Description

I have seen a few yield-oriented pitches on VIC over the years, including recently, including some on Treasuries or “treasury-like” vehicles such as agencies, as a way to earn good, safe-haven income with little risk, during bear markets or maybe for those who simply want to keep a small portion of their portfolios in safe-haven assets regardless of market conditions.

Though there are some limitations-- notably liquidity in any single issue-- this idea is to alert members of the club to an asset class which provides a way to essentially buy treasuries at roughly a 60-80% better after-tax yield. 

The asset class I am referring to are “pre-refunded” or “escrowed” municipal bonds.  What is a “pre-refunded” or “escrowed” muni bond?  To illustrate, let me give you a hypothetical example.  Say a municipality wants to fund the construction of an airport or it needs funds to improve/expand its library system, it issues a bond with a series of maturities.  In this example, let's say the 10-year maturity is priced to yield 5%.  If rates go down over the intervening period, the same issuer might issue a new bond on that same project (e.g., airport, library system, etc.) at a lower yield, say 4% in this example.  So, essentially “pre-refunding” is a way of refinancing their outstanding debt.  But, here are the interesting parts for our purposes:  the issuer then takes the proceeds of that newer, second issue and places those proceeds in escrow to repay the older bond's periodic coupon payments and principal at its first available call date.  And, the funds that are placed in escrow are then invested in treasuries or treasury-like instruments such as agencies or money markets. 

So, in short, by purchasing a pre-refunded bond, you own a piece of paper that has already been paid off (both principal and coupon payments), but the funds that are owed to you are held in trust in treasuries (and/or similar), with the proceeds to be handed over to you at the next call date (and at periodic intervals in-between). 

I have spoken to a number of fixed income desks over the years and no one has been able to give me an example of a pre-refunded bond that has defaulted (munis in general have an extremely low default rate).  Moreover, there are no circumstances in which these instruments should default since escrowed deposits are irrevocable and are for the sole benefit of the escrow-secured debtholders  (NB: i've been told that one should read the fine-print on these since there could be an oddball issue here or there that contains language that is different than this, but i've never been able to identify one that is not irrevocable).

You can find an article with a bit more detail on how pre-refunded munis work here.

If you live in a state with no income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming), the income from any pre-refunded bond from an issuer in any state is state-tax free (in addition to being free from federal income taxes).  Otherwise, you’ll likely want to stick with issuers from your home state to get the full benefit.  (Note: you can also buy pre-refundeds from a territorial issuer such as Puerto Rico, Guam, the US Virgin Islands, etc. on a fully tax-free basis regardless of what state you live in).

I have bought these at various times over the last 25 years.  Sometimes they seem especially attractive to me when the spread to treasuries widens out and sometimes just when the absolute level of yield is attractive.  Currently, it is mostly the latter, though spreads are a bit higher than usual.  With 2-10 year treasuries yielding anywhere from 4.8-5.0 percent, if you are in a high tax bracket, you are netting between 2.4-3.0 percent depending on what your state tax is (this can vary from 0-13%).  I am seeing dozens of pre-refunded munis with maturities out roughly 1-7 years (which, again, are fully paid in advance and held in treasuries) with an after tax yields of 4-4.7%.  This is a spread of 100-230 basis points (or 50-100%) above treasuries.  In fact, I think these are a better deal currently than not only treasuries and agencies and the like, but also many preferred equities as well.

Below is  sampling of several of these issues currently available at one of my brokers.  Note: if interested, many club members will want to purchase a ladder as the availability from any one issuer is usually small.

One other note:  Pre-refundeds will gradually be going away as the Tax Cuts and Jobs Act eliminated them.  So if you are interested in these, you may want to look sooner rather than later and potentially add some to your portfolio with longer maturities.  Here is a link explaining this in more detail: Link.

Risks:

• Munis lose preferential tax treatment
• Liquidity not nearly as great as treasuries/agencies
• Supply will shrink over time given lack of new issuance of pre-refunded munis

Catalyst

Catalysts:

• Over time, earn a better after tax yield than treasuries/agencies by owning an instrument with essentially the same risk-profile.
• If interest rates go lower, you can exit before maturity with a gain on top of the very strong after tax yield you’ve collected in the meantime.