DowJones.com, MAY 13, 2009
While the turmoil in the credit markets has scarred many investors, it has also created an opportunity for bond buyers to snap up offerings with healthy yields that eventually could be backed by Treasurys.
The phenomenon is a regular but a little-known part of the bond world that is attracting increased attention: municipal bonds ripe for refunding.
As part of a refunding, a state or county, for example, issues a bond at a lower rate to effectively retire a bond that was issued earlier at a higher rate. Typically, municipalities will spend the cash raised by the new issue on Treasurys or other government debt, and at a certain date use those securities to retire the older bond.
Refundings hold appeal for investors for at least three reasons: using Treasurys or agency debt means the original bond in essence becomes backed by the federal government - but with a higher yield than Treasurys, and when the issuer does cash the bond, the holder has enjoyed a longer-duration yield for a shorter amount of time.
These two facts also mean that prices for pre-refunded bonds inevitably rise.
"These are really good bonds to own because they're defensive," said Kathy Stylarek, senior portfolio manager at Huntington Funds, who runs several state muni-funds. "But they're harder to find because everyone's focusing on them right now."
Demand And Performance
Buying interest for these bonds is higher than at any time since the early 1990s, she said.
"The market has been in pretty serious disarray in the past six months and issuers have had to pay fairly high rates," added Cynthia Clemson, co-director of municipal investments at Eaton Vance Corp. (EV). Those issues have a better chance of being refunded once the market settles down, she said.
Ron Schwartz, manager of Ridgeworth Investment Grade Tax Exempt Bond Fund (STTBX), agreed the market is set up nicely for refundings.
"We're buying a lot of bonds we like, but in particular we're buying [issues that are candidates for] refundings," said Schwartz.
A municipality refunding is similar to a consumer refinancing their mortgage - the aim is to pay off a higher-interest loan with a lower interest loan. When a new bond is issued, the money raised is used to buy Treasurys or similar government-backed bonds and held in an escrow account or trust - enough to pay or even exceed required payments.
At this stage the older bond is known as pre-refunded - it's still technically a muni bond with its stated tax-free yield. But because of the government debt in the background, it's now a Treasury-backed bond.
Longer-term munis typically have call dates - which give the issuer the right to redeem the bond prior to maturity. The Treasurys would be used to retire the older bond at its call date.
A likely candidate for a refunding, Schwartz said, would be a muni bond that has issued 30-year debt at between 5.5% and 6.5% and features a 10-year call.
As the credit markets improve, top-rated municipalities can expect to issue 30-year debt at lower rates. The 10-year call provides a window for the issuer to buy out the bond ahead of its maturity.
Stylarek said that based on certain calculations, bonds may be called in at a premium - meaning that the bond holder is paid more for the bond than its face value.
Added Schwartz: "They're still high quality debt, still good bonds, but they have an advantage to them."
And while Clemson said there aren't as many refunding candidates among new issues nowadays, the market certainly hasn't dried up.
"The opportunities have lessened," she said, but there are still bonds available.
