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Municipal Bond Strategies
by Tim Bock (Write for us!)
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There are a number of municipal market inefficiencies that
can bring value to laddered municipal bond accounts relative to other account managers or mutual funds. Aggregating the cost/benefit of these inefficiencies can potentially add a significant amount of incremental yield to a municipal portfolio.
Secondary Market Bonds
While many believe new issue bonds and access to the new issue market are a very important part of muni bond investing, for individual investors and small- to mid-size money managers, this isn’t necessarily the case. In fact, secondary market bonds generally trade quite a bit cheaper than new issue bonds (10 to 30 basis points). By navigating the secondary market, investors are usually able to add considerable yield while sacrificing very little, if anything, in the way of efficiency.
Odd Lot Bonds
Most demand in the municipal market comes from institutions and large wire-house brokers. Because these firms are moving large sums of money, they typically will not buy bonds that are less than $100,000. Because demand is less for smaller pieces ($5,000 bond pieces to $100,000 bond pieces), we may be able to purchase these bonds 20 to 30 basis points (.2% to .3%) cheaper than institutions can buy the larger blocks. This is a great way for us for us to potentially add yield relative to bond funds or new issue bonds. It is counterintuitive, but smaller lot sizes are cheaper than larger ones.
High-Coupon (Premium) Bonds
Many individual investors do not understand bond arithmetic, so they will avoid bonds with high coupons that are trading at premiums. Also, trust managers tend to avoid premium bonds due to some limitations related to certain types of trusts. This lack of demand often allows us to pick up extra yield.
For example, say you were considering purchasing a new issue 10-year municipal that offered a yield to maturity of 4%. Say you were also offered a secondary market 10-year municipal that paid a coupon of 7%, significantly higher than the current ten-year rate of 4%. The market would not allow you to pay par (100) for that bond, as you would be getting a 7% YTM when current 10-year rates are only at 4%. You would therefore have to pay over par, about $124.5 ($1,245 per bond) to be exact. In other words, for a $10,000 face-value bond, you would have to pay $12,450. But in ten years, you will only be receiving $10,000 back. How can this be a good deal? The 7% coupon you are earning over the next ten years will make up for the $2,450 “loss” of principal. Due to the lack of demand for bonds like this from institutions, we could probably purchase the above bond closer to a 4.25% yield to maturity.
Zero-Coupon Bonds
Because most investors in the municipal marketplace require income to be generated from their portfolio, they do not want to hold zero coupon bonds. Zero coupons are bonds that are purchased at a discount (below par), and come due at 100. Thus, your return is coming completely from this discount “accretion.” Again, less demand means we often are able to buy them cheaply, potentially adding to the return in your portfolio. Zero coupons can have a place in portfolios even when income is the primary objective. When you combine zero coupons with high-premium bonds, you may be able to increase both the income and yield on the portfolio, as compared to a portfolio constructed with par bonds.
Callable Bonds and Sinking Funds
Some issuers of municipal bonds have retained the right to call a bond before its stated maturity date, either through a call provision or sinking fund (a partial, random call). If you were to have a portfolio that was built using all callable bonds, you wouldn’t have very much control over what was coming due and when (the chance that the lender will prepay or call the bond before it is due, giving you back your principal but depriving you of future interest payments is a risk factor). Because this is a risk to the investor, callable bonds can be purchased more cheaply than non-callable bonds. By mixing some into a portfolio, we can potentially add incremental yield.
Secondary Market Bonds
While many believe new issue bonds and access to the new issue market are a very important part of muni bond investing, for individual investors and small- to mid-size money managers, this isn’t necessarily the case. In fact, secondary market bonds generally trade quite a bit cheaper than new issue bonds (10 to 30 basis points). By navigating the secondary market, investors are usually able to add considerable yield while sacrificing very little, if anything, in the way of efficiency.
Odd Lot Bonds
Most demand in the municipal market comes from institutions and large wire-house brokers. Because these firms are moving large sums of money, they typically will not buy bonds that are less than $100,000. Because demand is less for smaller pieces ($5,000 bond pieces to $100,000 bond pieces), we may be able to purchase these bonds 20 to 30 basis points (.2% to .3%) cheaper than institutions can buy the larger blocks. This is a great way for us for us to potentially add yield relative to bond funds or new issue bonds. It is counterintuitive, but smaller lot sizes are cheaper than larger ones.
High-Coupon (Premium) Bonds
Many individual investors do not understand bond arithmetic, so they will avoid bonds with high coupons that are trading at premiums. Also, trust managers tend to avoid premium bonds due to some limitations related to certain types of trusts. This lack of demand often allows us to pick up extra yield.
For example, say you were considering purchasing a new issue 10-year municipal that offered a yield to maturity of 4%. Say you were also offered a secondary market 10-year municipal that paid a coupon of 7%, significantly higher than the current ten-year rate of 4%. The market would not allow you to pay par (100) for that bond, as you would be getting a 7% YTM when current 10-year rates are only at 4%. You would therefore have to pay over par, about $124.5 ($1,245 per bond) to be exact. In other words, for a $10,000 face-value bond, you would have to pay $12,450. But in ten years, you will only be receiving $10,000 back. How can this be a good deal? The 7% coupon you are earning over the next ten years will make up for the $2,450 “loss” of principal. Due to the lack of demand for bonds like this from institutions, we could probably purchase the above bond closer to a 4.25% yield to maturity.
Zero-Coupon Bonds
Because most investors in the municipal marketplace require income to be generated from their portfolio, they do not want to hold zero coupon bonds. Zero coupons are bonds that are purchased at a discount (below par), and come due at 100. Thus, your return is coming completely from this discount “accretion.” Again, less demand means we often are able to buy them cheaply, potentially adding to the return in your portfolio. Zero coupons can have a place in portfolios even when income is the primary objective. When you combine zero coupons with high-premium bonds, you may be able to increase both the income and yield on the portfolio, as compared to a portfolio constructed with par bonds.
Callable Bonds and Sinking Funds
Some issuers of municipal bonds have retained the right to call a bond before its stated maturity date, either through a call provision or sinking fund (a partial, random call). If you were to have a portfolio that was built using all callable bonds, you wouldn’t have very much control over what was coming due and when (the chance that the lender will prepay or call the bond before it is due, giving you back your principal but depriving you of future interest payments is a risk factor). Because this is a risk to the investor, callable bonds can be purchased more cheaply than non-callable bonds. By mixing some into a portfolio, we can potentially add incremental yield.
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