Maybe Not So Boring

Marilyn Cohen, Forbes Magazine, 05.08.06

Through hurricanes, floods, tornadoes and 15 consecutive hikes in short-term interest rates, munis have remained rock-solid investments. Their coupons are free of federal tax and, if from your home state, usually free of state tax, too. Their 10-year cumulative default rate is tiny, only 0.04%, according to Moody's. The muni market is large, with $2.25 trillion of outstanding debt, so plenty of choices exist.

Munis are boring. They are too steady for the volatility-loving hedge fund crowd--to which I say: Amen.

Many carry safeguards. A lot of them are insured. Others are backed by stashes of Treasury bonds or kindred federal obligations; that's called being "escrowed to maturity" in bond-speak. Still other munis are guaranteed with letters of credit from large banks.

Munis are especially attractive now that corporates are becoming less creditworthy as the companies borrow willy-nilly to buy back their stock. Too many corporates are degenerating into junk (see my Mar. 13 column). Munis, when you factor in their tax-free advantage, can give you yields that beat those on investment-grade corporates, whose interest payments, of course, are taxable.

The sweet spot for municipal bonds right now is in the 10- to 14-year maturity range. It's not worthwhile to go out an extra 10 years, because if you are lucky you will earn only four-tenths of a percentage point in incremental yield.

My favorite munis are those that have been refunded, meaning the issuer replaces an old batch of munis with newer ones paying lower coupons. Cash from the newer bonds is invested in Treasurys deposited into an escrow account. When the first bonds mature (or can be called), the Treasurys are cashed in and used to pay off those bonds.

Since interest rates are on the way up, we aren't seeing refundings anymore, but there are ample numbers of such bonds refunded a couple of years back that are available in the secondary market. If an issuer defaults, the Treasurys in the escrow account will make investors whole. This is like buying a tax-free Treasury, which of course is default-proof.

One tip: When buying a refunded muni, make certain you know when the old bonds can be called. Find out what the yield is to the various call dates. Also consider the possibility that, if interest rates rise, the bond will not be called, and you will be stuck with it for longer than you expected.

A refunded muni I like is the New York Metropolitan Transportation Authority 5.125s maturing July 1, 2014. These were issued in 1998. In 2002 the agency issued another round of bonds at a lower interest rate, using proceeds to buy U.S. Treasury paper. The MTA says it will retire the old bonds at their first call date in 2012. Should, God forbid, a terrorist attack devastate the New York subway system, MTA bonds backed only by the agency's revenue, which is most of them, would collapse and their holders would be out of luck. The refunded securities would be paid off.

Today these bonds are priced at 106.2 cents on the dollar and yield 3.9% to maturity. That's a handsome yield for someone in a 35% federal tax bracket. It's equivalent to a taxable yield of 6%. To match that yield on the corporate side, you'd have to invest in near-junk preferreds or bonds.

My second-favorite munis are water and sewer revenue bonds. These are essential services, which nobody wants to see slighted. In the Dallas suburbs, Garland Water & Sewer Revenue 4.5s of Mar. 1, 2019, priced at 100.95, yield 4.36% to the worst call date of Mar. 1, 2014, with a 4.4% yield to maturity.

Ambac insures these bonds, which gives them a AAA rating; without the insurance, they would be AA-. If you are in the highest tax bracket of 35%, you would have to buy a corporate bond yielding 6.7% to match that yield, which is doable only with a near-junk BBB corporate.

I also like the Berkeley County Water & Sewer Revenue 5s of June 1, 2018, priced at 106.35 for a 4.16% yield to worst call in 2015 and 4.32% to 2018 maturity. These South Carolina bonds are AAA-rated by dint of insurance from Financial Security Assurance.

As with other investments, diversity is important here. Buy revenue, general obligation, special tax and sales tax obligations. And also diversify your secondary source of repayment. That is, buy bonds insured by Ambac, FSA, FGIC and MBIA and don't forget escrowed issues.

Shy away from the smaller municipal insurers; they are not as well capitalized.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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