Municipal Bond Forum
On Hidden Gems in the Muni Market (Cont’d):
Q
I evaluate bonds based on yield to maturity. But on rare occasions, I’m faced with a conundrum: If a bond has an early call (2010) but the agency offers 102 or 101 to make the prospect of the lower yield to call less threatening, I ask myself, “Why would they pay more to retire the issue if, by waiting a year or two, they can retire it at a lower cost?” My answer is, it doesn’t make sense to pay premiums to retire bonds. Am I wrong?
A
James A. Klotz responds:
Premium bonds cannot be evaluated solely on yield to maturity because their higher coupons make them more likely to be called.
You must also keep your eye on the yield to call. The yield to call calculation factors in the call price. Make sure your yield to call is higher than the yield to maturity of a comparable quality bond maturing that year.
Regarding the issuer paying a premium to retire bonds: Most call features start at a premium price the first year the bonds are callable and decline each subsequent year until the call price is 100.00.
The issuer offers a premium because of the interest cost eliminated by retiring the debt.
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