Municipal Bond Forum
Non-callable bonds in worst-case scenario
Q
I own a number of long-term PA zero-coupon muni revenue bonds. All of the bonds are AAA insured — many are also ETM — and they reflect revenue from water and/or sewer systems. All of the bonds were listed as “non-callable” when I purchased them, with no conditions attached whatsoever. If the worst were to happen to one or more of the water/sewer systems whose bonds I hold (e.g., large-scale destruction or significant long-term disruption due to terrorism, major earthquake, etc.), can these bonds be called (i.e., paid off at less than par prior to maturity) even though they were listed as “non-callable” when I purchased them? Or would I still be able to count on the $1,000 per bond value at the original maturity date of the bonds? I have received much conflicting advice on this from different brokers.
A
James A. Klotz responds:
The bonds you asked about may both be rated “AAA” but they are secured differently. Bonds that have been escrowed to maturity (ETM) typically have been refunded by a new bond issue. The proceeds of the new issue are invested in U.S. Treasury securities and held in an account restricted in use for the payment of the original bond issue on its interest and principal due dates. Such bonds are no longer the responsibility of the original issuer, no longer appear on its balance sheet and are considered “defeased.” In such a case, the relationship between the fortunes of the original issuer and the payment of the original bonds ceases to exist. Bondholders are solely secured by the Treasuries held in the escrow account by the bond trustee. It is important when buying such bonds to make sure they have been re-rated by a major rating agency who looks to ensure that the defeasance has actually occurred and that the cash flows will be adequate to pay the bonds when due. Some escrowed issues are not re-rated by a rating agency and the purchaser of such bonds will need to check the documents on his/her own.
In the case of bonds rated “AAA” resulting from the purchase of bond insurance, the insurance policy actually represents a second level of security that is invoked in case the issuer fails to make bond payments from its own sources. In such a case, the bond insurer steps up to the plate and makes the payment. Such policies are noncancellable. In the case of a bond default, the insurer has the option to continue payments on the maturity schedule, or pay bondholders the face value due to them at maturity. If the bond is a zero coupon, the accreted value would be paid. This would result in the bond being retired prior to its original maturity date.
In either case, both ETMs and “AAA” insured bonds are considered among the most secure municipal securities available.
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