Why CA muni at ytw 4.9, what is the catch?

[mikebh]

at schwab I see

Chula Vista Ca Esd REV 2.25% 09/01/2039 OID Callable
17131MTY3
Continuously-Callable on 03/01/2027 @ 100.00000

at price: 70.29400

S&P Rating: AA

why so steep discount?
What I'm missing?

thanks

[Silk McCue]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

[mikebh]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

thank you for the reply
would you educate me about this muni case, please
I thought to use YTW rate of 4.9% to compare to TBill of 5.5% for CA state, and this YTW 4.9% is way better then TBill best rate via Fidelity calc due to exempts from Fed and State taxes
what does 2.25% mean in this case?
what income distribution rate this muni produces? 2.25 or 4.9 per year ?

how to compare muni vs TBill ?
yes, I'm aware of muni can be for many years - 10 - 30 years, while TBill up to an year
with TBill I've re purchase better rate one as rates have gone up, while the muni is fixed and on secondary market can be bough at discount price (coupon?)

thanks

[Geologist]

Assuming you have described the muni bond correctly, 2.25% is the coupon rate. The bond will pay half of that percentage per $100 par value every six months (i.e., $1.125 per $100 par) until it is either called or reaches maturity.

Because interest rates have risen, the market value of the bond has declined and the result is the interest rate on the market value is higher (you give it as 4.9% as yield to worst, presumably meaning to the earliest call date of 3/1/27). However, since this has a low coupon rate and the call value is par (far above current market), it is unlikely to be called anytime soon. If interest rates stay close to current levels, this bond may well stay outstanding until 2039. As muni’s are not all that liquid, you may have trouble getting out of this bond at a decent price if you need the money. Yield to worst includes the return in going from 70 to 100 by the earliest call date; it is not the same as some annual percentage payment.

I’m not sure that calculating current yield this way is the right way to do it but 2.25%/70 gives 3.2% (I don’t buy individual munis). This is obviously rather lower than 4.9%.

All in all, you are comparing a bond with 16 years to run and no guarantee of being called to T-bills that have a maximum maturity of 52 weeks. You better think carefully about this.

[typical.investor]

I’m not sure that calculating current yield this way is the right way to do it but 2.25%/70 gives 3.2% (I don’t buy individual munis). This is obviously rather lower than 4.9%.

All in all, you are comparing a bond with 16 years to run and no guarantee of being called to T-bills that have a maximum maturity of 52 weeks. You better think carefully about this.

I'm not sure how to calculate it either, but Schwab lists the YTW as 4.969.

3.2% is current yield.

I will guess that if called, we will get $100 back for the $70 we paid, and that we need to included that $30 as though it earned (which it is since we didn't pay for it).

A new issue AA 10 year muni is paying 4.66% and a 20 year new issue pays 5.08%, so isn't 4.969% about what you'd expect? I don’t trade munis either but 0.3% higher (than the 10 yr) doesn’t seem impossible given it’s secondary, these things aren’t so liquid, and you’d expect the seller to have to let it go at a discount to market to induce a sale.

I always bought small odd lots of brokered CDS to earn that premium.

[typical.investor]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

It actually pays $100 * 2.25% and returns $100 at call or maturity, and that costs you $70.294. I think your math is wrong.

[Artsdoctor]

This is a muni bond with a market discount. The coupon is low enough that there would NOT [amended] be reasonable expectation of calling the bond although no one can predict the future. You should know that the discount is taxed as regular income--it's not exempt from federal or state income tax. The coupon is tax-exempt but the discount is not.

[Silk McCue]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

It actually pays $100 * 2.25% and returns $100 at call or maturity, and that costs you $70.294. I think your math is wrong.

I was explaining how they got from $70.294 to $100 at 2.25% in 16 years. That math isn’t wrong. It’s what the offering declares.

I did not address the callable aspect of the post at all.

Cheers

[typical.investor]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

It actually pays $100 * 2.25% and returns $100 at call or maturity, and that costs you $70.294. I think your math is wrong.

I was explaining how they got from $70.294 to $100 at 2.25% in 16 years. That math isn’t wrong. It’s what the offering declares.

I did not address the callable aspect of the post at all.

Cheers

Huh? What do you think you are saying?

$70.294 at 2.25% annual is $1.58. In 16 years that is $25.28.

Perhaps there is another way to read what you are saying but it doesn't make sense to me.

$70.294 for $100 of bonds paying 2.25% is a return of 4.969% which is what you'd get on a new issue today.

[alex_686]

This is a muni bond with a market discount. The coupon is low enough that there would be reasonable expectation of calling the bond although no one can predict the future.

You call in high coupon bonds and replace them with low coupon bonds. So you have it backwards.

Maybe nobody knows the future, but considering underwriting costs and the rate structure it is highly unlikely.

[petulant]

Since there is a large discount, there would be a large taxable hit when the bond matures. That means for a high-bracket investor, the net YTM is less than 4.9%. For example, if the applicable combined federal and state tax is 50%, then the net YTM if the bond matures in 16 years might be 4.182%. That is probably closer to the market rate for new munis, but I don't know the California market well.

[Artsdoctor]

This is a muni bond with a market discount. The coupon is low enough that there would be reasonable expectation of calling the bond although no one can predict the future.

You call in high coupon bonds and replace them with low coupon bonds. So you have it backwards.

Maybe nobody knows the future, but considering underwriting costs and the rate structure it is highly unlikely.

You're absolutely right. I'm trying to stick to my resolution of proof-reading posts and emails but I have a ways to go. Thank you, and I've amended the post. The coupon is LOW by today's standards so there would be very little reason to call the bond.

[Artsdoctor]

Since there is a large discount, there would be a large taxable hit when the bond matures. That means for a high-bracket investor, the net YTM is less than 4.9%. For example, if the applicable combined federal and state tax is 50%, then the net YTM if the bond matures in 16 years might be 4.182%. That is probably closer to the market rate for new munis, but I don't know the California market well.

Yes, that's a point that really needs to be posted on the computer of any investor buying individual munis. Discount bonds in the muni markets are not your friend. It's almost always going to be to your advantage to buy a premium bond and amortize it. Sometimes, the discount is so significant that it might be worth your while (perhaps here) but everyone will need to do their own tax math. But for those in the highest of marginal tax brackets, heavily discounted munis should be avoided.

[mikebh]

does it mean that bought on secondary market discounted muni will be taxed for that discount difference?
so it will nullify muni advantage for high marginal tax brackets, is it correct?

how to make sure that muni will NOT be taxed or exempt from all taxes?

[petulant]

does it mean that bought on secondary market discounted muni will be taxed for that discount difference?
so it will nullify muni advantage for high marginal tax brackets, is it correct?

how to make sure that muni will NOT be taxed or exempt from all taxes?

Right, sort of. For a discounted bond, part of the return comes from the coupon, but the rest comes from appreciation from the discounted price to the par amount at maturity. For the coupon portion, the muni will keep its tax exemption. So the investor will not pay taxes on that part every time. However, at maturity (or call), the part of the return from appreciating will be taxed. That would be the growth from $70ish to $100. That would nullify part of the tax advantage; it's best to do the math for a tax equivalent yield or an aftertax yield to get everything apples to apples.

The way an investor makes sure they avoid this question is to only buy munis at a premium or with a "de minimis" discount. The de minimis discount is .25%, e.g. a bond higher than 99.75 has a de minimis discount.

[Artsdoctor]

^ Right. And just to reiterate, since this is so often misunderstood, the tax on the discount will be taxed at the prevailing marginal INCOME rate and not the capital gains rate. If you bought at 70 and hold to maturity (par, or 100), you're not paying capital gains tax on the difference between 100 and 70, but rather income tax.

[LFKB]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

That's not the right math. You buy the bond for $70.294 and you get the 2.25% off of the $100 par value (so $2.25 a year), plus you benefit from the $70.294 to $100 par at maturity. The bond price went down to $70 because interest rates went up so much.

The OP's 4.9% looks right to me.

I don't know anything about that muni and what it's credit worthiness is, but potentially there is some credit/default risk.

[Scorpion Stare]

It isn’t discounted deeply.

$70.294 at 2.25% annual for 16 years is $100

Cheers

That's not the right math. You buy the bond for $70.294 and you get the 2.25% off of the $100 par value (so $2.25 a year), plus you benefit from the $70.294 to $100 par at maturity. The bond price went down to $70 because interest rates went up so much.

McCue might have been confused by the fact that $70.294 * (102.25% ^ 16) = $100.353.

That is, if you invested $70 for 16 years at 2.25% APY with compounding, you'd end up very close to $100. (However, this is just a coincidence and is not what is happening with these bonds.)

[mikebh]

looks like I have to avoid this muni as it will not be tax free for me as I expected from CA muni
thank you all for explaining about that large discount, as I understand that anyone wants to sell a muni with below current Treasure rates have to discount as much to get any buyer, who also can take that ordinary income tax for about 30% discount price.

how to find CA muni at schwab with above 4% rate and totally tax free?

I evaluate CA muni vs GSA at above 6.2% for high margin tax bracket

[petulant]

looks like I have to avoid this muni as it will not be tax free for me as I expected from CA muni
thank you all for explaining about that large discount, as I understand that anyone wants to sell a muni with below current Treasure rates have to discount as much to get any buyer, who also can take that ordinary income tax for about 30% discount price.

how to find CA muni at schwab with above 4% rate and totally tax free?

I evaluate CA muni vs GSA at above 6.2% for high margin tax bracket

Just make sure the price is not at a discount, i.e. it is quoted at 99.75 or higher, not significantly lower than 100, like 70.

[Artsdoctor]

looks like I have to avoid this muni as it will not be tax free for me as I expected from CA muni
thank you all for explaining about that large discount, as I understand that anyone wants to sell a muni with below current Treasure rates have to discount as much to get any buyer, who also can take that ordinary income tax for about 30% discount price.

how to find CA muni at schwab with above 4% rate and totally tax free?

I evaluate CA muni vs GSA at above 6.2% for high margin tax bracket

There is a terrific, classic book by Annette Thau called "The Bond Book." If you're really interested in buying individual bonds, the book can be very helpful.

When a bond is priced at 100, it's priced "at par." If it's below 100, it's a discount bond; if it's above 100, it's a premium bond. If you're interested in buying a municipal bond on the secondary market and you want your investment to be entirely tax-exempt, then you'd want to buy an in-state bond (CA) at a premium. You would then amortize the bond as long as you own the bond, and the coupons will be exempt from state tax.

Many people buy individual bonds without understanding the fundamentals but I think it's helpful to know what you're buying as well as understanding all of the tax ramifications. It's a lot of work to buy individual munis wisely, especially at the beginning, and it's easy to be overwhelmed. You're right to be asking questions but I'd recommend against buying an investment without understanding the fundamentals since you'll want to avoid mistakes and surprises later.

[Geologist]

looks like I have to avoid this muni as it will not be tax free for me as I expected from CA muni
thank you all for explaining about that large discount, as I understand that anyone wants to sell a muni with below current Treasure rates have to discount as much to get any buyer, who also can take that ordinary income tax for about 30% discount price.

how to find CA muni at schwab with above 4% rate and totally tax free?

I evaluate CA muni vs GSA at above 6.2% for high margin tax bracket

According to Bloomberg’s handy table (https://www.bloomberg.com/markets/rates ... t-bonds/us), the only muni maturity showing a yield close to 4% today (but slightly below) is for municipal bonds with a 30-year maturity. While these are for national investment-grade bonds, yields for CA munis may be slightly higher (because tax rates are higher) but not a lot higher. Do you really intend to tie up your money for a long time? Your earlier post was making a comparison to T-bills, whose maturity is a year or shorter.

Ordinarily, municipal bonds have yields below taxable bonds (because of their tax-free characteristics). It is not simply a matter that already issued bonds are discounted, even bonds being issued today at par will have rates that are lower (Bloomberg says muni 5-year rates are about 3%).

With the highest Treasury rates right now between 5 and 6% (in the very short maturities), you will be hard pressed to find munis with rates close to these. (I assume you mean Treasury when you write “GSA” although I am not sure what you mean by GSA.)

I supposed there could be junk municipal bonds with higher yields but they come with risk.

I agree that you would find it useful to read Thau’s “The Bond Book” so you understand what you may be purchasing. Municipal bonds are not like CD’s and they have important differences even from Treasuries. Don't rush to purchase something just to get what you think are tax-free returns.

[mikebh]

my typo about GSA, has to be GSE
Agency bonds are a type of bond issued or backed by a federal government agency or by a government-sponsored enterprise (GSE)