The doors of safe-deposit boxes have been swinging wide open in recent weeks as holders of municipal bonds face the unpleasant reality that their high-interest, tax-exempt securities have been called for redemption.
In June and July, $70 billion in cash is flowing to municipal-bond investors in the form of early redemptions, scheduled maturities and interest payments.
Investors might hope that this tidal wave of cash would hit a similar wave of new tax-exempt bond issues, but that's not happening. Interest rates are rising, choking off new issues, and the massive refunding of high-interest munis by state and local governments is pretty much over.
The bottom line would appear to be a classic demand/supply squeeze, which means higher bond prices and lower yields. However, higher prices and lower yields have turned away many muni buyers who have decided instead to park their cash elsewhere for now. In addition, many municipal-bond fund investors still are pulling money out of the funds after being burned badly in the bond-market crash of March.
As a result, even when new municipal bonds are offered, they often end up on the shelves of underwriters.
For example, two days after a recent $94.7 million bond offering by the State of Utah, one investment firm had $55.6 million of unsold bonds on its hands.
Many muni bonds have call protection provisions that say they can't be called for early redemption for 10 years. Ten years ago, state and local governments were issuing tax-exempt bonds with double-digit interest rates, compared with rates of just more than 6 percent today on top-quality general-obligation bonds.
Bradford Langs, municipal-bond analyst for Kemper Securities in Chicago, said 1981 through 1984 saw the highest tax-exempt rates since the 1930s.
Naturally, state and local governments rushed to refinance this high-interest debt in the early 1990s, just as homeowners rushed to refinance mortgages. Indeed, many units of government seeking to capitalize on last year's bond rally issued refunding bonds before the 10-year call date on their existing bonds had arrived. They simply bought Treasury securities with the proceeds of the new debt in a process known as defeasance.
Now the redemption calls are continuing at a strong pace, but the supply of new securities peaked last year because of the defeasance process.
What's more, "virtually all the bonds that could have been refunded are being funded," said Dennis McDonnell, president of Van Kampen Merritt Investment Advisory in Oakbrook Terrace, Ill. "We're not going to see another wave of advance refundings."
Tax-exempt bond issuance last year hit a record high of $290 billion. The new-issuance pace this year is more than 30 percent less than 1993's. Several factors create demand for the scarcer supply of new municipal issues. The bite last year's tax law took on high-bracket taxpayers created many converts to tax-exempt investing.
"In April, people really felt for the first time what the higher rates meant," said Mr. Langs.
Also, the economic recovery in many parts of the country and the widespread availability of insurance for municipal bonds has boosted investor confidence in the safety of municipals.
But analysts advise a careful approach for bondholders getting redemption and interest checks. Mr. Langs said muni bond investors might be smart to reinvest redemption proceeds back into the tax-exempt market in stages rather than plunking the full amount down quickly.
Mr. McDonnell advised investors facing July 1 bond calls not to wait until then to turn in the bonds. Bonds held by individuals should be taken to the paying agent now, so the cash can be credited as quickly as possible, he said. That way, the investor may get a few days' jump on the pack if he or she chooses to reinvest in tax-exempts.
Mr. Langs said municipal-bond investors still can get a tax-equivalent, inflation-adjusted rate of return of 5 percent, which is well above the historic rate of 3 percent.