Twos Are the New Fives.

• Author: Marlowe, Justin
• Position: PERSPECTIVE

There's a subtle but seismic shift happening in the municipal bond market. States and localities should be aware of it and its consequences.

First, a quick "bond math" refresher. Let's say a city issues a ten-year $5,000 municipal bond with a semi-annual 2.5 percent coupon. This bond requires the city to make interest payments of $62.50 twice a year, and then pay back the $5,000 at the end of year ten. If an investor buys that bond for 100 percent of its face value, or at "par," they will receive those coupon payments and the $5,000 when the bond matures. They could also pay more than 100 percent--a "premium"--if they think the bond is a particularly attractive investment or pay less than 100 percent--buy it at a "discount"--if it's less attractive. Keep in mind that most municipal bond coupon payments are exempt from federal income taxes and often from state and local income taxes.

When issuers set coupons on their bonds they go through a "Goldilocks" exercise. A bond that sells at a high premium suggests the issuer could have raised the same amount of money but with less debt service. Extreme premiums are also unattractive to some investors because they don't produce noticeable cash inflows until close to the bond's maturity. By contrast, if the bond sells at a discount, the issuer might not raise all the money it needs. Discount bonds also have unique tax implications--for example, the "de minimis" rule--that makes them unattractive for many issuers. For these reasons, an issuer's goal is to sell the bonds at a slight premium. That suggests the coupons were, just like Goldilocks' porridge, not too hot and not too cold.

For more than a decade, five percent, known as "fives," was the Goldilocks coupon rate. Fives were considerably higher than the taxable equivalent coupons on U.S. Treasuries and corporate bonds. This made them appealing to big institutional investors like mutual funds, which liked their value relative to other potential bond investments. High coupons also appeal to individual investors who care about future cash flow. In an environment where interest rates and income tax rates are both expected to rise, as has been the case for about the last decade, it helps to have more tax-free cash flow from coupons to reinvest at higher interest rates later. Fives did that trick without pricing at too high a premium.

Fives also worked for issuers' long-term debt management plans. Many state and local debt managers have professed that...