Are Municipal Bonds Too Cheap?
Bonds (especially munis) are often viewed as boring investments that simply pay interest over time. However, the recent dramatic rise in interest rates has created an interesting quirk in fixed-income. Bonds issued in the low-rate pandemic era often feature low coupons. As you probably know, when interest rates go up, the price of bonds goes down, and without diving headlong into the math, suffice it to say that the price of low-coupon bonds is far more sensitive to interest rate movements than the price of bonds with higher coupons. This is called duration. Many of these low-coupon high-duration bonds have lost 30 to 40% of their “value” since the beginning of 2022; in other words, they are trading today at significantly discounted prices.
The good news for bond investors is that outside of a default (which has occurred at a rate of approximately 0.1% historically for investment grade munis), these bonds will all make their way back to 100 cents on the dollar or “par.” And if rates go lower in the coming years, this appreciation can be accelerated just as quickly as prices declined in the first place. Who knew that bonds could be so exciting?
Here is a quick example, using a current bond offering at the time of my writing:
Vallecitos, CA Water District with a 2.375% coupon, offered at 4.235% yield, which is a $69.131 dollar price. If you were to buy 10 bonds, it would cost you $6,913.10 and you would get paid $237.50 per year in federally tax-free income until the bonds mature in 2051 and then you would receive the full principal of $10,000 back. Nine months ago, these bonds were trading at a 2.375% yield, at par ($100). Which means they have lost over 30% of their value in 2022. If rates turn around, and go halfway back to where they started 2021, you would expect these bonds to trade around 3.30%, resulting in a $80.128 dollar price, a 16% increase from current levels.
In our view, discount bonds present an interesting opportunity in the current market environment. Although many of these bonds are currently trading below the de minimis threshold (meaning any capital gains will be taxed as ordinary income), this tax burden can be greatly reduced by strategically swapping the bonds for a similar credit if the value rises above the de minimis price. This ensures that any gain beyond that level is taxed at the capital gains rates.
Finally, for current bondholders who are feeling a bit shellshocked by 2022’s precipitous price declines, there may be a way to benefit from the current discounted prices. As we mentioned, almost all of these bonds will make their way back to par eventually, but you can take advantage of low near-term prices through “tax-loss harvesting.” Munis are one of the easier securities to swap, allowing you to realize a tax-loss by selling a current holding, while immediately reinvesting the proceeds in a similar credit without triggering wash sale restrictions.
(We highly recommend clients seek individualized advice from their tax professional to determine how the strategies mentioned above may affect their specific portfolios.)
As always, if you would like to discuss any of the commentary above, please give us a call. And please share this with anyone you think would be interested.
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