Premium Bonds:

Hold value better

Partial return of premium with interest payments

Can be sold at a profit

More likely to be called before the maturity date

• Reinvestment risk in low interest rate scenario

Discount Bonds

• Preferred by retail clients, along with par bonds.
• Lower cash flow, but interest payments may be only interest due.
• Pay face value at maturity, including appreciation from the discounted price.
• Less reinvestment risk in a low interest rate environment.
• More reinvestment risk in a rising interest rate environment because there is less to reinvest.
• Subject to the diminimus rule.

Whether one should buy premium or discount bonds is very vexing. Ideally the individual investor often prefers par bonds – those selling at face value. However, they are currently not often available. If you find bonds with low coupons that are selling at par, and interest rates start to rise, then they will soon become market discount bonds, so the issue of premiums versus discounts is always pertinent.

We recommend that you purchase bonds in order to create a cash flow that is independent of other sources of income. Though we recommend you do not buy bonds with the idea of selling them to take advantage of price appreciation, it is hard not to notice the fluctuations in market value that is posted on brokerage websites. Higher valuations make us smile and lower valuations make us consider the alternatives. Here are some of the considerations in purchasing bonds with higher and lower coupons to help you retain your smile.

Will you get your full premium returned if you buy premium bonds?  If the bonds are redeemed on their maturity date you will. A piece of the premium is returned with the higher coupon. For example, if you purchase a bond with a 5 percent coupon, and were receiving a payout of 5 percent per year, but the yield-to-matuirty was 4.5 percent, the premium you pay is amortized (liquidated or extinguished) over the life of the bond. that is why you cannot take a tax loss on your tax return.

Are there times when you will not get your full premium returned? If the bonds are called before the maturity date, then you would lose some of the premium you paid, and hence get a lower return because the interest payments would be truncated. That is why your yield-to-call (YTC) is lower than your yield-to-maturity (YTM) on premium bonds. It is also referred to as the yield-to-worst (YTW) or the worst yield that you can get. Premium bonds are always priced to the YTW if there is more than one call.

Are there times when you might sell your premium bonds for a profit? We are currently in a low rate scenario where issuers might find it advantageous to call their bonds. Even if they cannot call them immediately, they can pre-refund them – call them ahead of time- by placing funds in escrow that back the bond payments of principal and interest until the first call date. The bonds may now be selling at a significant premium, a premium which will be lost as the bonds approach maturity because they will come due at par.

Why should I consider buying a bond at a premium and possibly losing some of my principal if the bonds are called early? The adjustment of the premium is how the market reflects the value of the bonds in different economic scenarios. If the bonds initially sold at a 5 percent YTC, then interest rates declined, the bond might now yield a 3.5 percent YTC, so the seller must be compensated for losing such a nice cash flow.

If there is inflation, does it matter what kind of coupons my bonds have? Premium bonds return some principal with each interest payment. If there is inflation, you therefore have a quicker return of principal on premium bonds that can be reinvested at the higher interest rates. In this scenario, lower coupon bonds will lose their value faster.

Who favors one kind of bond over another? Individual investors, referred to as ‘retail’ in bond market jargon, tend to like par bonds and bonds selling at a discount because they know they will get all their invested cash back. Institutional traders like premium bonds because they offer the possibilities of higher returns in a rising interest rate market.

Why not buy bonds that are close to par with low coupons? It might be very tempting to purchase par bonds or bonds with a small premium that have a 3 percent coupon. These bonds will lose value more quickly if interest rates rise, because they will quickly become subject to the diminimus rule, the rule governing the taxation of bonds selling at a discount. If the bond price is below a specified cut-off point for the bonds, then all of the discount will be subject to tax at the buyer’s ordinary income rate instead of at the capital gains rate. There is no one specified cutoff that is applicable to all discounted bonds. Since an individual’s ordinary income rate is higher than the capital gains rate currently, the value of the bonds will drop as it approaches that cutoff.

Conclusion: Premium bonds will hold their market value better and provide a more substantial stream of income than discount bonds. The dates when bonds can be called is of greater importance on premium bonds. You can get a higher return on bonds with an early call date. If the bonds are pre-refunded to their first call date, your bonds might  significantly appreciate. You can continue to get the high cash flow or sell the bonds for a profit.

Discount bonds may lose value more quickly if interest rates rise because they may be subject to ordinary income. However if a low interest rate environment, there is less reinvestment risk because there is less return of capital.

Answer: There are at least two factors contributing to the price of TIPS: price of Treasuries; and TIPS as an inflation hedge. Unlike TIPS, Treasuries are relatively risk free, very liquid and actively traded. The market for TIPS is not as big or as liquid as for traditional Treasuries. There may be other factors about which we do not know. Also, we do not know how to weight these factors.

Lately, TIPS prices have been moving up in conjunction with Treasuries. However, we have not seen inflation in some time, and don’t know when it will appear next. Thus, we don’t know how TIPS will move if there is a spike in inflation. With inflation, we would expect Treasury yields to rise and prices fall. However, we do not know if TIPS will continue to track Treasury yields and prices in that scenario because they are considered an inflation hedge.  Accordingly, we have no idea how TIPS prices will move. To further complicate the picture, the TIPS are trading in an institutional market, not a retail market. Who know what strategies institutional traders have devised.

Question: Counting just the principal and inflation adjustment, what level of inflation would equate to the current TIPS price level?

Answer: TIPS are generally compared to traditional Treasuries. With the 10-year Treasury at 2 percent, TIPS are generally considered a good investment if you can project inflation at more than 2 percent.

Question: Here is another question that I should know, but am not quite embarrassed enough not to ask (even though I just reread the chapter in your book): Does the Government (a) payout the inflation adjustment every six months or (b) adjust the principal? In the case of deflation, I guess it can only adjust the principal, so the answer must be (b)? What am I missing?

Answer: The government just pays out the coupon, but not the inflation adjustment in cash. However, you have to report for tax purposes the inflation adjustment each year. If your TIPS are held in a retirement account, this does not apply to you. In the case of deflation, the face value of the TIPS is adjusted downward, but cannot go below 100, the par value of the bond.

Many investors are sure that higher inflation and higher interest rates are right around the corner.  As a result we have had a number of inquiries as to whether, in 2012, a bond investor should buy Treasury Inflation-Protected Securities (TIPS). Investors like the idea of TIPS because they will appreciate if there is inflation, whereas the market value of the usual interest paying bonds will decline in value before their due date when there is significant inflation. If you are a trader, this might be a significant concern.  However, this is not the whole story because those bonds will eventually come due at their face value. TIPS may also come due and pay their face value, and that is the part of the story we plan to address.

The Basics

Here are some basics regarding TIPS.  Traditional (non-TIPS) Treasury bonds pay out a fixed amount of cash every six months.  In contrast, every six months, TIPS pay out a variable amount of cash that is composed of a fixed rate of interest (generally a low coupon) plus the inflation rate as represented by the Consumer Price Index, (the CPI-U).  If you hold the TIPS until they come due, the Treasury will pay you the sum of (a) the face amount of the security plus (b) an amount equal to the inflation (as measured by the CPI-U) that has occurred over the life of the security.

If there is deflation, rather than inflation, the principal of the TIPS is adjusted downward by the amount of the deflation.  That’s right: the inflation increases are not locked in. Thus, if there is deflation of 3% for a year, the adjusted price of the TIPS will decrease by 3%.  For example, if you purchased TIPS at a premium price, the premium will erode due to deflation, though the securities are guaranteed by the Treasury to pay at least their face value on their due date. The minimum that you will receive, therefore, is the face value of the TIPS. All the accrued value of the TIPS may be lost if the economy is deflationary.

This is different from paying a premium on Treasury bonds or other interest paying bonds that pay semi-annual interest. Those interest payments represent part interest and part return of principal so you never mathematically lose the premium you paid. It is returned to you over the outstanding life of the bond.

Considerations in Buying TIPS

In January, 2012, most TIPS were selling at very high premiums to their face value.  Many are selling at unit cost prices above 200 per 100 face value, so for a $10,000 security you would have to pay $20,000.  The prices are so high because the value of the securities appreciated because of the value added from inflation and the general decline in interest rates.

Who would buy TIPS at these prices taking into account the risk of deflation?  The Fidelity bond desk advised that TIPS are generally sold in an institutional market.  Two major buyers of massive amounts of TIPS are China and retail clients through United States mutual funds.  Professionals often buy TIPS as an alternative to a traditional Treasury coupon bond.  If a 10-year traditional Treasury bond is yielding 2%, professional investors might buy TIPS if they project the CPI-U to exceed 2% on average for future years. However, projections are just that. They may not come to pass. Should you go along for the ride?

If instead of inflation there were deflation in the United States, professional investors might sell large amounts of TIPS to avoid losses.  As a retail investor, you may not find yourself ahead of the curve. Our conclusion is that if you project deflation, you should not buy TIPS at high premiums.

Also, if you are looking for income, then TIPS may not be for you. In January, 2012, even 10-year TIPS with coupons of less than 2 percent are selling for a unit cost of 120+, or $1200 per security. These TIPS have very little current cash flow. You would be buying them solely for the possible appreciation coming from the inflation rate of the CPI-U.

You might suffer adverse tax consequences, if TIPS are bought in a non-retirement account. In these accounts, you must report the upward adjustment in price of the TIPS security each year (the inflation adjustment) on your federal income tax return. It is reported as ordinary taxable interest income even though you don’t currently receive the value of the upward adjustment in cash. That’s right – pay taxes on phantom income that you may never get! You can avoid this problem by purchasing TIPS only in retirement accounts.

TIPS are issued by the United States Treasury and thus have essentially no default risk, despite what S&P thinks.  Because of this, at some inflation level, TIPS would be an excellent investment. You will have to decide as to whether you are expecting inflation or deflation, and your time horizon for this kind of investment.

November 22, 2011

There are two times in a man’s life when he should not speculate: When he can’t afford it, and when he can.

—Mark Twain

Like Rodney Dangerfield, bonds get no respect. Their advantages of predictable growth and cash flow are woefully underappreciated. Like our streams and rivers, cash flow can be created from many tributary sources. We believe that a diversified portfolio of “plain vanilla bonds” has proven to be the best investment available, and we wholeheartedly agree with Andrew Mellon’s prescient late-1920s observation that “gentlemen prefer bonds.” We believe that ladies should, too.

Mellon’s statement was memorable, although a bit too pithy. Bonds are an extremely diverse financial category. They come in all denominations and maturities, from ultra-safe Treasury bills to risky junk bonds and unfathomable CMOs, and they serve a variety of needs and purposes. You don’t simply buy “a bond” just as you don’t simply buy “a car.” There are important choices involved, and you need to understand the specific reasons for your intended purchase, what you are going to use it for, and how long you intend to keep it.

Investors tend to buy bonds with different strategies in mind. The All-Bond Portfolio is a strategy for investing in very conservative, plain vanilla bonds in order to preserve principal and receive a steady stream of cash to support the life objectives and financial needs of the investor. This is in accord with Richelson Investment Rule 1: Define your objectives and Richelson Investment Rule 3: Don’t lose money.

Create cash flow with bonds

We believe that cash flow is the key to financial planning and retirement planning for individual investors. You can’t eat gains and losses but you can live on cash flow. In this section, we explore the reasons to use bonds to create the needed cash flow.

 Focus on cash flow not performance

Unlike most financial advisors, we don’t track bonds in terms of their yearly unrealized gains and losses. Unless there is a good reason to sell a bond, such as a significant decline in its credit quality or a change in a client’s needs or financial situation, we generally hold bonds until they come due. With this buy and hold strategy, the ups and downs of the price of your bonds before they come due is meaningless. In Wall Street parlance, it is just “noise.” In our view the concept of performance (tracking yearly unrealized gains and losses of a bond portfolio measured against an index) is pointless. In some instances, the index changes as the portfolio changes, so it is not clear what is being tracked.

Instead of performance, we focus on cash flow – how much cash will a portfolio of bonds produce each year on an after-tax basis. You can determine your yearly cash flow from a portfolio of bonds quite precisely and easily by adding up the interest coupons that the bonds will pay twice a year. Fidelity Investments and some other broker-dealers provide a 12-month estimate of cash flow with their monthly statement. If you are not spending all of the cash, you can reinvest the surplus in additional bonds. You can also easily determine how much tax you will pay on your interest income each year. You will see unrealized gains and losses reported on your bond portfolio statement as interest rates move up and down during the year. However, these gains and losses will not affect the cash flow from your bond coupons (interest). Your coupons stay fixed no matter how interest rates and bond prices fluctuate. You can live on your cash flow.

Buy cash flow, not diversification

Now compare the cash flow of a portfolio of bonds to a portfolio that includes an assortment of the following investments: stocks, real estate, commodities, gold, hedge funds, private equity, and other investments that may have unpredictable cash flows or no cash flow, and never come due. With investments other than bonds you may be relying on appreciation that may vanish before you can cash in. How can you plan to live in retirement on a portfolio of these volatile investments whose value and cash flow is unpredictable over the short-term or long-term?

It may be comforting to run complex financial planning programs that spit out 50 pages of detailed numbers and Monte Carlo programs that provide 10,000 or more scenarios based on past financial scenarios. It may also be comforting that based on these programs you are told that you can safely withdraw somewhere between 4% and 6% of your portfolio a year after retirement. However, we are living in a financial environment that is the most dangerous since the Great Depression of the 1930s. With the present uncertain times, as seen from the vantage point of 2011, how can you comfortably look back to the past for substantial guidance of future outcomes? Similarly, how can you determine the cash flow on investments, other than high-quality bonds, when the best economists are in substantial disagreement as to whether we will have a massive deflation as occurred in Japan for the last 21 years or a rapid episode of inflation as occurred in the United States in the 1970s? Events like the 2011 earthquake and tsunami in Japan add considerably to the uncertainty of the future.

The conventional wisdom is that a portfolio of diversified asset classes will outperform a portfolio of bonds while minimizing risk. Most investors believed that to be true until the crash of 2008, when all asset classes, including U.S. and foreign stocks, real estate, mortgage securities, and commodities, crashed together. On the other hand, a portfolio of high-quality bonds held their value and provided a reliable and consistent cash flow during and after the crash. In fact, as a result of the crash the price of Treasury bonds went up dramatically. A deeper understanding of risk resulted from the crash of 2008.

The clearest analogy to cash flow from bonds is the paycheck from a secure job with which most of us are familiar. A bond portfolio providing a steady stream of interest payments is like a paycheck you would receive from working. It is a defined amount that you can count on. If you had a blended portfolio of many asset classes instead, the amount you could safely withdraw would become uncertain. You could not count on a set amount unless you were prepared to invade principal in the face of down markets. Market volatility is not a problem unless you are required to sell assets when the market is declining. If you are counting on a specified withdrawal, you might quickly deplete your principal if you face years of nonexistent returns or losses, such as we experienced between 2000 and 2009. “You may need more flexibility in your spending analysis,” suggests Fred Amrein, a financial planner at Amrein Financial in Pennsylvania.

 Get cash, not hoped-for returns

We have heard the argument endlessly that a portfolio of high-quality bonds will not pay out enough cash flow to support you in your current lifestyle after you retire. You can calculate the return on bonds and determine whether this is true. If so, you then need to decide whether you believe that some other portfolio of investments will provide higher consistent returns. You then need to evaluate the promise of high returns from this alternative portfolio and ask yourself these questions: What is the basis for your belief? How certain is your conclusion?

In psychology, there is a concept called wish fulfillment that says “I need this to be so and, therefore, it will be so.” Are you prepared to pay the price if it is not so? And how high is that price? Many investors are essentially throwing a “hail Mary pass” when they invest in stocks and other high-risk investments in the hopes of investment success. We believe that the fewer resources that you have the more conservative you should be with your investment selection because you have less room for error. Remember Richelson Investment Rule 2: If you can’t afford the risk, don’t play.

 Inflation and cash flow

We are always challenged with the argument that future inflation resulting in higher interest rates will overcome the merits of the All-Bond Portfolio. But before you close the book on bonds for this reason, you need to look at the deeper meaning of inflation and then at our strategy to turn inflation and higher interest rates to your benefit.

At the outset, we agree that inflation does hurt your buying power. However, an investment in stocks doesn’t cure the inflation problem. When inflation exploded in the 1970s, stocks declined by about 50% in 1973 and 1974. One substantial cause of this decline was high interest rates that accompanied that inflationary era.

Our solution to the inflation problem is to put in place a bond ladder. Briefly, a bond ladder is a strategy to have one or more bonds come due in multiple years. For example, if you have $100,000 to invest, you might have a $10,000 bond come due in each of 10 different years beginning in 2012 and ending in 2021. If your bond ladder is in place and inflation breaks out and results in higher interest rates, you will be able to increase your cash flow by reinvesting your bond proceeds as they come due and your excess interest income in higher yielding bonds. For example, if you are getting a 4% return and interest rates go up over time to 6%, your cash flow will increase by 50%. Thus, if your bond ladder is in place, inflation resulting in higher interest rates is your upside case, and not a reason for concern.

Now let’s take a look at what the inflation rate as measured by the Consumer Price Index (CPI) really means. There really should be two CPIs, one for a middle-class family of four earning around $50,000 to $60,000 per year and another CPI for rich people. President Obama says you are rich if your family earns more than $250,000 per year. The CPI is heavily weighted to real estate, food, and oil products. If the CPI goes up, it really hurts the middle-class family. However, it doesn’t hurt the rich family because the percentage of their income that they spend on food and oil products is a very small percent of their income. As to real estate, the rich already own a home, the value of which will inflate with inflation. So why should rich people worry about inflation? We think that the possibility of inflation should not stop them from investing in bonds, particularly if they have a bond ladder.

Cash flow in retirement

If you are spending some of the principal returned to you from maturing bonds, then you will be reducing your overall cash flow in the future. If you are retired, you may prefer to have greater cash flow currently even if the principal declines. However, it is important to realize that the consumption of principal results in the gradual diminution of the portfolio’s ability to generate cash flow.

Though you may think that planning on living on the interest payments from your bond portfolio may crimp your style, accepting what is – rather than what you hope might be – may encourage you to more realistically look at your options. You may have many sources of cash flow or few.

You may decide:

 • Early retirement is not in the cards for now if interest rates are very low.

• Start a small business you can manage in semi-retirement.

• Invest longer-term despite market fluctuations in value to achieve a higher return.

• Consider living in a lower-cost community.

 In summary, we believe that cash flow from bonds is the key to successful investment planning and retirement planning. By purchasing a diversified portfolio of high quality bonds, you will have many streams of income to create the river of cash to support your lifestyle.

Does it agree with me?

We have a further tendency to focus only on information that supports our decision. This is called “confirmation bias.” When our thinking slips into this mode, we tend to gloss over inconsistencies and risks and look only for information that confirms our view. For example, a prospective client who we will call Jim, a Florida litigator by trade, gave Stan a copy of an offering proposal for a fund that had a very consistent long-term record of returning more than 10 percent per year. Jim asked Stan to review it. Stan suggested that Jim pass on the opportunity because the fund had no independent custodian. Stan explained that without an independent custodian, there would be no independent party verifying that Jim’s assets were actually there. Jim explained that he was told that a custodian was expensive, just complicated things, and got in the way. Stan replied: “Yes, that is what custodians are supposed to do!” Jim decided to invest with the fund because he thought the hoped-for 10 percent was better than the 4.5 percent that he could get with safe individual tax-free bonds. Years later we discovered that Jim had put his money with Bernie Madoff. You know the end of this story!

And your assumptions?

The concept of confirmation bias is elaborated in a book titled WHY Smart People Make Big Money Mistakes and HOW to Correct Them: Lessons from the New Science of Behavioral Economics by Gary Belsky and Thomas Gilovich. They suggest if we come at this idea from the other direction it can be called “disconfirmation disinclination.” In English, this means that we avoid focusing on anything that challenges our assumptions. For example, it had to be quite evident to smart investment bankers that if they packaged mortgages and sold them without risk to themselves, then there would be little reason to keep the mortgage packages healthy. This was obvious to anyone inside the mortgage game. However, once the financial market executives saw the money to be made, the banks and brokerage houses swallowed their own advertizing and purchased their own toxic brews. Seeing the demand for the securitized loans, it became very difficult, even for insiders, to turn away.

“Hope is not a strategy”*

Once we become aware of our tendency to “anchor” on an investment objective, we can see the result of “confirmation bias” by looking at the outcome of conventional investment advice. After experiencing the brutal reality of the 2007-2009 losses in the stock market, many investors are beginning to realize that relatively safe “plain vanilla” bonds actually present a fundamentally different, more secure way of investing and planning for the future.         *Michael A. Dubis, financial planner

Stocks for the Long Run?

Robert Arnott challenges the point of view that over many decades stocks outperform bonds.  The amount investors hope to earn from stock above the risk free rate on Treasury bonds is called the “risk premium.”  Even we were surprised to learn “… that the 40 year excess return for stocks (the risk premium), relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.”  Arnott’s chart showing the historic advantage of bonds over stocks is presented at the beginning of this post (Source: Standard & Poor’s, Ibbotson Associates, Cowles Commission and Schwert;  Graphic courtesy Journal of Indexes, found in Robert Arnott, “Bonds:  Why Bother?”  May/June 2009, pp. 10-17).

Hildy & Stan Richelson are bond experts and authors of 4 bond books, including their recent bestseller Bonds:  The Unbeaten Path to Secure Investment Growth, Bloomberg Press, 2007

Question:  “Please discuss buying bonds at a premium in the secondary market. The bond traders at one of the brokerage houses try to push buying bonds at a premium to get the higher yield. I think bond mutual fund managers do the same.  To me it is like buying a reverse mortgage on your home -money upfront, nothing at the end. But, is there some value in receiving the higher yield and letting your heirs suffer the loss of principal at maturity?”

Response:
1.  Currently most bonds are selling at a premium, some of them being above 110.

2.  Brokers tend to want to sell whatever product they have in inventory.

3.  Newly issued bonds are also coming at a premium, so it is hard to avoid paying a premium.

 Problems with Premium Bonds:

• Individual investors look at the cash flow as income they can spend. They don’t realize that part of the interest payment represents a return of premium.
• May be called early and buyers may not look at the yield-to-worst call, just to maturity.
• Individual investors may not adjust their spending to take into account the return of premium.
• More likely to be called in this environment.

Advantages of Premium Bonds

• A percentage of your principal is returned with each interest payment, giving you the opportunity to reinvest at higher rates .
• If you are retired, you may be OK with consuming some principal in order to have a better cash flow.
• The value of your bonds will be sustained better than if your bonds sell at a discount in a rising interest rate environment.

 Problems with par bonds in the current environment.

• Par bonds may have 2-4 percent coupons currently, resulting in low cash flows.
• Bonds with those coupons will quickly lose value if interest rates rise because they will be subject to the diminimus rule. Briefly what this means is that after a particular price is reached, the difference between the discounted purchase price and the price at maturity will be subject to ordinary income tax instead of capital gain.
• In a rising interest rate market, these bonds will be more difficult to sell.
• Less cash to reinvest if interest rates do not rise, which might be good if money had been invested at yields higher than those currently available.
• More limited cash flow. Less flexibility if you need more cash flow.
•  Should you scrimp on your cash flow so that your heirs inherit more?

Benefit of par bonds

• Interest is interest and not return of principal as well.
• Less problem with early call risk.
• Retail buyer is more comfortable with par bonds.

 How do we advise an individual investor?

It depends on the individual’s goals and needs.   There is no one answer that suits everyone.

Unfortunately words we think mean one thing are sometimes modified to mean something else. In some sense this is comparable to Atlantic salmon. Wild salmon are highly prized for their taste and nutrition. Farm raised Atlantic Salmon are fed a grain based diet and therefore have much lower levels of the essential Omega-3 fatty acids, and a much higher concentration of disease and sea lice that can spread to wild salmon populations.

Issuer defined “moral obligation bonds” are bonds backed by revenue that must be appropriated by a governing body. In the event that the governing body fails to appropriate funds for debt payment, there may be a reserve fund to pay the interest and principal when due. Initially only state governments issued moral obligation bonds. The market players accepted them because if the states walked away from bonds they were morally obligated to support, all types of securities they issued would suffer price declines and their credit ratings would be downgraded by the rating agencies.

Moral obligation bonds have become so acceptable that even small issuers use them to support their funding needs. Apparently some of these small issuers find themselves in a quagmire. They can be moral and pay the obligation to the detriment of the community, or take the position that they won’t pay if it might increase taxes or affect municipal services. According to the Wall Street Journal[ii], Buena Vista, Virginia, with a population of 6,349 in the 2000 census, issued $9.2 million of moral obligation bonds in 2005 to finance a municipal golf course. That is a per person debt of $1,449. Twenty-two percent of those individuals were under the age of 18 years, according to Wikipedia. Since businesses were leaving and the population was declining, Buena Vista decided to construct a golf course that was supposed to attract the development of residential housing, shops, hotels and small businesses.

Buena Vista pledged their court house and police station as collateral for bonds to construct the golf course. The Great Recession beginning in 2007 clobbered the value of real estate and strangled new developments. The usage of the golf course fell dramatically. Given the choice of raising taxes and cutting services or not paying the interest due on their bonds, the city officials decided not to appropriate the required funds. The insurer of the bonds, ACA Financial Guarantee Co, is now trying to repossess the municipal buildings, but not without difficulty because they are the police station and the court house.

In another instance of small, inexperienced issuers swimming in deep waters, five Wisconsin school districts issued collateralized debt obligations (CDOs) to fund their pension obligations. CDOs are securities that are composed of fixed income assets, some of which were considered excellent credits. The CDOs imploded in 2007, according to an article in The Bond Buyer.[iii] Since the matter is in litigation, the school districts decided not to fund the repayment demanded by Depfa bank by deleting it as a line item in their budgets. The districts are alleging fraud in the original issuance of the CDOs and have decided to withhold payment until the court case is resolved.

Depfa bank is dissatisfied that the school districts are not immediately complying with the repayment of their obligations. An official at Depfa says that the actions of the school boards call into question the viability of the moral obligation pledge that is widely used in Wisconsin and many other states to support bond issues. It is a way for politicians to fund projects without vote approval or pledging dedicated revenue streams for repayment of the bonds.

Why is it that some government officials’ with little financial experience are able to enter into complex financial matters that obligate an entire population without the approval of that population, or the experienced oversight of the state administrators? It might be helpful if the Municipal Securities Rulemaking Board (MSRB) actually makes a contemplated rule change that would prohibit an issuer’s financial advisor from also being the underwriter of new negotiated or competitive bond issues.[iv] This rule change was suggested by Mary Shapiro, the chairperson of the Securities and Exchange Commission. Do you think advising a client how to structure a deal and then actually doing the deal just might be a conflict of interest? We recommend that there should be a review of complex legal structures that enable town officials to legally commit all of a town’s resources to a project that might bankrupt the town or that the majority of the citizens might not support.

We recommend that you proceed cautiously when considering the purchase of bonds backed by a moral obligation pledge, especially from small issuers.

[i] Black’s Law Dictionary
[ii]Ianthe Jeanne Dugan, “Fight Over City Hall – Literally,” TheWall Street Journal, August 17, 2010.
[iii] Yvette Shields, “Wisconsin Schools Renege on Depfa Notes,” The Bond Buyer, July 20, 2010.
[iv] Andrew Ackerman, “MSRB Eyes Limits on Dealer-FAs: Rule Would Bar Switching Roles,” The Bond Buyer, August 18, 2010.