In his 25 years in the municipal bond industry, James Colby has learned that one obscure corner of the market sometimes offers substantial value for those privy to it. This is one of those times.
Colby, who is municipal strategist at Van Eck Global, is referring to escrowed-to-maturity zero-coupon munis.
"Escrowed zeroes" are cheap sometimes for the same reason many people have never heard of them.
The universe is small; no funds are dedicated to them; no index tracks them. On any given day, not a single one might be available for sale. Colby urges investors to start paying attention. They are very cheap right now, he said. The forced selling that plagued the market toward the end of last year left bonds with the highest imaginable credit quality bearing abnormally high yields, he said.
"Looking back over the last two or three months, escrowed zeroes have demonstrated unusual cheapness relative to [zero-coupon] Treasury strips," he said. "I observed and felt strongly that escrowed zeroes were extraordinarily attractive."
A zero-coupon muni is a bond issued by a state or local government body that does not bear an interest rate. Instead, the investor buys the bond at a discount to face value and receives the entire principal upon maturity.
An escrowed-to-maturity bond is a muni a state or local government body has effectively refinanced. To do this, the government buys Treasuries with the same principal and maturity as its own debt, places them in escrow, and uses the interest and principal from the Treasuries to pay the coupons and principal on its own bonds.
An escrowed zero is a muni that combines these two elements: a zero-coupon bond escrowed to maturity. It is a sliver of the $2.6 trillion muni market, and Colby believes it is a well-kept secret.
To illustrate what Colby believes is the unusual cheapness of escrowed zeroes, take for example the Cook County Consolidated Community School District #21 in Illinois.
In 2005, the district refinanced some of its debt by buying Treasuries and depositing them in an escrow account to provide the principal when the district's bonds matured in 2016.
The bonds in theory have the same credit quality as an eight-year Treasury. They do not trade that way.
The yield to maturity on the escrowed bonds is 2.96%, according to Bloomberg LP, which is 115% of the yield on a Treasury of the same maturity.
Assuming the investor is in the 35% tax bracket, the tax-equivalent yield is 177% of the Treasury, even though the credit quality is theoretically identical.
Colby said investors have to buy individual issues to gain exposure to this asset class. Many portfolio managers do not buy zero-coupon bonds because funds typically offer monthly or semi-annual dividends. Zero-coupon bonds provide no cash until maturity.
According to a Raymond James search platform, 19 escrowed zeroes were available for sale yesterday. Other issuers with escrowed zeroes outstanding include the Tarrant County Housing Finance Corp. in Texas and the Escondido Union High School District in California.
Most of these bonds trade with yields to maturity higher than their counterpart Treasuries. Colby said investors missed the best time to buy, when yields were an improbable 150% or 175% of Treasury yields, according to his own calculations.
Still, prices remain compelling, he said. Escrowed zeroes historically trade at lower yields than Treasuries.
"For those people who have an ability to utilize them, there are moments in time when you have terrific opportunities," he said.
