No. of Recommendations: 5
A few weeks ago, this statement in a Barron's article, "the Yields Are Staggering," caught my attention and interest:

"Just last week, 30-year bonds backed by the triple-A-rated Texas Permanent School Fund (PSF), one of the premier muni guarantors, were sold at a yield of 6.25%. Double-A-rated New York City issued $500 million of general-obligation bonds at a top yield of 6.40%. Top-grade 10-year debt recently has been yielding 5% or more. 'The yields are staggering,' says Jim Evans, who heads the muni investment group at M.D. Sass in New York. Evans points to the top yield on the Texas PSF bonds and to recent secondary-market offerings in which 20-year pre-refunded California GOs traded at a yield of 5.85%. Pre-refunded bonds probably are the safest bonds in the muni market because they're secured by U.S. Treasuries. Long-term debt from ohter top issuers, like Harvard University, yields nearly 6%.
A 6% muni yield is equivalent to a 10% taxable yield for residents of high income-tax states like California, New Jersey and New York. This assumes that residents by in-state bonds. Tax-equivalent yields for out-of-state bonds are around 9%."

So in my research on pre-refunded municipal bonds, I found the following informative links to Morningstar Advisor and Morgan Stanley:

According to Morgan Stanley,
"Pre-refunded municipal bonds are among the highest quality municipal bonds available. The income and principal from pre-refunded municipal bonds is normally secured by an irrevocable trust of U.S. Treasury securities. Thus, the payments from pre-refunded municipal bonds are no longer dependent upon the revenue stream or tax collections of the original issuing municipality. Because of this enhanced security, pre-refunded municipal bonds generally carry a rating of 'AAA.'

Since the income earned from municipal bonds is federally tax-exempt, and in most cases, state and local tax-exempt as well, an investment in pre-refunded municipal bonds will often result in more net disposable income than a comparable investment in taxable securities.

Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed, the issuer uses the proceeds of the new deal to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called. The call date and price is set when the refinancing is completed; usually the call date is within 10 years of the refinancing, while the call price can be set at a premium, e.g., 101.00, or par. The cashflows from the original issue, revenues or taxes, are diverted from the original deal, to the new issue."

The advantages of these bonds from both articles are:

Better Yields and Higher Cashflows - Due to the higher coupons on pre-refunded municipal bonds, they are priced at a premium to their par value. Some investors may be reluctant to purchase premium priced bonds since, at first glance, it doesn't seem to make sense to buy a bond at 105.23, but only get back 100.00 at the refunding date - less than the original investment. However, pre-refunded municipal bonds are often offered with higher yields than par bonds of similar quality and maturity. This, plus the higher coupon inherent in pre-refunded bonds, creates a higher cashflow over the life of the bond.

Better Price Stability - Bonds with higher coupons enjoy a lower duration than similar bonds with a lower coupon. Duration is a measurement of the bond's sensitivity to interest rate changes. Many variables affect duration such as maturity, credit quality, call features, and coupon rates. A higher coupon bond tends to be more stable and exhibit less price volatility when interest rates rise than a lower coupon bond.

Tax Advantages - The interest received on a pre-refunded municipal is still federally, and usually state-tax exempt for investors living in the state of issuance. When compared with the taxable equivalent yield needed on an actual Treasury bond, the pre-refunded bonds generally provide a better deal. For example, a U.S. Treasury note maturing in July 2012 with a 4.63% coupon is priced today at a taxable yield of 1.83%. There is also an Arizona municipal bond carrying a 4.6% coupon and pre-refunded to July 2012 selling today at $104.71 for a federally tax exempt yield of 3.23%. The taxable equivalent for a taxpayer in the 35% federal bracket would be 4.96%. That is an astonishing 3.13% more real return for a bond with essentially the same risk as the U.S. T-note. Even for a taxpayer in the 28% federal bracket, the yield on the pre-refunded has the taxable equivalent of 4.48%.

"The risks are the same risks inherent with any bond such as interest rate risk or reinvestment risk still exist. The credit risk is mitigated with the escrow account of U.S. Treasuries. All municipal bonds do carry a legislative risk that Congress will do away with the federal or state income exemptions which would reduce their effective yields."

More importantly, according to Morningstar, "The excess after-tax yield we are seeing on pre-refunded bonds is not normally this high. Today's flight to the safety of Treasuries is part of the reason. The other factor is that clients don't understand pre-refunded municipal bonds. Here's an opportunity to be a hero and offer them real security, with an acceptable return."

I contacted a bond agent at my broker Ameritrade about their pre-refunded muni bond offerings in California and found 47 bonds online. When I read the above statement from the Barron's article to the bond agent, he responded, "That equivalent 10% taxable yield is too good to be true!", to which I responded, "Well, the article is titled 'The Yields Are Staggering.' He asked for both links and related that he would look into more and get back to me.

Since I now have very little confidence in the rating agencies, I plan to get a professional opinion on the 47 California pre-refunded bonds from my brother-in-law, who is an owner/partner of a California firm that assists California governments and agencies in securing financing and ratings for public projects.

I will continue to search for the best places to invest the cash in my taxable accounts.

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