Bonds That Build the House and Raise the (Yield) Ceiling
I sometimes encounter people who find bond investing boring! This rather old-fashioned notion was fostered by the general obligation (GO) bond and the essential service bond (e.g., electric or water utility) which are paid off by property taxes and utilities revenues, respectively. Although these types of municipal bonds pay reliable, predictable returns, some investors find them too “vanilla.”
Here’s how you may be able to raise the yield roof a little with your municipal bond purchases. Housing bonds may offer a substantial yield advantage to investors — from .50% to .75% over vanilla-type munis. This advantage stems from the added risk of early, unexpected calls, a risk that is inherent in all housing bonds.
These bonds are issued by a Housing Finance Authority to raise funds for mortgages for individuals buying homes, typically in large affordable-housing projects, either as “multifamily housing bonds” or “single-family housing bonds,” an important distinction I’ll explain later.
I won’t go into great detail on the various individual characteristics related to credit enhancements or protection of the revenue streams supporting the individual type of housing projects (i.e., VA, GNMA, muni insurance, Section 8, etc.). These factors matter when selecting a specific bond, but for the topic at hand, how to minimize the risk of early calls, let’s assume that we are discussing high-quality, AAA rated bonds.
The key to prudent investing in these muni bonds is calculating up front the effects of an early call. In some cases, an early call can eliminate the yield advantage over non-housing bonds. The following is a review of the kinds of calls that must be considered when purchasing housing bonds.
It is not unusual for bonds to be called by the issuer prior to maturity. This means that the bond issuer could call for the redemption of part or all of the bond issue at the call date(s) stated on the bond, usually 8 to 10 years from the date of issue. This date(s) is printed clearly and is known from the moment of issue.
Your financial advisor can calculate what your yield would be if the bond is called at the stated call date and price, and can help you compare that yield with a similar call and yield of a non-housing bond with a maturity of the same date.
Your financial advisor should also calculate yields in the instance of “extraordinary calls.” These are a bit trickier to anticipate, but equally important to take into account.
Extraordinary Calls allow the housing authority to call in bonds (return investors’ capital) for any number of unusual and unexpected reasons (i.e., catastrophes, natural disasters, changes in the status of underlying credit enhancement, unused funds, and early prepayment). Some of the extraordinary circumstances that lead to a call cannot be predicted, so a yield cannot be determined. Nonetheless, ask about the replacement of the credit enhancement supporting the housing bond issue. Letters of Credit or CDs on loans, all of which have periodic renewals, may trigger a call. Compute your yield to that date and determine if the bond is still attractive. A few other extraordinary calls also give us the opportunity to “guesstimate” a yield, to help us determine whether or not to buy any particular bond.
Unexpended Funds Call
Usually a housing project is given 1.5 to 3 years to pay out the money raised by the bond issue in the form of mortgages to project homeowners. If the project can’t or doesn’t use all of the money raised by the bond issue, money must be returned to investors. The issuer returns the capital raised from the bond issue by calling in bonds.
An interesting phenomenon of the 1990s, and again beginning in 2008, was that funds may also go unused because, due to a dramatic drop in interest rates, it becomes impossible for the housing project to make mortgages at rates that are competitive with the rates that project homeowners could get elsewhere.
Thus, if you are considering purchasing housing bonds, your financial advisor will want to do a “what if ” yield calculation based on a 1.5-year call. You might also calculate the yield to a 2-year call, 3-year call, etc., until you reach that call date which results in a zero or negative yield. Then assess the risk of being called at that break-even date against the greater yield you receive for each successive period that your bonds are not called. The prevailing mortgage interest rate environment should be a significant factor in your assessment.
By the way, multi-family housing bonds do not seem to share the frequent extraordinary call experience that single-family housing projects do. Be sure to take this into consideration too when assessing your call risk.
Early Prepayment Calls
Just like with mortgage-backed securities, housing bonds are very sensitive to movements in the mortgage interest rate market. A significant decline in mortgage rates will result in some individuals refinancing their higher-rate, original mortgage. When an individual returns money to the Finance Authority (who made the original mortgage), the Finance Authority returns the money to the investors by calling in bonds.
Don’t let all these call features scare you! There can be opportunity in housing bonds when mortgage rates are stable or moving only modestly. Don’t pay too big of a premium for a single-family housing bond, as it might be called away from you quickly and result in a negative yield. Consider buying them at or slightly above par price and regard them as a shorter-term investment. (Buying any housing bonds at a discount means that you may have to wait until redemption to realize a portion of your yield, and that might be a very long time away!) When rates are falling, try to stick with multi-family housing bonds too. They don’t happen to experience the same frequency of extraordinary calls as single-family housing bonds, probably because a great deal of the project’s buildings would have to be refinancing their mortgage(s) and this is a more different set of circumstances for the project to accomplish.