Last week, we were rudely reminded of the adage, “Be careful what you wish for,” after reading a Wall Street Journal article entitled “Municipal Bond Fans Get A Rude Awakening,” (February 8, 2005).
As regular readers know, we are continually lamenting the lack of useful information available to individual investors involved in the $1.8 trillion municipal bond market. But if the phone calls and e-mails we received were any indication, investors would have been spared a considerable amount of confusion had the story never been written.
The author, we believe, was suggesting that “call features” on bonds are a source of mystery, that they can catch investors and money managers off guard, resulting in catastrophic losses and negative returns for investors.
Background
The story itself is an interesting one. It revolves around the redemption, by New York City, of $430 million in tax-free bonds that had been previously refinanced and “escrowed to maturity” in U.S. Treasury securities.
Our understanding from this article is that the money managers and brokers featured in the story sold these bonds to investors as if they were “non-callable,” which is what they assumed since the bonds are termed escrowed to maturity (ETM), which sounds like a guarantee that the bond won’t be redeemed prior to maturity.
Therefore, the bonds, which carried interest rates of 7 to 7 1/4%, were not priced to a call as most premium bonds would be, but were priced to the maturity date, which resulted in premium prices of approximately 115.00 to 120.00. Once it was announced that these bonds would be called at 100.00 in March and April of this year, the market value of the bonds plummeted to 100.00.
The author concludes that the losses stemmed from “investors’ misunderstanding of a common bond feature known as the call.”
In our opinion, this conclusion grossly underestimates the sophistication of the average municipal bond investor and skirts the real issue: The brokers and money managers quoted in the article did not know these bonds could be called, and should have.
The calling of ETM bonds has been a controversial practice in this industry since the early 1990s, when the dramatic decline in interest rates allowed issuers to borrow at much lower rates and pre-refund (refinance) existing, higher-rate debt.
Warning shot fired
A similar controversy arose in 1993 when the East Baton Rouge (Louisiana) Mortgage Authority attempted to call outstanding 7% debt, which had been escrowed to maturity in 1989.
As interest rates steadily declined in the early ’90s, East Baton Rouge politicians were informed by a group of ambitious investment bankers that the Treasury bonds used to escrow the authority’s 7% munis had appreciated substantially in value.
The authority was advised to sell the Treasuries, find a loophole to call the original bond issue and pocket the healthy sum remaining, to use as they pleased.
FMSbonds joined with other municipal dealers and securities attorneys and successfully thwarted the authority’s plan, but the warning bells had sounded. The industry was put on notice that unless an issuer specifically “defeased all prior calls,” ETM bonds were subject to redemption prior to maturity.
Info easy to find
It would have been quite simple for the brokers and money managers featured in The Wall Street Journal story to determine the “callability” of these bonds prior to buying them or selling them at these prohibitive prices. A cursory check with Bloomberg or J.J. Kenny Information Services would have shown in the legend that “prior optional calls may be exercised.” Or they could have read our Bond Forum, where we addressed this issue and warned of this potential problem.
Our response to an Aug. 22, 2003, question regarding ETM bonds, was as follows: “The one caveat when buying ETM bonds is to be certain that all calls have been defeased or the bonds are priced to the call date.”
One broker in The Wall Street Journal’s story is quoted as saying that he told his clients about the possibility of a call, but added that he considered it remote since New York could have called the bonds for years, but hadn’t done so. We bet he never says that again.
The concept is simple: when buying ETM bonds, investors should be certain that all calls have been defeased or the bonds have been priced to the call date. Their brokers should know it and explain it to them, and the media should have the perspective to understand where the problem really is. The story here isn’t that call features are mysterious, it is, once again, the shortage of credible information provided to tax-free bond investors.