The “Magic of Munis.” We examine municipal bond coupon structures with a focus on high coupon and high premium bonds.
The $4 trillion municipal market represents only a small part of the global and domestic fixed income market but it possesses structural nuances and unique characteristics that separate municipal securities from other fixed income instruments. This is the first in a series of articles that discusses the exclusive attributes of municipal securities. In this initial article, we examine what is different about municipal bond coupon structures and the broader implications for the asset class and investors, with a focus on high coupon and high premium bonds.
The key defining characteristic of municipal bonds is their tax-exempt status; ultimately, it’s the reason the asset class exists. The interest component of the bond is exempt from Federal income taxes and this subsidy allows states and local governments to borrow at lower interest rates than the comparable taxable market. For investors, it’s important to understand the tax exemption only applies to the income stream and not to price appreciation. Realized gains are taxed in the same manner as other fixed income investments, with short-term gains taxed as current income and long-term gains taxed as capital gains. Under some circumstances a municipal bond purchased at a deep discount may suffer the unpleasant consequences of the de minimis tax rule. This rule determines whether the price appreciation of a discounted municipal bond, as it moves towards par at maturity, is taxed as ordinary income or capital gains, which could have a large impact on an investor’s after-tax returns.
The tax code creates a distinct advantage for municipal bond coupon payments and effectively makes $1 of income worth more than $1 of price appreciation and the higher an investor’s tax bracket the wider the spread between income and price appreciation. Aware of this advantage, municipalities have an incentive to issue high coupons (4%, 5% or even 6%) to make bonds more attractive to investors given the larger amounts of tax-free cash flow they provide. As a result, the municipal market has an average coupon that is greater than other domestic fixed income asset classes and the average coupon for municipal bonds has remained significantly higher even during the recent period of low rates that we experienced. Other bond markets experienced a downward trend in coupons over the last 13 years as issuers refinanced their outstanding debt and reissued bonds with lower coupons to reduce borrowing costs. However, that hasn’t happened at the same magnitude in the municipal market.
Average Coupon for Select Fixed Income Markets
|Bond Market||Average Coupon|
Represented by Bloomberg indices as of Feb 28, 2022
There are numerous benefits to owning higher coupon bonds and those benefits may be greatest in a period of rising rates or inflation. When holding all other bond characteristics equal, the lower a bond’s interest rate sensitivity, the lower its duration. Second, the higher the coupon the more durable the bond price in a rising rate environment. Bond prices and interest rates are inversely correlated so when rates rise bond prices fall and this is very important for municipal bonds because as a bond’s price falls below par the bond will flirt with becoming taxable according to the de minimus tax rule. When the discount crosses the threshold making any of the accretion back to par taxable for a prospective buyer the price will drop to compensate for the tax liability. Lastly, in a rising rate environment an investor can benefit from higher levels of cash flow by reinvesting coupon payments into higher and higher yields. If this laddering is executed consistently throughout an interest rate cycle, it will increase the yield of a portfolio and ultimately the portfolio’s total return over time.
The last key aspect of higher coupon bonds is that in times of depressed market yields, such as what has occurred over the last several years, investors become more willing to pay a premium for higher coupons. Bonds that pay above market yields typically increase in price to levels often higher than the par value. When this occurs, and the bonds are priced at a such a premium, investors may question why anyone would purchase a bond for $120 when the bond matures and only pays $100 therefore guaranteeing a $20 “loss”. The idea may seem even more nonsensical when market yields fall as low as they did in the summer of 2021 and muni bond prices rise to the nosebleed levels of $130 or $140.
Average Price for Select Fixed Income Markets
|Bond Market||Average Price|
Represented by Bloomberg indices as of Feb 28, 2022
While it may appear as though bonds priced at a premium create a loss at maturity, that is not the case. The higher priced bonds carry the higher coupons that we previously discussed. The resulting improved cash flow is advantageous for muni investors because of the tax-exempt nature of the coupon income stream. This means an investor may be better off paying above par for a municipal bond and collecting more in tax-exempt cash flows than they would be paying par for a similar municipal bond.
|Bond A||Bond B|
|10 Years of Cash Flow||$25,000||$50,000|
|Net Cash Flow||$25,000||$28,001||$3,001|
Source: Thornburg Investment Management. Hypothetical figures illustrate the possible advantages of holding premium municipal bonds.
The table above illustrates just such an outcome. Bond A is a straightforward municipal bond issued at par with a 2.5% market coupon. Over the 10-year maturity of the bond, Bond A pays out $25,000 in tax-free income. At maturity, the bond returns the $100,000 purchase price at par. Bond B, however, is a premium municipal bond as reflected in the 5.0% coupon and $121,999 purchase price. While investors will have to pay more to purchase Bond B, they will receive $28,001 in tax-free coupon payments over the life of the bond and get back the $100,000 maturity amount. Clearly, Bond B is more favorable for income-seeking investors. Purchasers should keep in mind that a portion of the higher coupon payments associated with premium bonds is the return of principal. Still, the tax advantages associated with the coupon payments typically outweigh that consideration.