Investors to Lose in Payoffs of Muni Bonds : Refinancing: Municipalities that issued a huge amount of debt in the early 1980s want to call in their bonds to reissue at lower interest rates.
Many municipal bond investors will have their bonds pulled out from under them this month.
About $9 billion to $11 billion of municipal bonds issued in the early 1980s are expected to be “called”--paid back before maturity--in January, industry experts say. That allows state and local government agencies to lower their borrowing costs by reissuing new bonds at lower interest rates. If the experts are right, this will be the second largest month ever for muni-bond calls, following a record set six months ago.
But for investors, the municipal bond refinancing boom is a bust.
Many of them have been enjoying double-digit interest rates on those for the last decade. They’ll not only lose those well-paying interest coupons, they will have to reinvest their principal at dramatically lower rates.
And because millions of investors are likely to be in the same boat, those who want to purchase other bonds are likely to see yields plummet further as demand for munis far exceeds supply, experts say.
Last July, when about $14 billion in muni bonds were called, setting a record, average bond yields dropped as much as 0.8 percentage points--the equivalent of $800 in annual interest payments on a $100,000 bond. That’s because an estimated 70% to 80% of the investors whose bonds were called immediately reinvested in munis, bond dealers say.
There were simply too many dollars chasing too few bonds, and prices--which go in the opposite direction of yields--soared as a result, said Peter B. Coffin, senior vice president and a portfolio manager at Massachusetts Financial Services, a mutual fund firm.
Much the same thing is expected to happen this month. And some experts believe that it could become a recurring theme every six months for the next several years.
That’s because a huge amount of debt was issued by municipalities in the early 1980s when interest rates were dramatically higher. Many of the issuers were barred from calling their bonds until 10 years after issuance. And those 10 years are now almost up.
About $77 billion in municipal bonds were issued in 1982 at average interest rates of 11.6%, according to L/G Research in San Francisco. The following year, $83 billion in bonds were sold at an average rate of 9.5%; $102 billion in bonds were issued in 1984 at 10.1%, and $204 billion were issued in 1985 at 9.1%, according to L/G.
The going rate for intermediate and long-term municipals now ranges from 4% to 7%, so government agencies are refinancing in droves.
Indeed, a substantial number of these old municipal bonds have been “pre-refunded,” which means that the issuer has already issued new bonds and is simply sitting on a horde of cash waiting to pay off holders of old bonds at the first possible date. Record bond calls are virtually assured for the next couple years as a result, said Craig Litman, principal at Litman Gregory & Co. and co-editor of the L/G No-Load Fund Analyst.
That leaves investors grappling with the sticky question of what to do with their money.
Many experts believe that the municipal bond market remains attractive because these bonds still offer relatively high after-tax yields. A 6% yield on a tax-exempt municipal is equivalent to an 8.3% yield on an after-tax investment, such as a bank certificate of deposit, for a person in the 28% federal tax bracket.
And for someone who lives in a high-tax state, such as California or New York, the attractiveness of a muni bond can be even higher. That’s because investors generally don’t have to pay state tax on interest earnings from their home-state munis.
“There are not a lot of other investments that you’d want to own that can generate an 8% or 9% return,” said Jim Lebenthal, chairman of Lebenthal & Co. in New York.
However, someone who has dropped tax brackets--possibly because of retirement or a layoff--may want to reconsider muni investments, Litman said.
