``Flight to quality'' has been the buzzword in investments lately, especially in the fixed-income area. Even though the default of bonds by the Washington Public Power Supply System happened over two years ago, painful memories for municipal bond investors are fresh. Other investors with more of a daring bent, however, have been looking at slightly lower-grade bonds in hopes of obtaining a higher yield.
But nowadays, the slightly higher return may not be worth the risk, says Richard Ciccarone, vice-president for municipal bond analysis at Van Kampen Merritt Inc., an investment banking firm in Naperville, Ill.
To find out if the reward is worth the risk, Mr. Ciccarone checks something called the ``quality spread.'' This is the difference in yields, expressed in ``basis points,'' between two rating categories. There are 100 basis points in a percentage point.
Say you're trying to decide between a bond with a Baa rating and a yield of 9.25 percent or one carrying an Aaa rating and a yield of 8.30 percent. The additional 95 basis points earned on the Baa bond is the quality spread.
That difference, Ciccarone says, makes the Baa bond only ``marginally'' worth the added risk. Last week, however, the quality spreads were even narrower, at 52 points, so there is less reason to give up higher quality. With 95 being the borderline, then perhaps a quality spread above that makes the higher risk worthwhile.
Quality spreads change for a number of reasons, but the main one is interest rates, he says.
``When interest rates go down, then the spreads narrow,'' he notes. ``In 1982 there was a 150- to 160-point spread. The all-time high was 175 points in 1976-77.''
The wide spreads in 1981-82 were related to the high interest rates at the time and the recession. When the economy is weaker, investors are even more interested in quality, so lower-rated bonds have to offer higher yields, while the Aaa's and Aa's can sell quite nicely at significantly lower yields.
Also, in the last couple of years quality spreads have narrowed because municipal bond insurance has increased the proportion of higher-rated bonds. About 40 percent of all new issues either had some form of bond insurance or a letter of credit behind them, Ciccarone says. As a result, many bonds that would have had an A or Baa rating from Moody's are now rated Aa or Aaa.
The increased emphasis on quality comes during another record year for the municipal bond market. Last year's record for new issues was broken by the end of this October. The pace is expected to get even heavier between now and New Year's, Ciccarone says, partly because of tax reform. One item in President Reagan's tax package would severely limit the deductibility of about 80 percent of all municipal bonds, including student loan bonds, hospital bonds, and industrial development bonds. Thus, many bon ds are going to market now to beat the Jan. 1 deadline.
Also, if the top personal tax rate is cut from 50 to 35 or 38 percent, it will take a higher yield to generate the same tax-free income after a new tax law passes.
If you are a municipal bond investor, or plan to be one, Mr. Ciccarone says, buying lower-grade bonds after the spreads have narrowed could be just adding more risk if you are not experienced in analyzing bonds and comparing equal ratings from different issuers.
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