Why are some municipal bond variants out of vogue right now?

Market Realist

Why investors should consider municipal bonds despite Puerto Rico (Part 5 of 8)

(Continued from Part 4)

Municipal bonds (or munis) are issued by state and local governments and their agencies to fund capital expenditure on public projects (like highways, bridges, schools, or hospitals). In the last article of this series, we discussed variable-rate demand obligations (or VRDOs). In this article, we’ll discuss other variants of municipal bonds.

Taxable municipal bonds

Unless the underlying investment planned to be financed by the municipal bond issue provides a significant benefit to the general public, the Federal government would levy taxes on the interest on the bond issue. Examples of such activities include bonds issued to construct sports stadiums or finance under-funded pension plans. An example of taxable bonds are Build America Bonds (or BABs), which incentivize issuers by giving them either a rebate of 35% on interest costs or a direct tax credit to bond buyers. BABs were introduced in the wake of the 2008 financial crisis to stimulate investment in infrastructure projects in the economy. Due to the government subsidizing interest costs, the issuer can afford to pay a higher rate of interest.

Although the BABs program expired on December 31, 2010, the government plans on permanently reinstating it, as this has proven popular with issuers and institutional investors alike. Popular ETFs investing in BABs include the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS) and the PIMCO Build America Bond Strategy Fund (BABZ).

An increase in infrastructure investment would benefit companies like Caterpillar (CAT), which supplies heavy equipment and machinery to the construction industry, and Vulcan Materials (VMC). An S&P 100 Index (OEF) component, CAT will announce Q1 2014 results on April 24.

Zero-coupon municipal bonds

Zero-coupon munis are issued at a discount to the face value and don’t pay interest. They’re redeemable at full face value at maturity. Interest income is usually exempt from federal taxes. Retail investors can use these to fund a particular future liability, like college tuition. These bonds tend to be more sensitive to changes in interest rates and have higher durations because they don’t pay a coupon, which would help mitigate some of the interest rate risk. When interest rates rise, bond prices fall and vice versa, and the long durations of zero-coupon bonds make them particularly vulnerable to interest rate increases.

In the next article in this series, we’ll discuss some of the major benefits of investing in municipal bonds. Please read on to Part 6 of this series to find out more.

Continue to Part 6

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