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Bond Market Primer: Corporates, Munis or Preferreds?


Wall Street has been able to constantly create new security types to fit almost any investor's needs.


As a fixed income manager, I have a myriad of choices when building bond portfolios for clients. From my perspective, one has to consider credit risk, interest rate risk, reinvestment risk, and extension risk (this applies to mortgage backed securities). Fortunately, Wall Street has been able to constantly create new security types to fit almost any investor's needs, which leads me to this brief, but important analysis of current credit market conditions.

Perhaps the most important return number for my clients (those that are tax-paying clients, not pension plans, endowments and IRAs), is what is your after-tax return net of risk taken? Just because a security has a higher after-tax return, you may not be being compensated for the inherent risk in the security, such as credit risk. But what if I told you that the security with the least credit risk had the highest after-tax and 'tax equivalent yield ('a tax equivalent yield is the 'after tax yield grossed up by the maximum federal tax rate')?

As you are likely aware, I have been cautious towards real estate and its far reaching implications over the past few years. We are finally seeing the effects of the real estate correction in the credit markets, although not nearly as much as I would have suspected.

At least, we are not seeing them yet. As a result of my cautious attitude about real estate, I have been mostly void of credit risk for the better part of three years and also void of municipal bonds. I have fielded a few questions from clients and others why I was so cautious towards municipal securities.

There were a few reasons. For instance, municipals were trading richly to Treasuries (they were 85% of treasury yields for a while and have now climbed towards 95-100% and led to dramatic underperformance), fundamentals are shaky to me when I consider how much revenue municipalities receive from real estate taxes, and they generally lack the high degrees of liquidity I like to see in securities I buy for clients.

You may be asking yourself where I am going with this. In the charts below, I intend to compare four distinct security types.

  • The Bloomberg BB rated financial bond index.
  • The Bloomberg BBB- rated industrial bond index.
  • A long-term high grade Florida municipal bond with 10 year call protection.
  • A recent Freddie Mac (FRE) DRD (Dividends Received Deduction) preferred stock with 10 years of call protection.

I think you may be surprised to see which security (and the one that I have added a large position for my clients recently) has the highest tax-equivalent yield. All I can say is that the market continues to mis-price risk and this is another bout of "You have got to be kidding me!"

Bloomberg BB Rated Financial Bond Index

Click here to enlarge.

Bloomberg BBB- Rated Industrial Bond Index

Click here to enlarge.

Long-Term High Grade Florida Municipal Bond with 10 Years Call Protection

Click here to enlarge.

Freddie Mac 6.55% DRD Eligible Preferred Stock with 10 Years Call Protection

Click here to enlarge.

As Gomer Pyle would say, "Surprise, surprise, surprise!"

The Tax Equivalent Yield (TEY) of the securities is as follows:

  • AA Rated Freddie Mac Preferred-9.03% (at my cost).
  • 10 Year Bloomberg BB rated Financial Bond Index-7.08%.
  • Long-term AA rated Florida Municipal Bond-6.99%.
  • 10 Year Bloomberg BBB- rated Industrial Bond Index-6.32%.

This simple analysis leads me to a few conclusions:

There is still enormous dislocation in the credit markets. Many investors are over-paying for low grade securities. And, thankfully, I have found the inefficiency and have exploited it. I will continue to focus on this area of bonds and have also just yesterday added a position in Georgia Power (GAH) 6.5% DRD eligible securities at a TEY of 9%. Yep, you have to be kidding me.

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Positions in FRE 6.55 pfd and Georgia Power 6.5 Pfd

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