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July 1 recall will mark end of high bond returns


NEW YORK -- It's been a sweet decade for investors who put up $34 million to finance a retirement home in Roland Park. Since 1982, many have received 15.25 percent per year in interest payments.

That will end July 1, when the issue's $27 million outstanding will be recalled, along with $10 billion to $15 billion in other municipal bonds sold in July 1982. At that time U.S. rates were cresting at their highest level in the 20th century.

Bonds often are issued with call provisions, which allow the issuer, in effect, to refinance the debt after a stated period if interest rates fall. That way, bonds paying 12 percent can be recalled and new ones sold at 6 percent, for instance.

Maryland investors are more fortunate than most. A 10-year call provision is common, but only a small portion of the $3 billion or so in state-issued bonds permit early redemption, said Thomas Daly, head of the municipal department for Legg Mason. However, "there are a few issues that will break some hearts," he said.

Among them, according to Legg Mason research, is the Maryland Health and Higher Education issue for Roland Park Place, the retirement home, and the $15 million outstanding on a $20 million Maryland Health and Higher Education offering yielding 11 3/8 percent for Church Home & Hospital in Baltimore, which also was used to finance retirement care facilities.

Those issues were not scheduled to be repaid for 30 years, but the precipitous decline in interest rates has led to a big refunding. For issuers, that has pared interest costs dramatically, as even those who cannot recall old bonds have been able to refinance their debt by borrowing like amounts at lower rates.

For investors, the consequences have been brutal, as double-digit returns have been cut in half. "It's like if you bought a car five years ago you can't replace it for the same price," Mr. Daly said. "That's life."

The most dangerous response, he said, would be for investors to try to make up for the lost yield by buying riskier securities or ones that are less well known or lack similar tax benefits.

Investors typically use their municipal portfolios for safety, Mr. Daly said, and it therefore would be unwise for them to shed prudence to receive equivalent yields.

Moreover, Maryland residents pinched by the recall should be aware that some of the tax benefits they receive on bonds issued by state agencies are not available with out-of-state bonds, nor do out-of-state bonds offer the same familiarity.

"If you buy a municipal bond, you are making a loan to somebody," he said. "Do you want to loan money to someone you don't know? If you buy a bond in the state of Maryland that ran into hard times, you'd know it."

That, however, won't ease the shock from many confronting lower returns as they consider how to reinvest their money. "There's a lot of sticker shock going on," said Dick Paget, head of the municipal department of Alex. Brown, who has fielded a number of calls.

And July 1 might only be the beginning, he said.. Municipal securities typically have two coupon payments a year, July and December being the most common months. That is why next week probably will be the start of the refunding rush, but it won't be the end.

With yields for some facets of the market below what they have been for decades, Mr. Paget said, he has heard refunding estimates of $200 billion to $300 billion over the next two years.

For investors in municipal mutual funds, the decline in rates might be far less precipitous. As the market changed during the 1980s, the vast portfolio of municipal securities held in most funds slowly changed, too, and therefore the average rate has slid along with the prevailing rates throughout the market.

In anticipation of a huge inflow of cash July 1, said Stephen Wolfe, an associate portfolio manager at T. Rowe Price, the big mutual fund company already has purchased bonds with a delivery date of July 1 so that it will have new securities as the money comes in.

"Your yield on a fund should not go down by a tremendous amount," he said. "To the extent yields go down, we expect it will return to normal by mid- to late July."

The process of notifying holders of municipal securities that their bonds have been called is often arcane. Most are commonly held essentially as electronic notations in computer banks with tight access by brokerage firms. Conscientious firms will immediately notify clients, and mutual funds will take steps to redeem called bonds themselves and then reinvest the money for shareholders.

Traditionally, however, people have held their own bonds in what is known as bearer form. These are certificates, to be clipped biannually. Owners of these securities may not know when they are called.

"A lot of moms and pops that clip their own bonds will find out when they clip their next coupons at Christmas," said Thomas G. Moles, managing director, fixed income at J. W. Seligman & Co. "They will be useless."

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