| Bonds Online |
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| 5/10/2013Market Performance |
| Municipal Bonds |
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S&P National Bond Index
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3.00% |
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S&P California Bond Index
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2.96% |
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S&P New York Bond Index
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3.13% |
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S&P National 0-5 Year Municipal Bond Index
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0.70% |
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| S&P/BGCantor US Treasury Bond |
400.09 |
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| Income Equities: |
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| Preferred Stocks |
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S&P U.S. Preferred Stock Index
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848.03 |
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S&P U.S. Preferred Stock Index (CAD)
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636.26 |
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S&P U.S. Preferred Stock Index (TR)
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1,701.05 |
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S&P U.S. Preferred Stock Index (TR) (CAD)
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1,276.26 |
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| REITs |
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S&P REIT Index
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174.07 |
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S&P REIT Index (TR)
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425.30 |
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| MLPs |
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S&P MLP Index
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2,469.58 |
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S&P MLP Index (TR)
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5,428.50 |
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See Data
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Pre-empt deflation with pre-refunded muni bonds
Commentary: Unique Treasury-backed debt eases investment concerns |
| LOS ANGELES (MarketWatch) -- The current economic environment rests on thin ice, especially with growing investor concern about the possibility of deflation and its devastating effects. Smart bond investors should consider strategies to pre-empt deflation in order to avoid investment losses down the road.
As evidenced in Japan during the 1990s, deflation creates economic and financial hardships. Consumer and corporate buying grinds to a halt, motivated by the prospect that costs that will decrease in the future. Corporations lose pricing power, profit margins thin, bankruptcies increase, and unemployment soars. Borrowers, be they corporate, government, or municipal, get squeezed as the real value of their debt obligations rises.
During such times, it is essential that investors exclusively focus on highly secure investments. Traditionally, that has meant Treasurys, the safest investment around. But that market has become much too overheated, and Treasury yields are now far too miniscule.
Alternatives need to be considered. The municipal-bond market has been battered as the sinking economy has sapped state and local government tax revenues. Even top-quality muni bonds now sport yields several percentage points above comparable Treasurys on an after-tax basis.
No state has ever defaulted on its debt, but muni-bond investors who fear that possibility can take a look at so-called pre-refunded municipal bonds.
"Pre-re" bonds, as they're known, are an ideal substitute to Treasurys and have greater yields.
Moreover, pre-re's are tax advantaged and many have stellar credit quality because they are in fact backed by Treasurys. Why accept a five-year Treasury yielding just 1.50% when a pre-re with the same maturity yields 25%-50% more, tax free?
Pre-refunded bonds are created when a municipality refinances high-cost debt, but at a time before that debt can be called. The municipality will sell new, lower coupon bonds, and use the proceeds to fund a trustee-administered escrow account, usually consisting entirely of Treasurys.
Once a bond is pre-refunded, the only relevant date is the pre-re date. The pre-re date is definite and is the new maturity date.
The sole purpose of the escrow account is to insure adequate funds to repay the original debt. In so doing, the original bonds are no longer the obligation of the issuing municipality, but rather, are secured by the escrow account consisting of Treasurys.
More expensive
Compared to other municipal bonds, however, pre-refunded munis are definitely more expensive. This has been especially the case over the past few months due to investors' high demand for safety. Yields are typically 10% to 20% lower than comparable maturity general-obligation munis.
But in exchange for giving up yield, you receive pristine quality and safety. And if your investment goal is to challenge deflation, locking in Treasury backed pre-re bonds is a smart decision.
It's important to do your homework when choosing pre-refunded issues. Some are backed by agencies like Fannie Mae and Freddie Mac, rather than Treasurys. Agency-backed pre-re's are not quite as safe, so be careful -- be sure to read the fine print.
Here are two pre-refunded bonds to consider:
First, a Sacramento, Calif. Flood Control issue with a 5% coupon with previous maturity of Oct. 2021, but that now will refund/mature Oct. 2015 (Cusip #785840CS6).
This bond's recent yield of 2.10% might not knock your socks off, but that's 0.45 percentage points higher than the similar maturity Treasury. It's also tax-free and fully backed by Treasurys.
Another attractive Treasury-backed issue is a New York City General Obligation bond with a coupon of 5.375% previously maturing March 2027 but now refunding in March 2013 (Cusip #64966F4N1).
The bond's 1.75% yield is 0.60 percentage points above its corresponding maturity Treasury with the same minimal risk. Plus, it is city, state, and federally tax exempt for New York City residents.
Corporate-bond concerns
Corporations and their bonds also can struggle during deflation. In general, profits get squeezed, cash flow shrinks, and debt repayment becomes more costly in real terms.
These factors sometimes hinder a company's ability to pay bondholders. However, corporate bonds are a bargain buy currently compared to Treasurys.
Sstick with the highest-quality issues. Focus on producers of essential goods with good balance sheets and strong franchises. Companies like Kraft Foods Inc., Altria Group Inc., and Johnson & Johnson are examples.
Here are two attractive corporate-bond bargains that should weather the storm in good shape.
1. Altria (MO:
![]() 16.65, -0.31, -1.8%) bonds with a 9.7% coupon, due in Nov. 2018, recently yielded 8.26% (Cusip #02209SAD5). If you are comfortable with an investment in a tobacco company, this is a good bond to buy. A yield of 8.26% is 5.88 percentage points higher than a similar maturity Treasury. Plus it pays out huge semi-annual coupons.
2. Kraft (KFT:
![]() 28.15, -0.76, -2.6%) bonds with a 6.75% coupon, due in Feb. 2014, yield 5.17% (Cusip #50075NAX2). With solid brands like Maxwell House, Philadelphia, and Oscar Meyer, it's a good bet this company will remain strong through the credit crisis. This bond yields 3.9 percentage points over a similar maturity Treasury.
A high-grade corporate bond mutual-fund is also a sound alternative. Bond funds require lower minimum investments, provide excellent diversification, and have professional management.
One that is particularly appealing is the Vanguard Intermediate-Term Investment Grade Fund (VFICX:
![]() 8.65, -0.02, -0.2%) . This portfolio invests in high quality fixed-income investments, including a majority of high-quality corporate bonds from companies such as General Electric Co., McDonald's Corp., and Berkshire Hathaway Inc. But the two best things about the Vanguard fund are its low management fee and nice yield -- it charges about half of what most rival funds charge and yields almost 6%.
Alexander Anderson, Jr. is a portfolio manager at Envision Capital Management, a Los Angeles-based investment management firm
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