EnvisionCap.com: Forbes Article

The Beloved 5% Muni

Marilyn Cohen, Forbes Magazine, 11.12.07

MOST INVESTORS HAVE MAGIC NUMBERS ON WHICH THEY RELY. Some are looking for a certain threshold price/earnings ratio, dividend yield, interest coverage or percentage yield over Treasurys. Municipal bond investors perceive their magic yield as 5%.

That sterling number is hard to find. Until recently, and briefly, it had been five years since long-term munis yielded 5%. We reached that level for a few days in August during the bond market meltdown. Even though municipalities (governments, that is, as opposed to entities borrowing against a nontax revenue stream) are more reliable as borrowers than the average corporation, the selloff hit munis, too.

When the selling panic was intense, traditional muni holders like insurers added to the frenzy because they needed to raise cash so their portfolios, which are marked to market, wouldn't be hurt even more. Municipal arbitrage funds, and hedge funds in particular, were tossing bonds out with geyserlike force. Panic at seeing the bond values drop was one reason: Sell them before they fall more. Another reason was meeting redemptions from panicked investors.

At the height of the selling tumult 25- to 30-year long-term municipal bonds yielded 5%, more than the yield on long-term Treasurys. That muni yield translated to a taxable equivalent of 7.7% (assuming you're at the highest federal bracket).

If you blinked, though, the opportunity vanished. Now saner minds prevail, prices are back up and yields are down to the neighborhood of 4.5%. No longer is earning 5% on a long-term muni possible.

The exception: zero coupon bonds, which don't pay you your interest until maturity, so they have more rate risk built into them. In return, issuers need to entice buyers with slightly higher interest rates.

These bonds are sold at a discount, the interest accumulates beyond your reach during the bond's life, and they are redeemed at face value. Since they are munis, you are not taxed for the "imputed" interest that is building up in the interim, which is the fate of investors owning taxable zeros. The rate risk, it must be confessed, works against you. If rates shoot up, you are stuck with a low yield for many years. If rates collapse and the bond is callable, the issuer can cancel the deal by calling it in early; typically at only a modest premium to its accreted value.

Given that you might not see cash out of the bond for 20 or 30 years, you should lend only to borrowers you trust. Insist that the issuer have at least a single-a rating on its own, apart from any credit enhancement coming from an insurance company. Steer away from special-purpose bonds for things like stadiums and airport terminals. Water and sewer pipes provide essential services and can be trusted.

If you live in California or a state without an income tax, buy the Yuba California Community College District zero due Aug. 1, 2033. These are general obligation bonds, Ambac-insured, boosting them to AAA ratings. The underlying credit is rated a all on its own. The source of payment is property taxes. Selling at 27 cents on the dollar, the bonds are priced to yield 5.2% to maturity and, if called Aug. 1, 2017, would give you 5.55%.

Another buy is the Whitehouse Texas Independent School District zero due Feb. 15, 2028. Priced at 36, the bond yields 5.1% to maturity and 5.54% to its 2017 call. This general obligation issue has the Texas Permanent School Fund guarantee, which gives it an AAA rating. It also is undergirded by a property tax.

Comparison shop. If you buy bonds in the secondary market, refer to the Securities Industry & Financial Markets Association Web site. Another help is www.investinginbonds.com, for recent prices on municipal and corporate bonds. You would never buy a stock without getting a quote beforehand. So when buying municipals, ask for the Cusip number that identifies a bond. Pop the number into the space provided in the Web site and see where the bonds previously traded. You'll see both retail and institutional trades, giving you a good idea of the best purchase or sale price. It's not perfect transparency, but it shows you the transactions that have taken place.

And ignorance can be costly. In early September one investor didn't check the Web site for previous trades. If he had, he would have known not to sell his $50,000 Illinois State, AA-rated general obligation bonds due in 2016 at 98 through a brokerage firm. Two days earlier they traded at 108.

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.