Bizarro World – Corporates Are Munis and Munis Are Corporates

This past week presented an excellent relative value opportunity for those with the knowledge and wherewithal to cross reference the taxable and tax-exempt markets. We were able to take advantage of this relative value opportunity through collaboration between our municipal and corporate credit teams. How is this possible?  Well, there are times when municipal participants, like a public university or a city, issue taxable debt. A university or city can refund a tax-exempt bond issuance only once and still maintain its tax-exempt status. In the current interest rate environment, a city or town that has already refunded its debt can achieve significant savings by refinancing a second time and issuing taxable bonds called taxable municipal bonds. A taxable municipal bond has the same credit quality as a municipal entity, but yields are comparable or even better than an equally rated corporate bond.
Now here is where things get bizarre: private corporations can also issue tax-exempt debt. For example, companies like American Airlines or Waste Management can issue project specific, tax-exempt bonds when the proceeds go toward offering a public good. The issues may be secured by the full faith and credit of the corporate entity. For example, American Airlines may issue bonds to improve a terminal at DFW airport, or Waste Management may issue bonds to improve a solid waste disposal facility. Now, in this bizarro world where corporates are munis and munis are corporates, the taxable equivalent yield on a four-year Waste Management tax-exempt municipal bond is about 3.0% for a California resident in the highest tax bracket, while the same issuer’s three-year corporate bond will yield about 1.8%. Our clients are picking up significant yield for the extra year of duration, plus earning tax-exempt income. On the other hand, the taxable version of University of California bonds are rated Aa3 (in line with the long term rating for the tax-exempt debt), but were issued with spreads comparable to much lower rated corporate debt. In all, the overlap between our corporate and municipal credit research can provide significant relative value opportunities.

Source: SNWAM Research