The "Cost of Waiting" series presents compelling arguments. However, if I do want to keep some liquidity but still own bonds, what kind of shorter-term options do I have with FMS (besides maybe a bond fund)? If I have money to park from one year to three years, what are the choices you recommend for investors? I already own bond funds with other companies. I realize that interest rates may not go up very soon, but they can't go down much further. So an interest rate increase in the next one to three years will likely just send the value of the bond funds down. That's why I bought bonds, not bond funds, to begin with.
C.K., Wisconsin
10/22/03

Mr. Klotz responds: The majority of bond funds are longer term in nature. (Don't confuse the promise of liquidity with "short term.")

Funds that are truly short term will carry yields reflecting those on short-term tax-free bonds. We always recommend bonds over funds.

If you require ready access to short-term funds, for transactional purposes, you will probably be forced to sacrifice income for the "dollar in dollar out" accounting of money market funds.

On "Today's Lesson is Yesterday's News"

When reading your very interesting article, I was reminded about the "D" words - discipline and diversification. Although I have a few stocks in my portfolio, I am heavily weighted with tax-free munis. And while I have many different munis, would you conclude that my investments are too heavily weighted toward fixed-investments? I am 59 and have been retired for more than 10 years. My ratio of investments is about 4 to 1 in favor of insured, AAA-rated Missouri bonds. I emphasize insured and triple-A rated because I've already been caught up in the euphoria of the past bull market and have learned my lesson quite painfully. I do understand that in order to build wealth, one must venture out, be bold and take an educated chance. It is simply that I no longer want to take a chance and my tax-free investments allow us a good quality of life as well as capital remaining to invest - generally back into the bond market. My tax-free munis are spread all over Missouri and I really don't worry about them. But after reading your article, I'm wondering if you would feel that I'm adequately diversified. I have a wonderful, honest, bright young broker with FMS by the name of Mr. Michael DeStefano, whom I consider not only my broker, but also a friend, even though we have yet to be formally introduced in person. Thank you for your fine article.
R.F., Missouri
10/20/03

Mr. Klotz responds: Thank you for your kind words regarding Michael DeStefano. We are in agreement as to his ability and character.

My thoughts regarding diversification were directed toward investors who have forgotten the importance of maintaining a portion of their portfolio in fixed-income investments.

In regard to your personal asset allocation, it seems you have answered your own question. As a retiree, your investments should be heavily weighted toward high quality, fixed-income securities, particularly since your risk tolerance is lower and your investment income provides the quality of life you desire.

If you stick with AAA-insured bonds spread throughout Missouri, you are very well diversified.

Laddering and liquidity

I just read your arguments against laddering. I found your points interesting and persuasive, but you leave out one compelling reason to ladder: liquidity. In a rising interest rate environment, a long-term bond (20 to 30 years) obviously can fall dramatically in value. If an investor needs intermediate liquidity for a specific need, such as college tuition or a home purchase, and he sells in mid maturity, then he may realize a loss. Laddering allows investors to hedge against a rise interest rates, preserve safety of principal and create planned liquidity events. I do not own any munis and I am considering investing in a laddered CA Muni portfolio. I would appreciate your thoughts.
W.B., California
10/13/03

Mr. Klotz responds: We couldn't agree more. We have tried to make the point that our anti-laddering advice applies to investment funds only. One can only take advantage of the additional yield available on longer term bonds if constant market value is not a concern.

A couple of points to ponder: First, most people overestimate their need for short-term funds. Try to maximize your income on any excess capital. Second, you might want to investigate zero coupon munis for funding specific events, such as college tuition.

Colorado water bonds

Are you familiar with the Colorado ballot initiative regarding $4 billion ($2 billion plus $2 billion interest) for bonds to pay for water projects? The bonds are supposed to be paid fully by the beneficiaries of the water projects (unlike the federal taxpayer for all the water projects they've built throughout the west). If the bonds are defaulted on, the state is left holding the bag. I was wondering if this would have some potential effect on the state of Colorado's bond rating (the potential of having to pay off these bonds). Any thoughts? By the way, none of the water projects to be constructed under the bonds has been identified.
S.E., Washington, D.C.
10/9/03

Jay Abrams, Chief Municipal Credit Analyst, FMSbonds, Inc., responds: Thank you for your question regarding Referendum A on next month's ballot in Colorado. This proposal would allow the Colorado Water Conservation Board to borrow up to $2 billion for a number of unspecified water projects in the state. The limit for total repayment costs, including interest, would be $4 billion. Projects are expected to be self supporting, but it is possible that the state may guarantee repayment of the debt.

Issuance of bonds for multiple projects in one financing is a common approach state and local governments use to save costs rather than borrow for each project individually. A "blind" pool such as this one would require the water board to screen potential projects before they're allowed to go forward. The state of Colorado has very limited general obligation debt and does not carry an outstanding general obligation rating itself. Because the state's debt is so limited, it is hard to gauge the impact of any "make up" debt repayments on its debt profile. In all likelihood, should the state be called upon as guarantor, it would not be for all projects funded from this bond issue, only for any that had difficulty repaying its debt. Finally, an approach like this under consideration by Colorado's voters may allow the water board to better coordinate a number of projects to meet the overall needs of the state for new water sources -- an approach that might be very difficult if each project proceeded on its own, under differing project criteria and financing structures.

In summary, the state's proposal to issue a global bond issue for this purpose could affect its credit profile if it was called upon to make debt service payments for a substantial portion of a bond issue of this size, but such a likelihood could only be assessed upon review of the project projections, proposed debt service coverage and the actual financing structure behind both the bond issue and the projects in question.

More laddering...

Thank you for your insight into laddering and I agree with you. However, do you still think your approach is best now considering we are at historic lows for rates? And do you go out 30 years now?
D.P.
9/17/03

My colleagues don't agree with the article "Why laddering leaves you on the bottom rung." We think there are a lot of assumptions. First, you compare the 30-year bond to a portfolio that ladders out every three years to 10 years. We are not that stringent and have 20- and 25-year bonds mixed in with our laddered portfolios.

Second, you use a chart that shows interest rates continuously falling. If you believe they'll continue to go down for the next five or six years, you'd be correct, but I don't think either of us see that happening.

Third, you assume all muni bond investors have the same understanding of munis, are in the same tax bracket and have the same needs. Today, you can buy a AAA, 30-year muni and get 4.9 to 5%. We have a laddered diversified portfolio that is yielding nearly 4.5%, and as interest rates rise over the next five years, our client will be able to buy longer maturities with the matured bonds or use the interest they receive to buy long bonds. Of course, our client won't be taking money out of this account for two years, so every situation is different. If the client needed the income right now, we would probably have gone out further with at least some of the bonds. Please let me know your ideas on this.
T.J. (broker), Florida
9/17/03

Mr. Klotz responds: There are virtually limitless ways in which an individual municipal bond portfolio may be constructed. We certainly can’t address them all. Our attempt is to compare long-term bond investing with the “text book” laddered portfolio espoused “ad nauseum” in the financial press. This traditional ladder has maturities ranging from two to 10 years, provides 40% to 50% less income and has no call protection. We think this ladder is a bad idea.

The graph we provided in the article was taken from actual historical data of 30-year bond yields. Although we did not suggest that yields would always decline, the article was written in 1999 – and yields are lower today. The average income on a 10-year laddered portfolio has also declined over this period.

We are proponents of maximizing income on bond purchases because we can’t predict the future direction of interest rates. (Be honest, back in 1999, did you think bond yields would continue to decline?)

At FMSbonds.com, we do not “manage” bond portfolios. Since we are a bond specialist firm, our clients are generally “buy and hold” investors in the higher tax-brackets. Since they rarely have a need to sell their bonds, they have little concern for current market value or total return.

We consider the 20- to 25-year bonds you are buying to be long term, so we have no argument in that regard.

The only real difference we seem to have is with your statement, “If the client needed the income right now, we would have probably gone out further with at least some of the bonds.”

We don’t have any clients who don’t need the income. That’s why they buy bonds.

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