Advance Refunded Muni Bonds Can Cut Risk

High-income investors may be facing a Catch 22.

The prospect of higher tax rates under President-elect Bill Clinton makes tax-exempt municipal bonds attractive. But budget problems in many states and the prospect of rising inflation and interest rates makes long-term munis seem risky.

So what do you do if you’re a well-heeled investor who dislikes risk? Consider advance refunded municipal bonds.

In many respects, advance refunded bonds are just like any other. They are 20- to 40-year debt issued by a variety of finance authorities, school districts, redevelopment agencies, building and power authorities.

The bonds promised different yields and won various investment ratings when they were first sold. Most were issued in the mid-1980s and were expected to mature sometime next century.

What makes these tax-exempt bonds interesting today is that they all pay relatively high current rates of interest. So high, in fact, that the government agencies that issued them decided to refinance the debt.

The catch--for the government agencies--is that they can’t pay off the bonds until the first call date. And, in many cases, that’s several years away.

But what’s a problem for the issuer is an opportunity for investors.

That’s because a record number of issuers decided to refinance anyway to lock in today’s historically low interest rates. About $80 billion in new debt was sold in the first nine months of 1992 for the sole purpose of paying off old, higher-rate debt, according to the California Municipal Bond Advisor, a newsletter published in Palm Springs.

The government agencies couldn’t pay off bondholders, since they’re contractually obligated to wait until the first call date. So they bought U.S. government securities and placed these notes, bills and bonds in escrow to use in paying off bondholders at the first opportunity.

That makes “advance refunded” or “pre-refunded” bonds AAA credits, since they are now backed by the full faith and credit of the U.S. government rather than some small government agency.

These bonds pay high current interest rates--often 8% or 9%--so they sell for premium prices. A bond that will be worth $1,000 in 1995 might sell for $1,050 today, for example. That premium should make the bond’s yield to maturity equivalent to the going rate on a non-advance refunded bond.

But because investors tend to balk at paying premium prices for bonds, advance refunded issues usually deliver a slightly higher yield to maturity than other AAA bonds that mature at the same time.

Where a regular municipal bond maturing in four years might yield 4%, for example, an advance refunded bond should yield about 4.2%.

That’s a small difference, to be sure. But these bonds tend to be purchased in $50,000 to $100,000 lots, so that marginal boost equates to between $100 and $200 in additional annual interest payments. And in today’s investment environment, that’s nothing to sneeze at.

Short-term munis such as these make the most sense if both tax rates and interest rates rise between the time of purchase and payoff. If both of those things happen, you would get a relatively generous return with an advance refunded bond. For example, you’d have to earn between 5.1% and 5.6% on another investment, depending on your state and federal tax rates, to earn the same after-tax return as on a 4% municipal bond.

And you’d get your money back in time to invest in other higher-yielding alternatives when interest rates start heading up.

This is what the market expects to happen, because President-elect Clinton has already said he plans to hike top marginal tax rates to 36% for high-income individuals and families. He has also promised to spur the economy with a variety of jobs programs. And that should push up interest rates.

But trying to predict the future is always risky. And if these things don’t happen, you might be better off with other investments. If tax rates don’t rise, for example, the after-tax yield on high-quality corporate bonds may be richer than municipals.

Meanwhile, if interest rates stay the same or fall, you’d be much better off with longer-term bonds that yield more.