David‘s September Bond Market Update
Good Day to All:
As interest rates continue to rise, we are seeing attractive investment opportunities in municipal bonds. In addition to potentially being double tax-free, certain municipal bonds are ‘pre-refunded,’ which is a process a bond issuer can take to lower their interest expense. Conceptually similar to when a homeowner refinances their mortgage. This process also ensures there is capital (collateral) already on hand, set aside in an escrow account, to pay bond holders on the pre-refunded date. For a California investor subject to the highest effective tax rate (approximately 54%) the implications are as follows:
Assuming the “pre-re” is 100% collateralized with U.S. treasuries, the credit quality of the pre-re would be similar to that of a U.S. treasury. Not ALL pre-re’s are collateralized with U.S. treasuries but most are. When thinking about buying a pre-re, be sure to ask your advisor to provide you with the collateral details. That information is easily available.
At a tax-free yield of 2.50% the taxable equivalent yield would be approximately 5.43% based on 2.50%/(1 – 0.46%).
As of this writing, the yield on the 2 year U.S. treasury is approximately 4.12%. Using the example above, the taxable equivalent yield of the pre-refunded bond looks more compelling than the U.S. treasury note with the same maturity.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal securities typically provide a lower yield than comparably rated taxable investments in consideration of their tax-advantaged status. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes. Please consult an income tax professional to assess the impact of holding such securities on your tax liability.