Watch Out! These Municipal Bonds Come With a Bit of a Kick

With high-grade municipal bonds offering meager yields, investors seeking an income jolt are embracing a slightly more exotic product known as "kicker" bonds.

Unlike traditional municipal bonds, which have set term dates of 10 years or more, kicker bonds can be called much sooner and unexpectedly—an unattractive feature for a retiree wanting a set-it-and-forget approach to receiving regular checks. They also sell at a premium to the price investors receive when the bonds mature. But investors get rewarded for that uncertainty—and that premium—with income payouts that can be double those of regular munis, plus the potential for an extra "kick" down the road.

Interest in these bonds waxes and wanes with the state of interest rates, but in today's low-rate climate, they have turned the $3 trillion muni market on its head. Barclays Capital says they now account for 64% of its Municipal Bond index, nearly twice the share from a year ago.

Fans of such premium callable bonds, sometimes called "cushion" bonds, are betting that the Federal Reserve is likely to raise interest rates slowly in coming years. If that happens, kicker bonds could prove a good portfolio protector, says Peter Hayes, head of BlackRock's municipal bond team.

Indeed, the kick comes if for some reason the issuer elects not to call these bonds early—usually because interest rates have risen and refinancing becomes unattractive. In that circumstance, the bond owners get bonus years collecting the higher yield.

Even if the issuer pays back early, the investor will have collected higher payments than with standard ! bonds. " It's kind of a win-win," says John Bonnell, portfolio manager of four municipal bond funds at USAA. "In either scenario you're getting better yield."

However, there is another potential downside for investors: If the bonds are paid back early because of a lower-rate environment, owners could be left holding cash with no good places to put it.

In part for that reason, regular investors have typically shied away from kickers, favoring run-of-the-mill munis for their stability. Demand has helped push the average yield on a Triple-A 10-year muni to a current 1.9% from 3.5% in January 2011, according to Thomson Reuters Municipal Market Data.

But now a growing number of firms, including Deutsche Bank, Wells Fargo and LPL Financial are urging clients to buy kickers instead. Patrick Early, chief municipal analyst with Wells Fargo Advisors, points out that a triple-A rated kicker bond with a 5% coupon would yield about 1.75% if it was called at its first possible chance in six years—almost double that of a current market muni that matures over that period.

Phil Condon, head of municipal bond portfolio management for DWS Investments, says he is selling regular munis to snap up more kicker bonds. He recommends investors look at long-term bonds with 10 years or more between the bond's call date and maturity date. If they aren't called at the first date, Mr. Condon says, the investor will keep collecting the higher interest.

Write to Jonnelle Marte at jonnelle.marte@wsj.com

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