How to Respond When Muni Bonds Are ‘Called’
If you own municipal bonds, watch out. You may be in for some rude shocks in the next two to four years, as many bonds you thought would pay you juicy yields for years may be “called” away from you.
If you don’t act, you may lose interest earnings or be subject to an unwanted tax liability.
Analysts expect a record amount of municipal bonds--as many as one out of every three outstanding issues--may be called in the next four years.
Basically, a bond is called when the municipality that issued it decides to redeem it--to buy it back at a preset price--before it reaches maturity. Issuers put this contingency in their bond agreements, allowing for the possibility of interest rates falling so low that they can float new bonds paying lower interest rates. That saves them money. Usually, issuers put in provisions allowing them to call bonds after seven to 10 years.
Thus, even though you may think your bond expires past the year 2000, it may really expire next year if it’s called. And if you own muni bonds through unit trusts--packages of bonds sold to investors in units of $1,000 or $5,000--part of your capital will be returned to you and the yield on the remaining investment will fall.
Bonds most susceptible to being called will be those issued in the early 1980s, most at rates exceeding 8%, says C. Richard Lehmann, president of the Bond Investors Assn., a nonprofit organization based in Miami. Since municipal bonds issued today yield only 6% to 7%, it pays for the issuers to call those old bonds. Many municipalities have already decided to do so by floating new bonds to replace them through a process dubbed “advance refunding.”
Many corporate bonds also are expected to be called, but this may be less of a concern to you because individual investors tend not to hold corporate bonds directly.
The prospect of a flood of bond calls is great news for Wall Street brokerages. They will earn sales commissions from investors seeking to reinvest money they receive when bonds are called. And they’ll reap more profits from underwriting an expected flood of new issues, reviving an otherwise laggard market for new bond offerings.
But for you, the bondholder, calls are bad news. First, you generally won’t be able to reinvest in new bonds or unit trusts with yields as high as your old bonds carried.
Second, it could be a hassle. If you happen to hold so-called bearer bonds that are unregistered with the bond trustee, you could lose interest earnings. That would happen if your bonds are called and you don’t know about it. You’ll wait six months to find out your interest coupons are no longer honored, and you’ll lose the use of your money to earn interest in the meantime.
Third, you could face unwanted tax implications. If you bought bonds when originally issued, and thus paid face value, you may be subject to unwanted capital gains taxes. That’s because bonds generally are called at a premium above the issue price (usually about 2% to 3% higher).
However, if you bought already issued bonds, you may have paid a premium for them far above the face value. Then you may face capital losses.
Here are some tips on how to cope with calls of your bonds:
- Review your portfolio. Find the first call dates and call prices as well as the current market value of your bonds. Call provisions should be on your bond certificate. Or call your broker or bond trustee.
- Determine if you should sell now. You might want to sell if you think interest rates will fall further in the next few years. Thus, you can reinvest your money now at current yields. You also might want to sell now if you expect to earn capital gains through the calls and also have capital losses from other investments. You can use those losses to offset the gains for tax purposes.
But keep in mind that if you sell now, most likely you will pay a sales commission. Waiting until your bond is called generally will allow you to avoid charges.
- Make certain that you don’t miss a call. If you have bearer bonds, consider registering them, suggests Zane B. Mann, publisher of the California Municipal Bond Advisor, a Palm Springs newsletter. That way you will be notified immediately.
As an additional precaution, you can register with the Bond Investors Assn. at 15327 N.W. 60th Ave., No. 240, Miami Lakes, Fla. 33014. For $1 per bond issue, they will notify you if your issues are called.
- Start thinking about how you will reinvest. If the idea of calls revolts you, consider buying Treasury securities. They cannot be called.
What if you own bonds through mutual funds or unit trusts? There’s not much you can or need to do, says Ralph G. Norton, editor of Muni Bond Fund Report, a Huntington Beach newsletter. However, mutual funds offer the least hassle: They will handle the calls and reinvest your money for you.
Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
