The decline in market interest rates over the past several months has been accompanied by declines in conventional and VA/FHA mortgage rates. Although this is good news for home buyers, it may not be good news for owners of certain single-family mortgage revenue bonds that have been issued by the various state housing authorities, especially during 1984.
Proceeds from the sale of a mortgage revenue bond issue are used to purchase mortgages with lower interest rates for individuals who qualify for the programs. The lower rates on the mortgages attract people to the program. However, as interest rates decline, as they have now, rates on regular conventional and VA/FHA mortgages fall below the rates of the mortgages being used and purchased in the state programs.
Generally, these state programs provide for a period of time in which all of the bond proceeds must be used to originate mortgages. That "origination period" usually runs anywhere from 8 months to one year from the settlement date on the bond issue. Most state authorities provide for an "extraordinary" redemption feature in case a large percentage of the bond proceeds have not been used to purchase mortgages by the end of the origination date. This call feature provides that the unused bond proceeds will be used to call in, or redeem, outstanding bonds.
When this extraordinary call feature is exercised, it creates three problems for the bond owners of that particular single-family mortgage issue. First, the bonds are likely to have high coupons on them which will be lost. Second, the owner may have purchased them at a premium, that is, at a price above par ($1,000 a bond), for example, 105 ($1,050 a bond). Because the bond is redeemed at par, the premium is lost. Finally, if the bonds are redeemed, the interest rate environment will be much lower (as it is now when compared with 1984), which makes the reinvestment of these proceeds difficult because current bond rates are between 200 and 400 basis points lower than on the redeemed issue. A basis point is one-one hundredth of a percentage point.
Rhonda Rosenberg, a municipal analyst for Drexel Burnham, mentioned two issues that possibly could exercise this extraordinary redemption feature. They are the Texas Housing Agency and the Hawaii Housing Authority, single-family mortgage issues issued in 1984.
Consequently, investors looking at outstanding mortgage issues should check first to see how much time is left in the origination period. If the period is almost over and a sizeable amount of unused bond proceeds remain, see what strategies, if any, the agency plans to use to stimulate the demand for the bond-financed mortgages. And in your investment decision to purchase bonds selling above par, you should consider the potential for a capital loss if the bonds are called at par and were purchased at a premium.
We will provide more names of issues that could be subject to an extraordinary call at a later date.
This week, the Treasury will offer three issues in minimums of $1,000. A four-year note will be sold on Tuesday, a seven-year note on Wednesday and a 20-year bond on Thursday. These issues should return 9.50 percent, 10.20 percent and 10.70 percent respectively. Lebherz has 25 years experience in fixed-income investments.