“Now that interest rates have finally risen…” is a phrase I wrote in jest, a mere six months ago, in this very column. I can now use these words in sincerity. And your collection of investments is potentially the better for it. We have contended that while the discussion of portfolio performance in the board room and among the investment committee is more pleasant if your bonds have net unrealized gains, it will take a rate environment that creates unrealized losses before your yields will be on the way up.
Such is the scenario we now have. The late-2016 bond market selloff has caused bank investments, on balance, to be under water. This produces a myriad of issues to consider when purchasing, some of which are specific to tax-free municipals. None of these are new; it’s just been the better part of a decade since they’ve been relevant. So here’s a list of factors to keep in mind, when you’re shopping for munis for your portfolio.
Hallmark of performance
Let’s first take a look at why municipal bonds are so popular among community banks. As industry profitability has returned to near pre-recession levels, there’s more income to be shielded from taxation. The muni market, particularly the subset known as “bank qualified,” has had few credit hiccups recently. And, even given the lack of supply, yields have remained historically wide relative to benchmarks like the U. S. Treasury curve.
Currently, about 28 percent of all dollars invested in a typical community bank bond portfolio is of the tax-free variety. This represents a high-water mark, as a decade ago only about 18 percent was in munis. Since this is the highest-yielding sector in a typical portfolio, the weighting of munis has a direct correlation to the entire portfolio’s percentile ranking. The top 25 percent of bank portfolios have an average allocation of almost one half to municipals.
Beware of discounts
Which brings us back to today’s issues. As prices have fallen since November, there are a lot of bonds that are being offered at prices below par, which originally came to market at or above 100.00. There is a proviso in the tax code that creates capital gains tax liability on the portion of the yield that is attributable to the discounted price. This is another argument, incidentally, for you to prefer or insist on purchasing high coupon munis.
The higher the coupon, the higher the price, all other things being equal. That alone will help ensure that the market price, even if it has fallen from its peak in 2016, will stay comfortably above par. And since most munis have a call feature at some point during their life, the higher coupon will help keep the average duration shorter. The advice here is to be sure you are shown the “after tax” yield on any municipal that you are offered that has a market price less than 100.00.
Only about seven percent of the muni market is of the bank qualified (“BQ”) variety. Bankers will almost always limit themselves to the BQ sector, as they get to deduct the majority (80 percent) of the cost of carrying that type. The 20 percent “disallowance” is also known as the TEFRA penalty. Sometimes there are temporary opportunities to buy non-BQ bonds, also known as general market paper, at sufficient yields to make up the 100 percent disallowance hit.
One condition is a muni market sell-off in which general market yields improve much more than do BQ yields. That occurred in late 2016. Another is that cost of funds is, at least temporarily, compressed. As of September the average cost of funds for U. S. banks was all of 38 basis points (0.38 percent). While today a case can be made that general market munis can create superior tax-equivalent yields to the BQ sector, extreme caution needs to be exercised. The exiting of general market positions, if a long-term trend of rising rates prevails, could end up costing a community bank more than the up-front benefits it realized.
So now that interest rates have finally risen (!), my advice is to take time to understand the nuances that attach to tax-free municipal bonds. This includes capital gains liabilities, premiums versus discounts, and the risks and potential benefits of general market paper. Proper application of these strategies can place your community bank’s investment portfolio solidly in the top quartile of your peers.
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