4.375% Interest… Tax Free. This is What Investors Should Be Looking For
Rodney Johnson | Thursday, September 12, 2013 >>
It’s no secret that the city of Detroit is bankrupt. While union officials and other creditors might disagree, there’s no way to look at the city’s assets and liabilities and reach any other conclusion.
In the world of common sense, it would be foolish to lend the city money. This explains why Detroit isn’t trying to access the municipal bond markets at the moment. Instead, it’s simply not paying its creditors and hoarding all its cash.
But are those entities that are close to — but still not a part of — Detroit behaving in the same way?
Recently, the Detroit Public School System (DPSS) went looking for cash.
It’s common for schools to issue short-term notes as they wait on payment from some other entity, like the state or federal government. Typically, these are one-year notes and are specifically secured by the reimbursement in question.
DPSS issued $92 million worth of one-year notes specifically backed by its expected payment from the state of Michigan.
To ensure that potential bondholders were comfortable with this offer, the school district wrote into the offering that the payment from the state would not go directly to the school district. Instead, the funds would first go to bondholders, with any remaining funds allocated to the district.
Also, the district is required to set aside funds each month to ensure that it makes its debt payments. All of this led Standard & Poor’s to give the bond deal a rating of SP-1, the second highest short-term rating.
So, with all of that backing, what is the interest rate on this debt?
At the 39.5% tax bracket, that makes this the equivalent of receiving 7.11% on a taxable security. Remember, this is a one-year note. And this is at a time when 20-year junk bonds are yielding just over 6%.
DPSS’s problem is clear. It shares a name with a certain city that has a financial issue. That’s not to say the Detroit Public School System is a bastion of financial responsibility. In fact, the district is in such woefully bad shape the state took it over. But that’s not the point.
The point is that the investors who saw this bond offering for what it was – a one-year note backed by payments from Michigan that have already been signed over – are going to win.
In a day and age where the Federal Reserve has done all it can to take interest out of the pockets of savers — and the federal government has done all it can to tax the rest — receiving 4.375% interest for a year is a heck of a deal.
This is the sort of thing investors should be trying to find.
There is no doubt that, in bond-trading terminology, this issue has hair on it because of the district’s name and history. Yet with the solid backing of the state, repayment is all but assured.
As time goes on there should be more deals like this in muni-bond land, where issuers have names similar to issuers that have gone under, or are on the brink of financial ruin. This is where homework pays off handsomely!
Of course, there are losers in this equation, specifically the families and workers in the Detroit Public School System.
There is no doubt that the 4.375% interest rate on this one-year note is exceptionally high and out of line with the risk involved. What should it be?
In May of 2012 DPSS issued a one-year note at 1.25%. Obviously rates have moved up since then. If we assume a 0.5% rate increase, which is wildly too much for the move in one-year interest rates, DPSS’s cost of financing would move up to 1.75%.
The additional interest the district has to pay (4.375% – 1.75%, or 2.625% of $92 million), adds up to $2.415 million. This is money that will not be available to the district to educate kids or pay for services. This is clearly the downside of having a poor history of financial management and sharing geography and a name with what will become the largest municipal bankruptcy in U.S. history.
So as we go through the next several years of financial turmoil in city and state financing, be on the lookout for extraordinary deals like the one above.
Another issuer that just hit our radar is the island of Puerto Rico. With a crushing debt load and little appetite for stronger financial oversight, the municipal markets are punishing the island state.
There could exist in the trash heap a bond issue or two that have solid revenue streams apart from the general budget but are getting thrown away because they share a name with the state.
And all it takes to find such gems is some old-fashioned research.
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