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Changing coupon and premium structures as the muni market adapts to falling rates

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      By Christopher J. Harshman, CFAMunicipal Portfolio Manager, Eaton Vance Management

      New York - We often discuss the premium price found on most municipal bonds. This premium is the result of a muni bond's fixed coupon rate exceeding the bond's yield to worst, which is the lowest potential yield that can be received on a bond without the issuer actually defaulting.1

      How are coupon and premium structures changing?

      While fixed coupons of 4% and 5% have remained industry standards for many years, falling market yields have caused the gap between the coupon and the yield to widen. The more the fixed coupon exceeds the yield to worst, the higher the premium price. So an environment of diminishing yields has resulted in ever-growing premiums.

      Over the past couple of years, we've witnessed the muni market start to adjust by underwriting an increasing number of new issue bonds with lower coupons. As market yields have fallen, sub-5% coupon structures have become more prevalent - especially in the first three quarters of 2019:

      CouponStructureTABS0930_680px

      Source: ICE Data Services, J.P. Morgan. * Data through September 30, 2019.

      These lower fixed coupon rates are more in line with prevailing market yields, resulting in premiums that are much smaller than those associated with higher coupons, such as the typical 5%.

      Why are municipal bonds priced at a premium?

      Premiums are intentionally created in the majority of municipal bonds, at the time of underwriting, as a safeguard against market discount taxes.

      If a municipal bond's price falls below par because of rising interest rates, the next buyer of that bond - not the original holder - is subject to ordinary income taxes on the accrual of the discount back to par. For example, a bond purchased at a market discount of $90 that accrues back to par at $100 would have a 10 point gain, which would be taxed as ordinary income.

      Premium bonds are less likely to become market discount bonds, which may help protect investors from incurring these taxes that can negatively impact municipal bond performance and liquidity. And compared to lower fixed coupon, lower premium bonds, a higher premium may also reduce duration - that is, the sensitivity of the bond's price to changes in interest rates.

      What is the impact for investors?

      As coupon structures have migrated lower, the resulting lower premium is a reflection of a smaller buffer - or "cushion" - between the fixed coupon rate and the yield to worst.

      In our view, it would be wise to consider how changing coupon structures could affect muni bond investments. A key concern may be the effect that rising interest rates have on bonds with lower fixed coupons - and the potential market discount tax consequences that can result.

      There's also relative value to consider, as lower fixed coupon structures may offer additional tax-free yield over bonds with higher fixed coupons. Weighing the value of higher coupon protection against additional tax-free income is a nuanced evaluation that professional bond managers make every day.

      Bottom line: Lower coupon structures and lower premiums are evidence that the municipal market is adapting to a lower interest rate environment. Understanding the changing dynamics of municipal bond structure is essential - particularly the role fixed coupon rates and premiums play in valuing muni bonds.