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Bond ladders tax and creditworthiness the case of US municipal bonds

In any jurisdiction investors need to be aware of tax rules which alter the terms on which investments are bought and sold. The $1.9 trillion US municipal bond market is attractive to taxable investors because interest on municipal bonds is exempt from federal income tax and state and local tax in the issuing state, whereas interest on US Treasury and government agency bonds is subject to federal income tax (but exempt from state income taxes). This difference in tax treatment leads taxable investors to bid up the price of municipal bonds compared with similar Treasury bonds.

Rules of thumb are normally used to compare municipal and Treasury bonds, such as a comparison of the difference in yields with the investor's tax rate. (Inaccuracies with this approach arise because of interest coupon reinvestment risk and the tax that has to be paid on the coupon of the taxable bond. The solution is not a comparison of yields, but a comparison of holding period returns.) Nevertheless, a key indicator is the ratio of the yield on highest quality municipal bonds to that on US Treasuries of similar maturity and a comparison of that ratio with the investor's tax rate. In practice, there are a range of factors that need to be compared:

e Whether the municipal bond issue has call provisions which enable the issuer to repay the bond at par (or a specified premium to par) early. Whether the issuer chooses to exercise this option will depend on whether this would reduce the debt interest burden. Call provisions will undermine the usefulness of a bond as part of a ladder intended to secure future income, because the bond will be called when it suits the issuer, not the investor. Call provisions always undermine the interests of investors and provide a valuable option for the issuer, so a callable bond should offer investors a higher yield than a non-callable bond. e The creditworthiness of the municipal bond issue, as any issue which is less creditworthy than the US government should offer a premium yield on a strictly like-for-like comparison. There is a difference in the creditworthiness of the two main types of municipal bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuer and are usually supported by the issuer's tax-raising powers. By contrast, revenue bonds are serviced from specific projects which have been funded by the bonds. If the project fails to generate sufficient income to service the debt, the bondholders have no access to other sources of revenue of the issuing authority. In practice this has led to the spread of insured municipal bonds, whereby an insurance company promises to pay if an issuer does not do so. This is of considerable benefit to less known issuers. By 2004, over 50% of all new municipal bond issues were insured.

The expansion of insurance has increased the range of issues available for inclusion in high-quality bond ladders. Other highest quality municipal bonds include those where the original issue is "refunded" or collateralised, for example with US Treasury securities. These are usually paid down at the first callable date after the refunding, though some are backed by collateral that matches the original maturity schedule of the issue. These are called "escrowed-to-maturity" bonds (though the existence of earlier call provisions still needs to checked). e Liquidity, and the ease of selling a bond in the market. For Treasury securities this will not be an issue, but for many municipal bond issues, the transaction costs can be considerable.

These factors help to explain why the municipal bond market has often traded at higher yields than might be expected by simply making a comparison with the US Treasury market and prevailing tax rates. This difference has been most marked for longer maturity municipal bonds. As a result, the term structure of the municipal bond market has often been steeper than that for US Treasuries. This is a most attractive feature for a laddered, buy-and-hold approach to investing in municipal bonds.

A further possible influence on the attraction of yields in the municipal and Treasury markets is the scale of borrowing by federal compared with state governments. This explanation relies on the fact that tax-paying investors naturally gravitate towards the tax-exempt municipal market, whereas tax-exempt investors naturally avoid the municipal bond market, and so differences in the scale of borrowing by federal or state and local government could, within limits, affect yields in one market more than in the other. In any event, investors should check that they are comfortable with the yield on offer from municipal bonds when compared with the after-tax yield offered on US Treasuries of similar maturity, after allowing for differences in liquidity and credit risk and for any provisions that might lead to the early redemption of a bond.

The Orange County saga: what is a good-quality municipal bond?

In December 1994, Orange County in California filed for bankruptcy following a $1.7 billion loss on a highly leveraged investment portfolio, which through extensive use of sophisticated derivative instruments transformed $7.6 billion of investments into $20.6 billion of market exposure. Ahead of this sudden announcement, there would have been little basis for questioning the creditworthiness of the local authority of such an affluent district. The Orange County crisis was therefore different from the more drawn out, and well trailed, financial difficulties faced by New York City in the 1970s, and so reveals much about risks that could in extraordinary circumstances be incurred in the municipal bond market.

e Many of Orange County's bonds were insured and were revenue bonds, and this reduced investors' exposure to Orange County risk. e The experience showed that if a state or local authority ever defaults, investors might be more secure with revenue bonds, which are tied to particular projects, than with general obligation bonds, which are supported by the "full faith and credit" of the issuer. The general rule, though, is that general obligation bonds are less risky than uninsured revenue bonds.

e Although the viability of Orange County finances was restored through the successful issue of "recovery bonds" in 1996, which permitted the County's exit from bankruptcy, any episode like this incurs significant costs in terms of anxiety to investors in the securities. It also imposes higher borrowing costs on the defaulter going forward.