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In Selloff, Higher Coupons Outperformed

The recent market selloff battered municipal bonds unevenly.

And those investors holding credits with higher coupons weathered the rising rate storm better than those with lower coupons in a relatively even diminution of prices, industry watchers said. Accordingly, 5% coupon bonds performed better than bonds with 4% coupons; 4s did better than 3s; and each did better than par bonds.

As rates rose, the higher the coupon, the better they were positioned to withstand the almost gravitational pull on prices, said Priscilla Hancock, managing director, municipal strategist, JPMorgan Asset Management.

“It’s a sliding scale: the closer you are to par, the bigger the downward pressure on prices,” she said. “And the bigger the cushion you have, the less downward pressure on prices. That’s why the 5% bonds significantly outperformed lower-coupon bonds.”

As yields started rising, a 3% bond, for example, would start to trade below par as yields crossed 3%. Consequently, those bonds would start to trigger some thresholds in the market.

Bonds would begin to lose retail investor interest, the largest segment of the market, when their prices on average dropped below 98 cents on the dollar. Then, as they continued falling, they would descend into de minimis range, prompting a penalty.

Certainly, the storm was brutal. From the start of May to the selloff’s pause on June 26, the 10-year triple-A tax-exempt yield rose 115 basis points; the 30-year vaulted 134 basis points, Municipal Market Data numbers showed.

Accordingly, while 5% coupons could be sold at these levels, buyers demanded an additional 40 basis points for 4% coupon bonds, industry analysts estimated. Following up, they demanded an additional 80 basis points for 3% coupons.

Many in the industry prepared for this eventuality. Last fall, investors were known to buy 5% coupons at premiums well north of 1.20 because of the extremely low rates in the market then.

They realized that rates were at the bottom of the interest-rate cycle and faced a potentially volatile period in the markets and so adopted a defensive stance with the munis they were buying. Their thinking held that investors of higher coupon bonds would have lower duration, so as rates increase, they’d experience less capital depreciation from 5s, said Eric Friedland, head of municipal credit research at Schroders Investment Management.

In addition, bonds with higher coupons face less extension risk in a rising rates environment. And they would have more protection from prices falling below par and into de minimis range, where they would incur a penalty that amounts to a tax. In the most recent selloff, bonds with 3% coupons were highly susceptible to this.

“So the 4s, with a slight increase in interest rates, fall more into the de minimis range, where you’re being taxed at an ordinary income rate, instead of capital gains,” Friedland said. “And with higher coupons, you’re more protected from that.”

More retail investors, who typically look to buy bonds priced in the 0.98 to 1.02 range, began to buy more 5s at premiums late last year and earlier this year as they adopted a defensive strategy. As a result, more bonds were issued with higher coupons to meet the demand.

“The 5s are more liquid, because there are more 5s trading,” Friedland said. “The 5s have been more desirable in this environment where rates are expected to rise. So, to the extent you need to liquidate, they’re going to be more potential buyers for those.”

And when investors paid say, 1.26, for their 5s in the lower-rate environment, they did so because they expected to get a portion of that premium returned to them in every coupon payment, Hancock said. For bonds priced at a premium, the coupon payment comprises a combination of interest and return of an investor’s premium.

“It’s not as though you’re paying 1.26 and getting par back at the end,” she said. “You’re paying 1.26, and getting a little bit of interest and a little bit of that premium back every six months. And when you have that return of your premium, you can reinvest those monies in that rising rate environment. So, a premium coupon bond brings forward your payment stream.”

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