TRICKS AND TRAPS IN TRADING MUNICIPAL BONDS

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TRICKS AND TRAPS IN TRADING MUNICIPAL BONDS

• Charles Sandmel, CFP
• First Affirmative Financial Network
• SRI in the Rockies
• October 2002

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YIELD CURVES, OCT. 10
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TAXABLE EQUIVALENT YIELD

• (nominal yield) / (1 marginal bracket)
• EXAMPLE 3.00 yield, Colorado joint filer,
  75,000 AGI
• Marginal rate 27 Federal 4.63 State gt
  30.38 (because state income tax is deductible)
• 3.00 / (1 30.38) 3.00 / 0.6962
• 4.31

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WHAT YIELD DO YOU MEAN?

• Current Yield coupon / price (little value)
• Yield to Maturity recognizes price change
• Yield to Call recognizes price change to some
  prior call date. Always less than yield to
  maturity if bond is priced above par.
• Yield to Worst dealer must price bonds to call
  that produces lowest yield
• Kicker yield to maturity if the bond isnt
  called

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THE KEY RELATIONSHIP WHEN YIELD RISES, PRICE
FALLS(AND VICE VERSA)
PRICE
YIELD
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DURATION TELLS YOU, BY HOW MUCH?

• Measures change in a price for a 100 basis
  point change in yield.
• Equivalent to the average time to repayment of
  all bond cash flows, discounted by the yield
• Good for apples-to-apples comparison
• Formula on Function key in Excel
• Too much math for today

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DURATION WITHOUT MATH

• DURATION OF
• CURRENT PAR BONDS
• 2 YEAR (1.63) 1.98
• 5 YEAR (2.48) 4.73
• 10 YEAR (3.36) 8.58
• 15 YEAR (4.02) 11.41
• 20 YEAR (4.50) 13.39
• 30 YEAR (4.65) 16.46

• EFFECT OF COUPON ON TEN YEAR PAR BONDS
• 3 duration 8.71 years
• 4 duration 8.42
• 5 duration 8.17
• TWENTY YEAR BONDS
• 3 duration 14.52
• 5 duration 13.11

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ROLLING DOWN THE YIELD CURVE

• 9/30 AAA YIELDS
• 7 year 2.95
• 6 year 2.75
• 5 year 2.48
• 4 year 2.19
• 3 year 1.87
• 2 year 1.63
• 1 year 1.50

• VALUE OF A 3 BOND
• IF RATES RISE 1 / YEAR
• 6 year _at_ 3.75 96.00
• 5 year _at_ 4.48 94.63
• 4 year _at_ 5.19 92.18
• 3 year _at_ 5.87 92.21
• 2 year _at_ 6.63 93.30
• 1 year _at_ 7.50 95.74

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Munis now is a good time to take call risk

• The lower the coupon, the less the call risk
• Rates probably wont decline much further
• Lowest yield since days of the 50 top Federal
  tax bracket
• Muni calls are usually not immediate, reducing
  reinvestment risk
• Make doubly sure look for refunding bonds
  which probably cant be refunded again!

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THE CUSHION BOND PLAY

• A bond selling above its next call price is
  selling at a cushion.
• Example CO Transit 5.375 due 11/1/2010
• Bought at 104.904 on 9/24/02
• Yield to worst is 1.81 to the 2003 call at 102
  of par (vs. 1.55 market)
• If not called, yield to maturity is 4.62 (vs.
  3.47 market)
• Be sure you get paid well for call exposure!

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USEFUL WEB SITES

• investinginbonds.com gt general info, yield
  curves, combined state/Federal tax rates, trading
  history
• bloomberg.com gt free AAA and Treasury scales,
  news, Joe Mysak column
• firstaffirmative.com gt my quarterly market
  comment

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IDEAS FOR NOW

• Swap muni winners like for like offset losses in
  equities
• Exploit oversupply in California GO and new power
  revenue bonds
• A new SRI idea public radio bonds