BAB's yield disparity

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Jul 16, 2009 1:06 am

There have been quite a few inefficiencies in the bond market over the last year (which is rare), but another one is poking it's beautiful head out.

 
If you've been paying attention to Build America Bond yields, especially for qualified money or for clients in a low tax bracket, yields are unbelievable.  Consider A rated BAB's averaging around 6.5-7% right now.  Then compare them to corporate A rated yields paying 6.25% for the same maturity.  Even though historic default rates are 10-20 times lower on muni's than corporates, yields on taxable muni's are significantly higher. 
 
With BAB's supposedly going away in 2010, and given their significantly lower historic default rate, why wouldn't you be adding these to client portfolios?  I've been averaging around 500k-1 million the last several months, and even opened a couple new accounts on prospects I've been dripping on for a while with some 100k trades.
 
Let me poll the forum: How long does everyone think this disparity will last, and has anyone else been using these?  I'm curious.
Jul 16, 2009 1:47 am

2010?

Not sure to be honest but the rates are out of this world.  My biggest problem has been the terms, no one wants to lock their money up for 20 years+

Jul 16, 2009 9:05 am

Because states are starting to tighten there budgets(i.e. california, IOUs what is this monopoly). I think all municipal bonds are becoming more riskier by the day, the lack of money in the states is mind boggling and if they start defaulting, then watch out.

Jul 16, 2009 9:07 am

Agree with Chief....I wouldn't lock anyone up for 20+ in any muni even if it was insured. I think the idea that these are safe(low default rate) is going to change real soon, when states just don't have the money to pay for these.

Jul 16, 2009 10:47 am
Squash1:

Agree with Chief....I wouldn't lock anyone up for 20+ in any muni even if it was insured. I think the idea that these are safe(low default rate) is going to change real soon, when states just don't have the money to pay for these.

 
Yeah, I have been a bit scared of these too. For many of these bonds it is still a municipal obligation of 4.5-5% or more. Hard to understand why these things are A rated sometimes, I am afraid it might be another case where the rating agencies just don't know how to look at these. Seems to me something has got to give. I would be interested to hear what BondGuy has to add to the conversation.
Jul 16, 2009 1:15 pm

hey rank.. how those CIT issues treating you...I know jones had tons of those when i was there..

Jul 16, 2009 1:18 pm

Ah, and there you have it folks! The reason these bonds are carrying such a high yield. Advisors are telling their clients to "Watch out!" "Ooooo, were gonna get muni bond defaults!" "Too long, too much risk and not nearly as comfy as a mattress." Are you kidding me!!!

 
Rank, I'm all-in on BABs. Also using them in retirement accounts as they are much safer than like rated corps. NJTP BABS up big short term!
 
As i read some of the reactions on this thread I question why people would pay for such advice. Any advisor worth his fee knows the history of munis and where munis sit on "get paid list" if something goes wrong. Knowing that i wonder why advisors continue to shy away not only from BABs but all munis. It's not the missing of the opportunity that amazes me it's the complete failure to recognize the opportunity. For that there is no excuse!
 
I'm certainly not saying all munis are created equal. Yet, a quick search of the Orange County debacle where their manager was truly a man ahead of his time - sinking the county with derivatives,  and  a search of the 1970's NYC scare show the resiliency of munis. Rarely do they default and even when they do bond holders get paid back. Usually 100 cents on the dollar. They stand first in line.
 
As for not buying long term - every investor needs long term FI to balance their portfolio. Whether it's a ladder or bar bell, LT gets a place at the table. BABs are a good fit for that space.
Jul 16, 2009 2:01 pm

BondGuy, I'm not worried much about the default rate; I am worried about what inflation will do to a 20yr bond with our government spending money faster than the most recent lottery winner.  The same history that says muni defaults are exceptionally low says to stick with intermediate durations for the best risk/reward...especially with interest rates so low.  In a bond ladder, of course there is room for longer maturities but I am far from being "all-in" with them.

Jul 16, 2009 2:12 pm

My feeling, and correct me if i'm wrong Bondguy, is that these are like the old War Bonds and the Fed Govt will never let an instrument called "Build AMERICA Bonds" default.  And with these rates, when inflation comes down the road, we will have had several years of premium rates during a low rate environment...and the breakeven point may be years away, if ever!  I love'em ...especially in Qualified accounts!

Jul 16, 2009 2:43 pm

So am I correct in understanding that there is a 35% govt subsidy on these bonds meaning if a bond is yielding 7%, the issuer is only responsible for 4.55% while the gov pays the rest (2.45%)?

Jul 16, 2009 4:04 pm

 Inflation? Ah, what we've had is deflation. And stimulous is an attempt at reflation.


For inflation to take hold takes a two step process:
 
1. Creation of money and reserves.
 
2. Velocity of money - the number of times money turns over, or in retail terms, turn rate.
 
We've got creation of reserves in spades. Bank reserves sit at something like 900 billion dollars, well above the long term rate of 800 billion. The stimulous act has increased the amount of money in the public's hands by about 9% year over year. This is what you, and the talking heads are seeing. Yeah, that's inflationary. Sure is!
 
Yet:
 
Despite having money to lend banks aren't lending it. Money not lent is non inflationary. Sitting on a balance sheet or in a bank vault it does nothing.
 
The velocity of money has decreased, not increased. Money sitting on sidelines creates no economic activity. money on the sidelines is deflationary, not inflationary. That's what's causing unemployment to spike.
 
Government can't increase the velocity of money, only people can. And they won't until they feel better about the economy, jobs, the future etc. That ain't happenin' any time soon as the unemployment rate will continue to climb through sometime in 2010.
 
But what happens then:
 
Hmm? The banks not lending the dough could hold an answer. They've got almost 15x in excess reserves. That's something like 8 trillion in lending power. 8 trillion would be inflationary! Still, they aren't lending anything. Why not? Because the the other shoe hasn't dropped. And it's a very big shoe! The banks have recieved 700 billion in govt help to cover losses. According to some sources there is another trillion plus in write offs to come. Those banks are going to need every dime of those excess reserves.  Once that money is used to cover all the bad bets there won't be much left to lend. Thus no inflation. And here's the thing: Nobody knows if that's the number or if its better or worse than that. But until the picture is clear credit will be tight.  Very tight!
 
And
 
With Capacity Utilization below 70% and tight credit capping things who is going to raise prices? A manufacturer running at 65%? In a struggling economy? More likely they will cut prices to increase capacity to keep the production lines running and drive cash flow. remember- Cash is King and lower prices are not inflationary.
 
For the foreseeable future, inflation is off the table. Meantime things like BABs give you 6x the return of a money market for fractionally incremental increase in risk.
 
Our government spending money faster than they can print it is nothing new. When congress passed the current drug and health bill 6 years ago it didn't spike inflation even though it put us on the hook, not for billions as the current stimulous plan has, but for trillions. The current stimulous plan is chump change when compared to our entitlement program obligations.
 
Hi bondguy here:
 
If you are managing a portfolio to be a risk neutral as possible you've got to hedge against all risks. The future is unknowable! Obviously one way for our leaders to cover the vig on all their spendingwill be to raise taxes. Can anyone think of an investment that might cover that base? So, such a portfolio would not only contain LT muni bonds, but short term muni bonds as well. Just buy bonds!
 
 But wait, there's more:
 
 That portfolio should also hold commodities and dollar bearish currencies. Round it out with some international non dollar denominated stocks and bonds.
 
I'm not done:
 
We can't forget U.S. stocks to cover the "we can grow ourselves out of this mess" scenario. We've pulled that rabbit out of our hat more than once. Can we do it again? Regardless, I have to hedge for it.
 
Here's how to order:
 
Just buy bonds stocks commodities, currencies, long term, short term, domestic, international, large cap, small cap, value, growth.
 
Buy now and your clients will thank you.
 
 
 
 
Jul 17, 2009 1:38 am

Well put  Bondguy.  Most people forget about the time value of money comparisons they need to be making on client's interest bearing investments.  Even if inflation rears its ugly head (which I doubt short term, as BondGuy so adeptly explained, as well as the fact government debt interest payments/GDP ratio isn't even close to historic highs), it will be years from now.  And at a 5-6% annual premium to CD's or moneymarket, It would take Zimbabwe style inflation to catch up with cash equivalents.  There are plenty of BAB's paying around 6-7% for 15 year paper A rated and better.  Those that aren't buying now will look back and realize they bought the whole "inflation" lure hook, line, and sinker.

Jul 17, 2009 10:12 am

THX rankstocks


One other point on your original post:
 
You state that you've been putting $500k to $1,000,000 into BABs every month over the past few months. At 2% that's $10,000 to $20,000 gross each month.
 
A point lost here is the fine art of putting together a campaign. That is, finding something you like and telling as many people as you can about it. And when done in an organized and systematic way the result is gross production. Ranks you've done that here. Old school, for sure. But then again, if it ain't broke why fix it. Putting together and executing a campaign is an idea that works.
 
Some place on this board is a "save my month" thread. Campaigns are month makers.
 
Find something to love and put together a list of clients/prospects who would benefit from that investment. Then dial the phone.  Just do it!!!!!
Jul 27, 2009 12:36 pm

Are some of the mark up worth it on these bonds now? For example New Jersey Turnpike.. Priced around 114 but still yielding 6.36%.. obviously good yield, however is the mark up justified..



Also I am seeing a lot of california bonds... I am not going anywhere near those at a premium..

Jul 27, 2009 1:21 pm

Demand is driving the price. Obviously, someone thinks they are worth the price.


Jersey turnpikes are very good bonds. They are the test case for teaching municipal finance in many schools. Yeah, plenty of waste, patronage and probably corruption, after-all, this is Jersey, but a cash cow that just keeps on giving!
 
As for purchase that depends? What alternatives are there? Look at the relative yields and safety of those alternatives.
 
Premiums are great for income buyers. Especially long term premuium bonds. Buyers are paying to buy a higher income.  Because most buyers don't understand premium bonds, premium bonds are more favorably priced than are discount bonds. In other words they are a better deal for investors because there is less demand for them than for discount bonds. This gives the buyer the most income for the buck.