Municipal bonds regaining appeal with 'enhancements'
Apart from ''two little flies in our ointment,'' James Lebenthal finds selling municipal bonds somewhat more enjoyable these days. Mr. Lebenthal is chairman of Lebenthal & Co., a New York municipal bond broker.
It's not that ''muni'' bond ratings have gone up, although some have. And it's not that all the states and cities are suddenly becoming more fiscally responsible, though some have.
What's happened is that more municipal bonds are being sold with various new ''enhancements'' to increase their safety without substantially reducing the yield. Until a year or so ago, Mr. Lebenthal says, the only enhancements, or outside guarantees, came from two private insurance companies that back municipal bonds. Now, he notes, there are more insurance companies, and groups of banks are backing some bond issues with their own letters of credit. Then there are some special arrangements, such as a state backing the bonds of a city or public authority.
''We are selling an awful lot of triple-A bonds,'' Lebenthal says. ''But not because of improved creditworthiness of the issuers. It is because of these credit enhancements.''
Still, there are those flies in Lebenthal's ointment. The first is the ''still unresolved situation of 'Whoops' (Washington Public Power Supply System).. . . You can't have 21/4 billion dollars in debt go bad without affecting the whole area, even though the State of Washington was not involved and even though the risks were known when those bonds were sold.'' Since the utility consortium defaulted on its municipal bonds last year, he noted, many cities and some of the states in the Northwest have had trouble selling bonds, or have had to offer expensive yields.
The second fly is something that, to Lebenthal, ''looks an awful lot like a tax on municipal bond income.'' It is the inclusion of municipal bond income as part of the earnings test to determine whether an individual's social security payments will be taxed. This is an indirect federal tax on municipal bonds, which goes against the principle of reciprocal tax-free status for government bonds: States cannot tax income from federal bonds, and the feds are not supposed to tax municipal bond income. A bill has been introduced in the Senate to repeal this part of the 1982 tax law.
In the meantime, the municipal bond business does have its bright spots, apart from enhancements. Having learned the lesson that cutting taxes is popular with taxpayers but unpopular with bond buyers, states and cities are seeking ways to balance the two interests. In 1982, reports Morgan Guaranty Trust Company, 18 states raised taxes, and in 1983, 38 states did so through temporary or permanent levies.
In some places, these measures have resulted in higher bond ratings, giving bond buyers a greater selection of good-quality issues. This has forced many municipalities to be more competitive and offer higher yields on AAA and AA-rated bonds. Traditonally, an investor gave up some yield in return for the security of a higher rating.
But with enhancements and competition, that is no longer so. ''In the old days, there were very few cities with triple-A's,'' Mr. Lebenthal notes. ''Today , there are so many that what you're giving up in yield is chicken feed.''
For example, bonds issued by the Puerto Rico Government Development Bank ''normally would be a tough seller.'' But a recent issue is guaranteed by banks in Japan, Latin America, and the United States. It's paying 9.5 percent.
At the same time, a recent issue by the Port Authority of New York and New Jersey, selling on its own merits and not backed by any outside banks, agency, or insurer, is paying 9.67 percent, less than two-tenths of a percent more.
Another example of an ''enhanced'' bond issue comes from the Metropolitan Transportation Authority (MTA), New York City's subway system. These bonds are backed by an $80 million fund set up by the State of New York, solely for this purpose. The bonds carry an A rating from Moody's and A- from Standard & Poor's and are paying 97/8 percent.
All these improvements are good news for individual investors, who ''have been dominating the municipal market for the last three or four years,'' observes John Noonan, a vice-president and manager of the public finance department at Nuveen & Co., a mutual fund specializing in municipal bonds. As inflatioin and increased family incomes push more people into higher brackets, the demand for tax-free investments, purchased directly or through a mutual fund , has been increasing continuously.
And despite recent concerns about municipal bond defaults, these investors can get a high degree of safety while sacrificing little, if any, yield. Some of this safety comes through various enhancements that can be discussed with a broker. And some simply comes from bonds being issued by fiscally stronger governments.
Still, there are some traditional precautions that are always in order, Mr. Noonan says. First, he recommends a close reading of the offering document. ''Everything is in there,'' he says. With bonds issued by a city or town, for example, you might note if the population is growing, the type of industry in the area, and any changes that have taken place regarding tax laws.
If you are still leery about buying munis directly, you can reduce the risk through a mutual fund. You may lose a fraction of a percentage point in yield, but by following the fund's quarterly reports, you can see the kinds of investments the professionals select, not the ones a broker is currently pushing.
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