Risky Munis

Marilyn Cohen, Forbes Magazine, 11.01.99

PEACE OF MIND IS NICE WHEN YOU BUY A BOND. Treasurys, of course, have Washington's limitless taxing power to back them up. Among municipal bonds, a number have taken to offering a guarantee called advanced refunding that is just as solid because Treasurys support them. At least these munis look safe on the surface. But they may be riskier than you would expect, so a sharp eye is necessary when buying.

With advanced refunding, the muni issuer sets aside Treasury or other federal securities in an escrow account to ensure timely semiannual interest, as well as principal paybacks. You are not relying on the credit quality of the issuer; you are relying on the sterling collateral provided by Uncle Sam. The county, hospital or city can go bankrupt and you will get your money.

The problem is that some of these munis can be called years early, which is a risk that many bond buyers don't look at. Last year the Gainesville, Fla. municipally owned utility--furnishing everything from electricity to water to sewerage--shocked the muni-bond community by moving to redeem three outstanding advanced-refunded bonds years before their maturity dates. The utility won the City Commission's approval to call the bonds, although it has not done so yet. Other muni issuers are following suit.

Can you imagine buying an 8% or 9% bond at a premium price of 120 or 130 and having it called at par? That is a painful loss. Relatively low interest rates in recent years are the cause. New muni bonds can be floated at a yield around 5% . Obviously, Gainesville would save a bundle if the utility issued new bonds at today's low rates and bought out the current holders. The three Gainesville Regional Utilities issues, which were escrowed in 1983 and are due in 2014, have been paying investors handsomely, between 6.5% and 9.3% .

Like the Gainesville issues, the bonds to worry about probably were advanced refunded before 1985, when rates were higher. Because most investors never see a bond issue's fine print, you may not have a clue of a potential explosion in your portfolio until the bonds are called. Moreover, if you hold bearer bonds, you won't know the bad news until you present your next coupons for payment. Sorry, there won't be one; only a redemption. That means you have gone six months without earning a nickel.

If you are in the market to buy an advanced-refunded issue, you can check out its redemption vulnerability. First, know that these munis come in two flavors: escrowed to maturity and prerefunded. Prerefunded means the bond can be called at a specific point a few years before the maturity date-say, in 2005 for a bond due in 2010. Escrowed to maturity simply means that there's no set call date. Regardless, either kind can be called right now in many cases.

The trick is to identify advanced-refunded bonds whose issuers have said they won't call. A good source for this information is the Bloomberg terminal's municipal bond description page. There, under Refunded Information, it may say "status of call provisions not addressed" or "optional call provisions may be exercised" or "status of call provisions unknown." Do not buy these issues. Or at least have your broker double-check by eyeing the bond indenture to see if the calls have been extinguished without Bloomberg's knowledge. If, on the other hand, the database's description page shows "original call provisions waived," you've got the green light to purchase the securities. See the accompanying table for a sample of advanced-refunded bonds that are safe from calls.

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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