In the Fixed Income Services Group, we are constantly building proposals for clients. For clients in mid to high income tax brackets, municipal bonds are a great way to add tax free yield. Year-to-date, the short end of the AAA-rated municipal market data curve (MMD) has decreased by 30 basis points for bonds maturing in 5 years (2% to 1.70%). With this recent market move, there has been a desire to boost yields in different ways. We would prefer to not sacrifice credit quality to achieve this. Most accounts practice a “buy and hold” strategy for their fixed income allocation tailor designing desired duration and income levels. Modified duration is the sensitivity in price movement that corresponds to a 1.00% move in interest rates. Bonds with vastly different maturities can have similar durations. Buying higher coupons (4.00%-5.00%) with longer maturities (12-18 years) that are callable in 3-9 years (kicker bonds) are great ways to add yield to a portfolio while keeping duration relatively the same.
Last week, I built two proposals consisting of Ohio municipal bonds with very similar credit quality. The details of the proposals are below:
Assumes a Federal Tax Bracket of 37% + 3.8% Medicare Tax and a 5% State Tax
Looking at these 2 proposals, one has a duration of 5.98 and the other has a duration of 6.00. So the bonds are equally sensitive to movements in interest rates. For an investor to possibly benefit from the higher yield-to-worst, they would have to be willing to buy bonds with longer stated maturities. In buying the bonds with longer maturities in the example above, the client was able to pick up 62 basis points on a yield to worst basis (113 TEY). If the bonds are not called, they continue to receive their 4.43% coupon on a tax free basis. A risk is that 7-10 year municipal bonds will be yielding more than 4.43% when these bonds would have been called (the 10 year MMD is currently 2.05%). If the bonds are not called, they kick from a 2.71% yield to a 3.48% yield.
It is also important to know the tax situation of your clients. Most states give an exemption from state income taxes on bonds purchased in the state the client resides. Some states have exorbitant state income tax rates. It will give a significant boost in tax equivalent yield when buying in-state bonds. Other states have low or no state income tax. In these states, it may benefit the client to buy a national portfolio of bonds.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
115 E. Putnam Ave, 3rd Floor| Greenwich, Connecticut 06830 | T: 203.900.4403 | F: 212.818.1115 | Map & Directions
570 Lexington Avenue, Suite 1600 | New York, New York 10022 | T: 212.818.1300 | F: 212.818.1115 | Map & Directions
Latitude One, 175 Southwest 7th Street, Suite 1900 | Miami, Florida 33130 | T: 305.529.6287 | F: 786.837.0465 | Map & Directions
Securities offered through Raymond James Financial Services, Inc., member FINRA / SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Tempus Advisors is not a registered broker/dealer, and is independent of Raymond James Financial Services. Raymond James financial advisors may only conduct business with residents of the states and/or jurisdictions for which they are properly registered. Therefore, a response to a request for information may be delayed. Please note that not all of the investments and services mentioned are available in every state. Investors outside of the United States are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this site. Contact our office for information and availability.
Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members.