Lower coupon bonds were hit the hardest in the recent selloff as prices declined much faster than premium bonds, leading some investors to say discount bonds are now cheap enough to buy.

Though lower coupon bonds don’t hold up as well in a rising interest rate environment, a slew of 2% and 3% coupon bonds dropped to the 70-80 price range, making them much more attractive to the retail investor than 4% and 5% coupons priced over 100.

“If you have a true buy-and-hold investor, these low-coupon bonds are likely to be entirely suitable,” said Phil Fischer, head of municipal bonds research and global index systems at Bank of America Merrill Lynch. “These lower coupon bonds all need to be priced and sold on an after-tax yield calculation. People need to be very sensitive, especially on the retail side, to make sure they’re buying the bonds on an after-tax basis.”

Phil Villaluz, head of municipal strategy at Sterne Agee, said current levels for 2% and 3% coupons may be attractive now after price cuts. “There’s appetite at the current level where 3% coupons have been cut to,” he said. “We’re seeing prices at 99 back in May cut to 89.”

Indeed, one CUSIP of Massachusetts State College Building Authority 3s of 2042 jumped 58 basis points between June 14 and July 1 to 5.21%, according to data provider Markit. The bid price fell to 67.24 from 77.19.

Yields on Frisco, Texas, Independent School District 3s of 2042 jumped 30 basis points in two weeks to 4.59%. The bid price fell to 74.60 from 79.65.

One CUSIP of Montgomery County, Texas, Municipal Utility District 2.75s of 2029 jumped 28 basis points between June 14 and July 1 to 4.26%, according to data provider Markit. The bid price fell to 82.93 from 85.78.

Yields on Mesa, Ariz., general obligation 2.5s of 2032 increased 11 basis points to 4.57%. The bid price fell to 73.95 from 80.04.

These current prices may be attractive to retail. “There definitely is appetite for those discounted lower-coupon bonds,” Villaluz said. “Because this is more of a retail-oriented structure, if you’re trying to gauge whether or not the discount on these smaller coupon bonds compared to the long 5% is enough, you also need to recognize the impact of de minimis.”

Paul Matus, vice president of tax-exempts at Smith Affiliated Capital, said the biggest factor influencing an investors’ preference for premium bonds is de minimus – or the tougher tax treatment imposed on lower coupon bonds selling at a discount. Any gains made on a bond that is sold is treated as current income instead of as a capital gain when realized. “The market recognizes that bonds falling under de minimus are less valuable to tax-sensitive investors, and therefore prices them less favorably,” Matus said.

“In a rising rate scenario, lower coupons reach the de minimus threshold sooner, no matter what their issue yield, and fall in price faster,” Matus said. “This behavior illustrates a second factor: lower coupons are more volatile than higher coupons, as measured by duration, making them less defensive. The reason for this is intuitive: more of the cash flow of a premium bond is realized sooner, in the form of higher coupons, than later, as in a discount issue.”

In the recent selloff, other CUSIPS of 2% and 3% coupon bonds were volatile and experienced steep price declines.

Yields on Radnor Township, Pa., School District 3s of 2032 jumped 63 basis points to 4.26% between June 14 and July 1, according to Markit. The bid price declined to 83.90 from 91.53.

Yields on Lafayette Parish, La., Law Enforcement District 3s of 2029 jumped 38 basis points to 4.27% in two weeks. The bid price according to Markit fell to 85.60 from 89.65.

Yields on Michigan State University 3s of 2029 jumped 31 basis points to 3.65% from 3.34%. The bid price according to Markit fell to 92.14 from 95.80.

Still, one New Jersey trader said he is waiting for prices to fall further before he buys lower coupon bonds. “I saw a 2.5% coupon in 2029 and it came at 101.5 and is now trading as 83 cents on the dollar,” the trader said. “But it’s a buying opportunity when it goes to 50 cents. I’m not sure about 80 cents.”

Others still say these lower coupon bonds can do well if interest rates start to fall again. “If for some reason interest rates do an about-face and start heading down, discount bonds can really do well,” Villaluz said. “We’ve seen enough of a move the past several weeks where they are getting attractive for buyers who are involved in that type of structure – retail buyers. The question is, is that discount enough attractive to those buyers, is that enough to offset tax ramifications?”

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.