Municipal bond issuance continues to accelerate in 2016 and now appears to be on track to set an annual (nonBuild America Bond) record for volume. This heavy issuance is increasing yields, driving up the relative value of munis. Yield levels are still low versus historical levels, but we feel this may be the status quo, going forward. For those investors looking to put cash to work for the long-term, we think your opportunity is here. For those in no hurry to invest, due to concerns that yields are historically low, we are still providing a great risk/return short-term strategy designed to manage cash for the next 1 to 3 years.
This month, in our credit review, we discuss our “which coupon is best for you” study. We present a time-series analysis on OAS (Option Adjusted Spread) and total return results for 5%, 4%, and 3% coupon bonds over six-month and fifteen-month time frames. The data is starting to give us some conclusions, with the market setting itself up for an interesting next 12 months. Now, before you read on, place your bets. 5%? 4%? Or 3% coupon?
Our objectives for this study remain the same:
- Which coupon prices cheaper using OAS (Option Adjusted Spread) analyses, and how does this affect the bond’s returns.
- Which coupon shows the best return in the short-run (6 months) as it gets acclimated to the market, and which coupons preform the best over the long-term (life of bond).
Refreshing the Background Data:
We understand investors have different investment objectives and, for some of them, this includes coupon preference. For this study, assuming the investors do not have a coupon preference, we step back to look at how the coupon impacts the bonds return. From there, we identify which coupon fits which type of investor.
We continue to age the same bonds from the first study, as I believe a time series analysis comparing the total returns and OAS’s (see appendix for description of this analysis) on different coupon bonds from the same issuer with roughly the same maturities is the only way to see the performance characteristics of a coupon. We also continue to add bonds to the study and will add them to the results once they are over a year old.
4% coupons show strong 6-month performance, as they get acclimated and marked-up in the market. It is the top total return performer over the 15-month time frame, but underperformed OAS versus the 5% coupon. This tells us that the longer duration of the bond was a benefit during the recent rally. At this point, the coupon and duration are just right to allow for the price appreciation to outpace the 5% coupon, and high enough of a coupon to outpace the 3% coupon.
3% coupons prices the richest on an OAS basis, but this did not hurt the 6-month return. The longer duration of the bond, the bullish market, and an initial OAS tightening as bonds acclimate to the market gave the 3% coupon the top total return over the first 6 months. Yet longer-term after the initial retail rally, OAS has widened and performance is back in line with the 5% coupon, as the low coupon is hurting performance. This shows the 3% coupon to be more volatile in performance and more sensitive to market yield levels.
Conclusions:
- 5% coupon bonds price the cheapest on an OAS basis, but to date have been the weakest performer.
- 4% coupon has been the top performer over the life of the bonds since issuance.
- 3% bonds are the top performer over the initial 6 month time frame, and then begin to underperform.
At this point, we can start hypothesizing coupon performance as follows:
- 5% coupon appears defensive in focus, and we would anticipate it to outperform when interest rates begin to rise and possibly as time continues to move forward due to the higher coupon payout.
- 4% coupon bonds appear to be the top performer over a long-term bullish interest rate move for more of a buy and hold investor. You are getting more duration than the 5%, which helps in a market rally, and more coupon than the 3% bonds.
- 3% coupon bonds, those at the lowest dollar price, are darlings in the retail food chain and show good initial returns over the first 6 months, as they acclimate to the market. They may be good for a short-term total return strategy especially at certain yield levels and a good market outlook.
We will continue to follow this coupon study and hope we can get some good market moves to further assess their performance over time. We understand that this study is not all inclusive and there are a lot of factors that can influence a bond’s return. It is intended to be more of a point of discussion and generality than our way of telling our investors: “what is your best coupon”.
This material has been prepared for informational purposes only and is not an offer to buy or sell, or a solicitation to buy or sell. The information herein was obtained from sources which Mainline West Municipal Securities LLC, a member of FINRA and SIPC, and its suppliers believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed herein constitutes a solicitation of the purchase or sale of any securities. Any prior investment results presented herein are provided for illustrative purposes only and have not been verified by a third party. Furthermore, any hypothetical or simulated performance results contained herein have inherent limitation and do not represent an actual performance record. Actual factual performance will likely vary and may vary sharply from such hypothetical or simulated performance results. An investor should consider the investment objectives, risks, and charges and expenses associated with municipal bond securities before investing. More information about municipal bond securities is available in the issuer’s official statement or can be found at http://emma.msrb.org.