As the market for taxable munis expands, many advisors and investors are rethinking their approach to municipal bonds.
As the market for taxable munis expands, many advisors and investors are rethinking their approach to municipal bonds. With issuance of Build America Bonds (BABs) anticipated at least through 2014, taxable munis have become the fastest-growing part of the $2.8 trillion U.S. municipal debt market.
Since 2009, state and local governments have issued almost $90 billion of BABs for construction projects nationwide. The U.S. Treasury currently subsidizes 35 percent of the interest costs on taxable BABs, in contrast to the tax breaks afforded to buyers of conventional municipal securities.
Like traditional municipal securities, Build America Bonds help cities, counties and states finance operations including upgrades for schools, airports, convention centers and roads. Current estimates are for municipalities to issue as much as $125 billion of BABs in 2010. That could represent about up to 30% of all expected municipal-bond issuance this year.
Taxable munis barely existed before BABs. The emergence of BABs has led to a two-tier municipal market in which new tax-free bonds tend to carry shorter maturities and taxable munis typically carry longer maturities -- and to trade at yields that are sometimes comparable to those of corporate bonds.
As a corporate bond alternative, BABs may fit well inside tax-deferred accounts. With a range of maturities, long-dated BABs can be suitable for IRA accounts. For investors nearing retirement and looking to transition their IRA and 401k accounts from a growth oriented equity based strategy to current income and capital preservation, highly-rated BABs offer many of the same features as their tax-free cousins:
• Known income: Both tax-free Munis and BABs offer stated coupons that pay semi annually
• Defined maturity or call: Both types of Munis offer stated call dates and final maturity dates so the return of your capital can be planned.
• Diversification with a wide range of issuers: BABs are competitive with similar quality corporate bonds that have historically been the main alternative to Treasuries for clients looking for permanence and definition in their retirement accounts.
• Flexibility: BABs may be laddered or barbelled to meet customized income needs, while taking advantage of future rate environments when the bonds mature. Potential call features on BABs should be factored into laddering decisions.
Consider the relative value to Treasuries and corporate bonds. Tax-free munis currently deliver approximately 81% of comparable treasuries in the 10 year sector and 89% of the 30 year. Below is a comparison of a recent Metropolitan Nashville Convention Center tax-free new issue, a corresponding BAB deal from the same issuer, and current corporate bond sector index returns for similar years. (Yields effective 4-15-10)
For portfolios looking for definition to an income distribution strategy, BABs offer new opportunities to meet a wide array of investor objectives. It should be noted that the market for these securities can vary depending on many factors, including available supply. Taxable munis and investment grade corporate bonds are highly correlated* to US Treasuries, but carry additional risk considerations. Sites such as investinginbonds.com offer detail risk disclosure for all three types of securities, as well as further information on BABs.
Critics of BABs point to a tendency for issuance from state and local entities with weaker credits. Because of the Federal subsidy, the increasing market share for taxable munis will also add to the Federal deficit. However, the current momentum and success of the BABs program have created a viable alternative for fixed income portfolios.
John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago, Boca Raton, and London. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.
