If you're risk-averse and want a tax break, most prerefunded municipal bonds offer the safety of government-backed Treasuries with the tax status of conventional munis. As an added benefit, they carry slightly higher yields. "They're one of the best-kept investment secrets," says Terence Tracy, first vice-president of Shearson Lehman Brothers' municipal bond department.
Prerefunded munis, or pre-res as they're called in the biz, are municipal bonds usually backed by Treasury securities instead of the guarantee of a city or state. The bonds, originally issued when interest rates were high, can't be retired right away when rates later fall. So the issuers sell new bonds at lower rates and use the proceeds to buy Treasuries, which they then put in escrow to cover the old bonds at the first call date. Since the money is set aside in advance to pay off the pre-res, "they're as good credit-wise as Treasuries," says Bank of New York Senior Vice-President James Cooner.
Many investors overlook pre-res, says Shearson's Tracy, because the bonds sell at a premium. People think they're losing money if they pay $110 for a bond and get back $102 at the call date. But to compensate for this premium, pre-res offer slightly higher yields than top-rated conventional munis. "They get less back at maturity," says Tracy, "but will have received much more in income during the life of the bond."
As with all bonds, rapidly rising interest rates and falling bond prices could prompt you to sell before maturity, says Cooner. But he doesn't see rates moving much higher in the near future. Even if rates do go up, pre-res, similar to other premium bonds, lose value more slowly than par bonds because their interest is so high. That's why they function as a hedge against rising rates.
Not all pre-res are created equal. A rare issue will be backed by certificates of deposit, or agency bonds such as Fannie Maes. These may not be quite as secure as Treasuries, warns Tracy.
An occasional issue also may have "sinking funds," or reserves from which bonds can be redeemed before the call date. So ask before you buy. Pre-res, which are usually called three to five years after you buy them, are available on the secondary market through any broker or financial adviser who also sells munis. The minimum investment is typically $5,000. Commissions range from $5 to $7.50 per each $1,000 invested.