Lower interest rates are generally seen as a boon to municipal bond issuers and a bane to investors. But for holders of individual munis, the current environment presents a unique opportunity.
Although issuers are taking advantage of low rates and are refinancing their bonded debt to reduce borrowing costs, the impact on investors can be unexpectedly positive.
Yes, issuers can refinance (pre-refund) their bond issues, but with certain important restrictions.
Investors’ bonds cannot be taken away before the first stated call date, and only at 100.00 or above.
The pre-refunding process entails escrowing the original bonds in U.S. Treasury securities until the call date. Typically, the result is a dramatic enhancement in quality, and a shortening of the final maturity of the bonds being refinanced (refunded bonds).
For investors, this can mean a substantial increase in the price of their securities, which gives them the option of either holding the bonds until the new shorter maturity date or selling them at the higher price.
A unique opportunity to sell
This is one of the few times we usually recommend selling bonds at a premium price and replacing them with bonds that provide a greater return on investor dollars. Primarily, this is because the yield on the refunded bonds is actually being reduced.
For example: we are currently expecting a pre-refunding by the New Jersey Economic Development Authority of its 5½ % and 5 ¾ % bonds due in 2031 and 2034, respectively. The bonds are not callable until June 2014 and will be retired on that date.
Once the outstanding bonds are escrowed in Treasury certificates, we anticipate they will be worth approximately 107.00. This means that an individual’s original investment of $100,000.00 has become $107,000.00. At that point, his investment dollars, which were originally working at 5 ½ % or 5 ¾ %, are yielding less than 2.00% because he is still receiving the same interest payment but has more dollars invested.
The compelling reason to sell these bonds is that in June 2014, they will mature at $100,000.00.
By selling the bonds now, these premium dollars can be used to purchase long-term bonds that provide a substantially higher yield.
The refinancing of outstanding muni issues is becoming increasingly prevalent as lower interest rates permit issuers to reduce the interest cost on their bonded debt.
If you’d like to explore the potential opportunities pre-refunding may present in your portfolio, please contact your FMSbonds representative.