Locking In Higher Rates

Marilyn Cohen, Forbes Magazine, 10.15.01

Callable munis issued a few years ago should pay handsomely as maturities near.

Sooner or later the Fed is going to run out of room to cut interest rates. The cost of overnight money is down to 3%, and could maybe go to 2% as Alan Greenspan struggles to revive a very troubled economy. But the short-term rate cuts are having less and less effect on long bonds. The 30-year Treasury's yield to maturity is 5.6%, up from 5.3% in January. I think we are close to the point where bond yields overall are near a low and bond prices have peaked.

What to do if you think bond yields are going to drift sideways or slightly upwards over the next year? Be very cagey in acquiring longer maturities. I have a particular defensive play in mind for those of you buying tax-free bonds. Buy older long-term munis that are trading at a premium and are callable. If they do in fact get called away, you will get a decent yield. If they don't get called, your interest return will be even better.

Specifically, I think you should take a look at munis issued in the late 1980s through the mid-1990s, when coupons were higher. They trade at only modest premiums because they are approaching the end of their call protection, meaning that issuers could yank the bonds away fairly soon. The modest premium is key to the arithmetic of this investment.

First, some background. Callable munis generally yield 10 to 20 basis points (hundredths of a percentage point) more than do their noncallable cousins. You get paid for running the risk that the issuer will call your bond out from under you, paying off your principal and leaving you to scramble for something throwing off less interest income. Callables, however, usually give you a grace period of five to ten years before the issuer can get them back.

After that period elapses, you face a series of call dates, typically one per year. The two bonds that I recommend here all are close to the end of their call protection. If you buy them now, they're priced with the expectation that they will be yanked away at the worst call date--that is, the date with the lowest yield. If, on the other hand, the bond is called later (or never), you wind up with a yield that is much better than you bargained for, because your premium is buying you more years of high coupons. That kick-up in yield gives these premium bonds their name, "kickers."

Most of the time you should be in noncallable bonds, known as "bullets." With those, you enjoy the full benefit of a decline in interest rates. But now is not the time to buy bullets, which will suffer price declines with any rise in interest rates. This is the time to buy kickers.

The uncertainty in these babies is the date the bond will ultimately be called; that's always up to the issuer. But even if kickers are called on their worst call date, you can get a yield that comfortably beats that of a comparable bullet bond.

Take St. Petersburg, Fla. Excise Tax revenue bonds, 5.15% due October 2013, which are AAA-rated since they are insured by FGIC, a General Electric Capital unit. Recently they traded at $104.10 per $100 of face value, producing a 3.5% yield to the worst call, October 2003. Meanwhile, AAA noncallable munis of that maturity yielded only 2.6%, or 90 basis points less.

Let's say interest rates rise over the next several years and St. Petersburg does not refinance its bonds. And let's say the bonds aren't called until their 2013 maturity. Then the yield kicks up to 4.7%. That's 40 basis points better than yields on comparable AAA 12-year insured bonds.

Too good to be true? Well, there is a subtle cost in a bond like this, in which the issuer, not the bondholder, controls the maturity of the investment. It has to do with the lopsided interest rate bet being made. If rates go way up, the issuer will leave the 5.15% bond outstanding and you will see the value of the bond go down, just like the holder of a 12-year noncallable. If rates go way down, on the other hand, you will not enjoy a mirror-image price appreciation. The bond will definitely be called.

But the owner of a kicker can come out ahead if rates go sideways or drift up just a bit. That's my prediction.

Another example is Mississippi Singing River Hospital System Revenue bonds with a 5.4% coupon due March 2008. Although I dislike the credit risk of hospital bonds, these are insured and both Standard ' Poor's and Moody's give these ones their top ratings. At $104.90, the yield to worst call recently was 3.25% in 2003; if they last until their 2008 maturity, the yield kicks up to 4.5%, or 50 basis points higher than comparable seven-year hospital paper.

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.

Back to Top