Investors’ attitudes towards premium bonds have changed.
Normally, individual investors would be reluctant to buy bonds at a premium of $1.06. Today, though, they have been known to buy 5% coupons at premiums of $1.26.
Why? The reason lies in today’s extremely low rates.
Investors realize that they are at the bottom of the interest-rate cycle and facing a potentially volatile period in the markets. So they are adopting a defensive stance with the muni bonds they are buying.
In addition, there have been noticeably fewer par-type bonds available over the last six to 12 months.
They have become more comfortable buying 5% coupon bonds for premiums sometimes higher than $1.20 at certain maturities, industry pros say.
When the market eventually swings, the thinking goes, they want to be in a position to trade below par or outside of the de minimis range, where the bonds otherwise would be less liquid and incur a penalty.
Having dealt with individual investors for many years, John Dillon, chief municipal bond strategist at Morgan Stanley Wealth Management, knows that bonds on offer with premiums at $1.06 usually would be a non-starter for any conversation. But nowadays, he added, these investors think differently.
“Today, it’s not that underwriters and issuers are pushing [5s at high premiums] so much as it is that individual investors are more accepting of them,” Dillon added.
But underwriters and issuers also have their reasons for offering investors 5s at high premiums. Issuers favor them because they can have a lower cost of borrowing and they get more proceeds when they do the deal, said Tom Metzold, co-director of municipal investments at Eaton Vance.
For example, when issuers ultimately pay back debt on a 5% coupon bond at, say, $1.20, they’re paying back less than the full amount they borrowed. If they borrowed $10 million at $1.20, they are paying back $10 million after having received $12 million in proceeds up front.
“Now they had to pay higher coupons, but they spread that out over the course of the maturity,” Metzold said. “So, the present value of that is such that they’re getting a better deal.”
After the financial crisis struck in 2008, triple-A municipal bond yields have entered a period of prolonged volatility, Dillon said.
Since 2009, swings in valuations over any given year have ranged from anywhere from 75 to 165 basis points.
“That’s enormous volatility, versus where we’ve been historically,” he said.
And the thinking holds that, at some point in the future, rates are going to rise, Dillon added.
In the face of such instability, investors view callable 5% coupons — in general, and definitely those that come at high premiums — as a very defensive bond, according to Brian Wynne, co-head of public finance at Morgan Stanley. And they pay close attention to the de minimis amount.
“Before 10-years, why do investors like [5s]? The de minimis rule,” Wynne said. “If interest rates went up and the bonds started to trade below par, or outside de minimis, it would be less liquid, because any new purchaser would have to record a capital gain appreciation each year, as well as the tax-exempt income.”
In other words, the bonds are allowed to trade at an amount below par equal to one-fourth of 1% — or 1/4% — of the principal amount of the bond multiplied by the number of full years until the bond’s maturity.
On a 10-year bond, the higher-premium coupon would provide some protection to the buyer, in terms of the de minimis incremental tax-taking effect, said Jaime Durando, head of municipal underwriting at RBC Capital Markets. Thus, the higher a coupon is purchased above par, the longer the free ride down in price holders receive should rates back up fairly dramatically.
“So, you have a higher chance of avoiding de minimis if you’re starting with a significantly higher dollar price,” Durando said.
With the prospect of such protection, paying a premium, in terms of dollar price, doesn’t factor into the equation at all for investors, Wynne declared. “It’s just about getting defensive,” he said. “To them, the yield is the yield. You’re getting 3.25% yield and you’re paying $1.20 — that’s not a big factor.”
There is another factor: investor groups vary, as there are different mixes of coupons and prices for different buyers. A retail investor would most likely prefer something priced around par, or at a modest premium, Durando said.
“They typically are more comfortable putting up an amount that reasonably approximates what they’re going to get back,” he added.
Another class of buyer, such as an investor at a property-casualty firm, might like a little higher premium.
For their part, separately managed accounts have more of an institutional mindset; they would typically look for more of a premium-type structure to give them that protection.
So they would be looking more at 4s and 5s.
High-net-worth individuals historically have displayed some reluctance for putting up a big premium, despite the fact that they are going to get a larger cash flow with that higher coupon, with the mindset that they’re going to get par back at maturity.
“By and large, for most institutional investors and a lot of the larger professional managers of money,” Durando said, “5% remains the coupon of choice.”