Municipal Bond Forum
The value in pre-refundings
Q
I think we were able to understand the process you describe in the article, “The Upside of Lower Rates.” However, we had some difficulty with the concept of replacing the bonds with higher- yielding bonds that are not sub par. Does it make sense to sell the portfolio while the bonds are at a higher value? Can the sale of pre-refunded bonds be replaced with safe bond investments?
A
James A. Klotz responds:
We do not believe in selling bonds when prices move up unless there are special circumstances, such as pre-refundings.
Pre-refundings are an exception because the original issue is escrowed in Treasury bonds and has a new shorter maturity date. This causes an immediate jump in the price. This higher price however, is destined to decline precipitously in a very short period of time, since the bonds will be defeased at the call date.
In the example given in our latest commentary, “The Upside of Lower Rates,” the bondholder will be forced to forfeit his or her 5 ½ %-5 ¾ % coupons in approximately two years at 100.00 or $100,000.00.
A sale today allows them to reinvest at least $109,000.00 (today’s price) in high-quality long-term bonds.
We don’t recommend selling bonds merely because prices are higher, as the bondholder will not be forced to give up these bonds. The higher prices are a result of market factors, not a change in description.
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