Buy Side

Though Popular, 4s Can't Beat 5s

When it comes to municipal bonds with longer maturities, most institutional investors still regard 5% coupons as the structure of choice.

Low muni yields over much of the past year have prompted the issuance of more debt with coupons lower than 5% that are priced to the call. With this, there has been growing acceptance of 4% or lower coupons among certain maturities.

Among callable bonds beyond the 10-year range, though, most muni bond investors still are more comfortable taking chances on 5s, despite the strong performance of 20-year muni 4s. The thinking holds that the higher coupon will retain more value if interest rates should rise.

“I don’t know that everyone has bought into 4s, once you get into the callable range beyond 10 years,” said Jaime Durando, head of the syndicated desk at RBC Capital Markets. “A lot of investors are still gun-shy about taking that leap.”

In recent years, 5s have been the preferred rate for institutional investors. A 5% coupon will grant investors more price protection as interest rates rise. Fixed-rate bonds fall in value as interest rates rise and increase in value as interest rates decline.

Conservative institutional investors also have tended to favor higher coupons because there is less potential for negative tax consequences, said James Ahn, executive director with JPMorgan Asset Management.

But investors pay a premium price for a 5% coupon structure. Retail investors, who are more price-sensitive, tend to prefer lower coupon bonds that are priced closer to par, which equals 100.

In the current low-rate environment, though, underwriters are almost stuck in a tug-of-war when they price new issues, according to Ahn. Do they cater to the demands of retail investors and price new issues closer to par? Or do they cater to institutions with premium prices?

At one point in mid-January, Ahn noticed how an increasing number of underwriters priced new issues in the early part of the week at 4%, knowing that they could draw both retail and institutional interest, as institutions were willing to settle for 4s inside of 10 years. But when the market started to weaken at the end of the week, institutional investors started to prefer 5s again.

“That spread changes rather quickly,” Ahn said. “The key trend in this environment, it’s dynamic.”

In late January, RBC encouraged investors to swap out of 5s for 4s. One can buy 4s more cheaply in the secondary market, Durando said.

“I think the biggest thing that would turn 5s into 4s this year is if we really do have a low-volume year,” he said.

Currently, 5s dominate the muni market, according to figures assembled for a research report by Bank of America Merrill Lynch’s John Hallacy.

Bonds with 5% coupons or higher account for $1.9 trillion of the total outstanding $3.7 trillion muni market. Coupons of between 3% and 4.99% account for a $700 billion chunk.

Finally, muni credits below, but not including, 3% coupons account for $1.1 trillion of the market. These include current coupons on floating-rate products.

Furthermore, based on all bonds with one year or more in maturity, 43% of outstanding bonds are in 5s versus just 8% in 4s, according to numbers gathered for a research report by Peter DeGroot, fixed-income strategist for JPMorgan.

Bonds with 5% coupons represent 43% of the outstanding market in the 15- to 25-year range, and 36% in the 25-year-plus range. At the same time, 4s represent just 2.4% of the outstanding market in the 15- to 25-year range, and 1% of the 25-year-plus range.

But over the past six months, 30% of recent issuance has been in bonds with coupons below 4%, according to numbers gathered for another DeGroot research report. That represents a level that is twice the typical distribution of coupons in the below-minus 4% range.

Investor interest in 5s might be a matter of perception, RBC’s Durando said. Continued interest in 5s shows that muni investors are conscious of the fact that the absolute rate environment is being held artificially low by central banks around the world, he added.

Any time it looks as though rates are going to rise, investors will back away from the lower coupon and return to the defensive nature of 5s.

“If investors thought the rate environment was natural, then they’d be OK with 4s,” Durando said.

Investors have seen some strength in 4s of late, according to JPMorgan research. Taking a closer look at total returns for a 30-year bond and a 20-year bond, DeGroot found that 4% coupons perform better given small changes in rates; 5% coupons are better when there are large changes.

Also, he found that 5s generally outperform in 30-year maturities, while 4s generally outperform in 20-year maturities.

“Despite the higher price sensitivity of 4% coupon bonds, these bonds can outperform long callable 5s for increases in 30-year high-grade yields of up to 20 basis points,” DeGroot wrote. “The outperformance is due to the strong appeal of these bonds to retail investors and their carry advantage.”

With muni yields so low, 4s have made their biggest headway with institutional investors inside the 10-year range.

For most of 2011, the institutional preference for coupons was 5%, said Priscilla Hancock, executive director and municipal strategist for JPMorgan Asset Management. But she said now yields have fallen to such strikingly low levels that the institutional preference has shifted inside of 10 years as people are willing to take a 4% coupon. This is also true because investors recognize that there is an expectation that the Federal Reserve won’t adjust interest rates higher in the short term.

Accordingly, the market is open to accepting a slightly lower coupon in the short end of the yield curve because today’s lower interest rates should persist for a longer period.

Rates will climb again, muni experts say. But the real question is, when? Meanwhile, investors’ calculations change according to their expectations about rates.

“Inside of 10 years, let’s say you think rates aren’t going to go up for another two or three years,” Hancock said. “Well, then getting the extra 10 to 15 basis points out of owning a two- or three-year bond at 4% might be a good trade.”


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