Pre-refunded municipal bonds ... a well kept secret for short-term investors.

Two months after April 15, investors can now appreciate the effects of the most recent income tax increase. It's hard to open a newspaper business section or a business magazine without seeing an article on the advantages of tax-free investing. Many investors with short-term parameters have not taken advantage of the tax-free municipal market. Opting to stay clear of the credit considerations associated with municipal bonds, safety-conscious investors have stuck with Treasury Bills and Notes. If you are one of those people, you may be interested in an alternative opportunity: Pre-refunded Municipal Bonds.

A pre-refunded municipal bond (often called a "pre-re") is a bond that the issuer has decided to redeem (call) from the bond holder prior to its maturity date. The early redemption feature is one that appears in most bond issues and is limited to specific dates outlined in the bond's official statement. The call feature gives the issuer the ability to lower their overall interest expense by retiring existing bonds with high interest (coupon) rates. Most calls occur during periods of low and/or falling interest rates. A tax-free bond issuer will distribute new bonds at lower rates and pledge the proceeds of the new issue to retire (pre-refund) outstanding bonds at their earliest possible call date. In many instances, the issuer will use the proceeds of the new bond issue to purchase Treasury securities that mature in conjunction with the call date on the bond being retired. When this occurs, the "pre-refunded" bond is said to be "escrowed to maturity in government bonds" and as such takes on the credit quality of the underlying treasury security.

The buyer of an "escrowed to maturity pre-refunded bond" is picking up the credit quality of a government security with the tax-advantage of the municipal security. When you add these two features together, the safety conscious investor is provided with an investment vehicle that has the potential for providing a higher after-tax yield on a conservative and short-term investment. A look at the numbers will help illustrate our point.

At the time of this writing, the yield on a two-year Treasury Note is 5.85%. The investor must pay a federal tax on the interest income. If we assume that an investor is in the 31% federal tax bracket, the after-tax yield on this investment is reduced to 4.04%. (This number is derived by multiplying the pre-tax yield by the sum of 100 minus the tax bracket or 5.85% x .69).