Cheap Bonds

By?Patrick Donley?and?Shawn O'Malley , edited by?Robert Leonard ?· September 20, 2022

*LinkedIn newsletter is posted at a one-day delay.

Welcome back to?We Study Markets !?

In?another turn in the riveting TerraUSD saga , a not-so-stable stablecoin that collapsed in dramatic fashion this spring, the creator of the token that destroyed around $40 billion in wealth after losing its peg is now seemingly on the run from authorities???

Yesterday, reports emerged that South Korean prosecutors have garnered support from Interpol to track down the accused fraudster, Do Kwon, who left South Korea for Singapore in April.

In other news, tomorrow is Fed rate hike day — Prepare for a media onslaught. We'll be here, in the evening as we normally are, to discuss our thoughts once things have settled down a bit.?

Here's the market rundown:

MARKETS

*All prices as of market close at 4pm EST

Equities finished off a bit from their low today but still down, as 2-Year Treasuries flirted with 4% yields and the 10-Year yield held over 3.5% alongside a stronger dollar once again.

Ford (F ) fell 12.4% after it estimated that Q3 earnings before interest and taxes would come in 50% lower than Wall Street's estimates???

Today, we'll discuss good news out of the housing market, corporate layoffs lurking on the horizon, Porche's IPO, and an analysis of cheap bonds.?

All this, and more, in just?5?minutes to read.?

Let's do it! ??

IN THE NEWS

?? U.S. Housing Starts Rebound?(Reuters )?

Explained:?

• U.S. housing starts unexpectedly rebounded in August as rising rents boosted the construction of multi-family housing units. However, soaring mortgage rates and high home prices are undercutting overall demand for housing and pushing home ownership out of reach for many Americans.
• Housing starts jumped 12.2% last month to a seasonally adjusted annual rate of 1.575 million units. Economists polled by Reuters expected starts to come in at a rate of 1.445 million units.

What to know:?

• The Federal Reserve's aggressive monetary tightening policy significantly weakens the housing industry. Other sectors of the economy, like the labor market, have shown strong resilience despite the Fed's efforts to cool demand.
• The 30-year fixed mortgage rate averaged 6.02% last week, breaking over 6% for the first time since November 2008.
• A survey by the National Association of Homebuilders/Wells Fargo Housing Market showed sentiment among homebuilders falling for the 9th straight month in September. Nearly a quarter of builders reported reducing home prices, and more than half were offering incentives to bolster sales, including mortgage rate buydowns and free amenities.

???Layoffs on the Horizon? (CNBC )??

Explained:?

• A red-hot jobs market sandwiched between rising inflation and negative GDP growth have economists divided on the health of the U.S. economy.
• The unemployment rate is at a 50-year low, yet many Americans are concerned about layoffs being on the horizon with talk of a recession.

What to know:?

• Big companies, such as Best Buy (BBY ?), Ford Motor (F ), Walmart (WMT ), and Wayfair (W ) have already announced layoffs, and a survey by PwC shows that 50% of firms expect to reduce their labor force in the next 12 months.?
• Oddly, this comes at a time when the labor market could not appear stronger. In July, there was a shortage of available workers for over 11.2 million job openings.
• Still, with the Federal Reserve raising interest rates and being willing to sacrifice economic gains for a lower inflation rate, more layoffs will likely occur in the U.S. economy.?

?? Porsche's IPO (WSJ )

Explained:

• Porsche AG shares are set to begin trading on Sept. 29 in one of Europe's largest public listings in years, raising up to $9.4 billion and putting the valuation of the sports car maker at approximately $78 billion.
• Volkswagen AG, Porsche's parent company, is selling the preferred stock along with a private sale of Porsche common stock to VW's largest investor, Porsche Automobil Holding SE. The combined sale of 25% of Porsche common stock and the preferred stock could generate up to $19.5 billion for VW.
• VW said it plans to distribute 50% of the proceeds of the combined Porsche sale to its shareholders in a special dividend.

What to know:

• The listing will test investor appetite for further offerings in a market burdened by soaring inflation, the war in Ukraine, and concerns about a global recession.
• The deal will put Porsche shares in the hands of the public for the first time since VW acquired the car maker in 2012.
• The money raised from the Porsche sale will finance VW's transformation to an electric car manufacturer, which is currently building six battery factories in Europe alone as part of the process.

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DIVE DEEPER: CHEAP BONDS

We are big fans of the excellent Jason Zweig, who we've written about?previously ?and who runs?The Intelligent Investor column ?at?The Wall Street Journal.?

In?a recent article , Zweig explores the nuances of municipal bonds, their tax-free allure, and their illusory cheapness.?

Bonds and taxes are seldom a sexy topic, though we think that for investors and those managing their own money, the takeaways are enlightening.

Let's discuss.?

What to know

Firstly, let's speak to what a municipal bond is.?

Unlike Treasuries, which are issued by the U.S. federal government to fund its annual expenditures or corporate bonds that raise liquidity for companies, the municipal bond market refers to securities issued by various state and local governments.

In buying these bonds, investors may fund public works projects like libraries, infrastructure, schools, etc.?

Notably, as an incentive to purchase these bonds, the interest payments are made tax-free (exempt from both federal and state & local), thus making them particularly compelling to individuals in high tax brackets.?

As of 2021, this is a roughly $4 trillion market.?

Breaking it down

Unless you've totally ignored financial markets this year (if so, we've got some bad news to break to you...), then you've probably heard that interest rates are rising broadly.?

The yield (interest payments divided by price) carries an inverse relationship to price. So as bond prices decline, the yield increases.

Default risk for these government-backed municipal bonds is low, but they still offer a better return than corporate alternatives on a taxable-equivalent basis, according to Jonathan Mondio, head of North American fixed income for abrdn.?

With many cities and towns holding fortified balance sheets following two years of generous federal stimulus, their bonds seem like a safe and attractive bet.?

At times this year, municipal bonds have even been higher than Treasuries outright, regardless of adjusting for their tax-exempt nature.

With this in mind, as bonds of all kinds have declined significantly this year, some contrarian investors have come to find the municipal market quite intriguing given that approximately $83 billion has been pulled out of mutual funds and ETFs that focus on these sorts of debts.

To traditional value investors, these market dynamics reek of bargain opportunities.?

I mean, who doesn't want to earn tax-free income at a discount?

Beneath the surface

Perhaps this is true but primarily on the surface. Zweig states that, "Investors shopping for bonds typically see a bond's price, the coupon it pays and the resulting yield. That yield, which incorporates the premium or discount of the price to par, is somewhat deceptive if there's a taxable gain embedded in it."

This boils down to a small nuance: although income from municipal bonds (munis) via interest payments is normally tax-free, the capital gains are not.??

In the low-rate environment of 2021, Zweig highlights that munis traded between $109 and $114, yet now after recent sell-offs, the price is often below the principal (par) value of $100.?

So if you buy a muni at $98, and hold it to maturity, you'll be paid $100, and that $2 gain would be subject to capital gains taxes.?

While investors planning to hold until maturity have previously not had to worry about the cost of capital gains taxes on their municipal bond holdings, for new investors today, the reality is fundamentally different due to the lower prices (below $100).?

Depending on the size of your capital gain, the tax rate can vary for munis from up to 20% for small gains to 40% for larger ones.?

Capital gains consequences

In other words, while yields on munis have risen dramatically making them rather enticing, the after-tax return for buying at current prices is far less alluring.?

Zweig explains, "Say, for example, you buy a conventional muni maturing in 2032 and you pay between $97.50 and $99.99. Even if you hold that to maturity, the resulting gain is taxable at the lower capital-gains rate. "??

And beneath the $97.5 threshold, your gains are subject to a larger tax rate.?

In one example, he cites a muni bond trading at the price: $90.402 and offering a yield of 2.7%.?

Accounting for the 40% tax rate applied to the muni's capital gains, the real return actually comes out to 2.5%.??

Takeaway

When investing at scale, these seemingly small differences in yields can amount to thousands and tens of thousands of dollars each year in expected returns that must really be paid to the government.?

To address this, Zweig suggests that, for those interested in stepping into the increasingly discounted municipal bond market to lock in tax-free income, search for newer debt issues that trade at or above their par price ($100), and hold to maturity.?

If you invest in mutual funds or ETFs that hold munis, you'll want to watch out for abnormally large payouts in recent years, as they could be a sign that they've been buying "discount bonds without regard for tax efficiency."

Wrapping up

If you like this sort of analysis from Zweig, you ought to listen to our?Richer, Wiser, Happier podcast interview with him .

Tell us, — What do you think of Jason Zweig and his analysis of municipal bonds here?

For more on investing in bonds and managing them in your portfolio, check out?this lesson ?from our (free)?Intelligent Investor video course .?

WHAT ELSE WE'RE INTO

???Books:?Smart Brevity , the book that defines Axios journalists signature writing style

???Video:?The ~Ultimate~ Guide to Stock Investing ?(plus retirement and savings strategies)

???Newsletter:?Unhedged , will higher rates kill big tech?

SEE YOU NEXT TIME!

That's it for today on?We Study Markets !?

See you later!

All the best,

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