Cinderella Bonds

Marilyn Cohen, Forbes Magazine, 03.19.01

With corporate credit quality deteriorating faster than a speeding bullet, conservative investors are eager to buy bonds issued by solid companies. Once upon a time, utility bonds were safe for widows and orphans. Well, that was before deregulation. Now California's two largest utilities have dispelled that myth.

Finding safe industrial bonds is a job for Sherlock Holmes. Standard & Poor's gives only 10 industrial corporations an AAA rating and another 41 an AA. In the race to buy these bonds individual investors typically lose. In the real bond world, hedge funds, mutual funds, bank trust departments, public pension and endowment funds get first dibs.

So what's a risk-averse investor to do? Buy taxable municipal bonds.

Aren't munis supposed to be tax free? Not always. These oddball bonds grew out of tax reform in the 1980s, when the federal government banned municipalities from using their tax-exempt status to subsidize projects that do not benefit the public at large—such as sports stadiums. And there are plenty of taxable munis. More than $66 billion of them were issued in the past five years.

Interest rates are high because you owe federal income tax on the interest. However, you often are exempt from state and local tax if you live in the issuing state. That's why, for investors in high-state-tax brackets, taxable municipals are a better deal than corporate bonds of comparable credit quality. And they have a lower default rate than corporates.

The sweet part is that there are plenty of taxable munis rated AAA. And they out-yield AAA corporates by anywhere from 25 to 65 basis points (hundredths of a percentage point). I consider that AAA rating well deserved. Taxable munis are often insured or collateralized with certificates of deposit and some are even escrowed to maturity with U.S. governments—Treasurys, Fannie Maes, etc.

Where are all the small-investor fans? They are hard to find. Insurance companies, money managers and public pension funds are the primary owners.

The downside: Liquidity isn't terrific—spreads between bid and ask are wide. That's why these bonds are more suitable for buy-and-hold individual investors. And then there's the federal tax bill. So tuck them in an IRA if you can.

Taxable munis pay better than top-rated corporates. And they're less likely to default.

Taxable munis come in several stripes and colors. There are taxable revenue bonds (like those for a stadium, where gate receipts meet debt payments); lease revenues (private-sector occupants pay rent to the municipal owner); and also taxable general obligation bonds. There are even taxable municipal bonds issued to raise money for underfunded pension obligations. New Jersey, for example, came to market with such a bond. That's the sort of issue that Congress can't allow to be tax-exempt, lest states concoct outrageous arbitrage schemes.

Here are three taxable munis I like:

New York State Environmental Facilities 7.05%, nominally due Mar. 15, 2021 but prerefunded so that they will be paid off Mar. 15, 2008. These are 100% collateralized by U.S. government securities. They are federally taxable but exempt from New York State taxes. The bonds are priced at 105.4 to yield 6.27% to maturity in 2008. That's 123 basis points over Treasurys. Any New York resident in the highest bracket would have to get an additional 50 basis points from a corporate to equal the aftertax yield on this piece of paper. Trading is reported to the Municipal Securities Rule Board, and you can see the number of trades that took place and at what price for the previous day by going to www.investinginbonds.com.

Another is Chicago Illinois Tax Allocation 6.8% due Dec. 1, 2005—earmarked for economic improvements in the Chicago Loop. They're priced at 103.1 to yield 6% to maturity. These are Ambac insured. Unfortunately, they are state taxable even for Illinois residents. But look at that yield. It compares with the 4.8% you get on four-year Treasurys or the 5.4% on a AAA corporate.

The third is the Washington State general obligation 6% of 2010, priced at 98.3 to yield 6.25% to maturity.

Taxable munis long have been considered the ugly stepsisters to corporates. I think they have the pizzazz to become the Cinderellas of your portfolio. They're surely the best-kept secret in bondland.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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