For the past decade, the size of the municipal bond market has remained relatively stable, while other major bond market sectors have grown rapidly (see Exhibit I). Ongoing Federal fiscal budget deficits have prompted a dramatic increase in Treasury borrowing. Corporations have ramped up their bond issuance as well to fund stock buybacks, avoid the repatriation of overseas profits, and finance mergers and acquisitions, among other reasons. In comparison, the muni market has been left in the dust. Following the Global Financial Crisis (GFC), many states and local governments operated in a more fiscally conservative manner to help their finances recover (a good thing!). These government entities have also faced the burden of pensions and related benefit obligations consuming a growing portion of their resources, which constrained the funds available for new projects. In 2017, the Tax Cuts and Jobs Act introduced a major new limiting factor – the prohibition of tax-exempt advanced refundings.
Exhibit I shows the aggregate growth of the Treasury, Muni & Corporate Bond markets. While Treasuries and Corporate Bonds have grown rapidly, the muni bond market has stayed relatively stable.
Municipal refunding is a process by which an issuer either redeems or defeases older, more expensive debt with the proceeds from a new bond that has a lower interest cost. There are two types:
Current Refunding: Occurs within 90 days of when bonds are scheduled to mature or when they become callable
Advanced Refunding: Occurs prior to 90 days of when bonds are scheduled to mature or when they become callable, commonly three-to-five years earlier
Prior to 2017’s tax reform, issuers had a one-time option to advance refund by issuing new tax-exempt debt. This flexibility was eliminated in the reform act as politicians sought to eliminate the tax expenditure1 associated with refunding activity. Prior to reform, an advanced refunding transaction would leave two tax exempt muni bonds outstanding for the same project:
- The new bond
- The older, defeased bond (the “pre-re”, short for pre-refunded)
Today, municipal issuers can still advance-refund, but they need to issue taxable bonds to do so. Prior to the tax law change, tax-exempt advanced-refundings were a major source of municipal supply, comprising 25% of total new issuance, on average. Today, advanced refundings are still a major driver of supply, but now of taxable municipal bonds, leaving the traditional tax-exempt market with a dearth of issuance (see Exhibit II).
But, leave it to creative public finance bankers to find a small loophole in the form of delayed-delivery bonds. Typically, municipal new issue bonds settle in less than a month. In contrast, delayed-delivery bonds usually settle in four-to-twelve months. This means a municipality may issue tax exempt debt now and take advantage of current rates, but not settle the bonds until a future date that falls within the 90-day current refunding window.
Exhibit II shows the Muni Bond Market’s total supply by year as well as the percentage of issuance that is taxable. Taxable issues have been on the rise since 2017, now accounting for roughly a third of total issuance.
Delayed-delivery bonds present some unique challenges that limit the size of the potential buyer base for the securities. We often find opportunities in areas of the market in which participation is limited. In this case, broker-dealers often apply their own credit constraints on the investors permitted to participate in these deals because of the extended settlement periods. In one instance, only public mutual funds and ETFs were allowed to participate. We have also faced situations in which investors do not wish to hold unsettled positions on certain statement dates and others who impose limits that govern maximum delay periods.
From an investment perspective, these bonds possess all of the credit and interest rate risk of normal bonds, but without any income during the delay period. In order to entice demand for these securities, issuers must offer a price discount, or additional yield that only begins accruing after settlement. We look to our valuation process to help us judge whether this additional yield is simply adequate, or attractive.
Whenever we approach a potential opportunity, we first must get comfortable with the credit profile of the issuer before thinking about valuation math. The basic question with delayed delivery bonds is whether the extra yield that the securities offer once they settle adequately compensates for the foregone income and accounting challenges during the delay period.
Exhibit III shows two examples… the first bond we purchased, the second we passed.
Exhibit III provides data points for two delayed delivery bonds, the State of California, and Cleveland Clinic. The State of California delayed delivery bond provided 21 basis points of additional yield versus only 2 basis points for Cleveland Clinic.
In a longer-term context, we viewed the base spread of 8 basis points for the double-A rated State of California as fair, and the extra yield associated with the forward delivery as quite attractive. Excess yield of 21 bps for an eight-year bond, implies that the new issue price was 1.5 points below its fair value. In the second example, even though Cleveland Clinic is a fine credit that we have owned before, we viewed the base spread of 20 bps as expensive compared to its longer-term spread range. And unlike the previous example, there was no meaningful discount attributable to the bond’s forward delivery.
One aspect of delayed delivery bonds that we find attractive is that the return potential associated with the discounted new issue pricing should be realized by settlement date. Said differently, the price discount should disappear as the settlement date approaches... you just have to wait. At this point, we have the option of selling the bond, or holding onto it, but in either case portfolio returns have benefited.
Unlike a year ago when most of the market was on sale, finding attractive values in today’s muni market has become more difficult as credit spreads have approached record lows and the investors have faced a supply / demand imbalance. At today’s valuations, it is clear that many investors have moved down in credit quality or into longer maturities in pursuit of yield. In contrast, we have increasingly invested in securities with non-standard coupon structures to enhance yield without compromising credit quality or exposing our portfolios to undue interest rate risk. For us, delayed delivery bonds offer similar benefits – high quality, intermediate-maturity bonds with greater return potential… all you have to do is wait.
1 A tax expenditure represents foregone government income such as from tax credits, tax exclusions (such as for traditional municipal bonds), tax deductions (such as from charitable contributions), and preferential tax rates (such as for long-term capital gains).
Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
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