On the heels of a month-long rally in the municipal bond market, some yield-seeking institutional and retail investors are turning to riskier credits to get their fix.
“I think there has been an increasing comfort with munis in general and more investors are sliding down the credit curve a bit,” said Peter Hayes, managing director and head of the municipal bond group at BlackRock.
Municipals fell out of favor in a brutal sell-off that began in the fall of 2010 amid predictions of widespread defaults and bankruptcies in the public sector. Municipal bond mutual funds — including high-yield portfolios that invest in lower-rated and unrated bonds — suffered massive outflows.
Fast-forward five months.
Portfolio managers say now that outflows are subsiding, high-yield funds are again looking for paper and there is robust demand brewing for airline debt, tobacco bonds, health care credits, and corporate-backed municipal securities.
Some more aggressive mom-and-pop investors are mulling over the high-yield sector for the first time in nearly six months, according to experts.
For the week ended May 18, high-yield municipal funds that report their flows weekly saw total assets rise to $386.55 billion after seeing inflows of $94.8 million. That was the second week in a row that flows were positive after steady outflows dating back to November, according to Lipper FMI.
“That unto itself is a sign that the thaw is starting to take place,” said Timothy Pynchon, senior vice president and portfolio manager at Pioneer Investment Management in Boston.
“As we have come off Meredith Whitney’s comments in December, we have started to see a thaw, and that thaw has been working itself from triple-A, and has filtered down to double-A and single-A, and now we’re sort of at the triple-B level,” he said.
The inflows for high-yield funds come as investors continue to withdraw cash from the overall municipal bond fund complex.
Pynchon is very bullish on the high-yield sector and he sees the potential for “robust returns” for 2011 and 2012.
“You take the idea of the coupon being robust, and as a baseline that unto itself is what I think makes it a compelling story for investors to come back to our asset class,” he added.
Funds “are only now beginning to see positive flows and beginning to provide the normal magnitude of support for the high-yield sector,” said George Friedlander, senior municipal securities strategist at Citi. “Just the pure action of the flows, going from extremely large to quite small, has created a temporary pocket of demand” for new deals, he said.
Despite Whitney’s latest op-ed piece last week in the Wall Street Journal — about states struggling to submit balanced budgets by the end of the fiscal year and imminent defaults among municipalities — experts say the need for yield is convincing some investors to look past plain-vanilla general obligation debt for value.
Some new deals have seen coupons as high as 8% and they have been “well absorbed and well-priced,” Pynchon noted.
Since he believes that the window of opportunity for such rates will be short-lived, with the proper due diligence, he is buying as much of the attractive paper as allowable for his $700 million Pioneer High Income Municipal Fund.
The strategy has proved fruitful, as he said his fund offers a current federally tax-free 7% yield — or a 10.5% taxable equivalent yield — that compares attractively to other alternative asset classes, like corporate high yield.
Pynchon said his fund has seen positive flows over the past eight weeks, which has given him “a lot of mobility in this market for picking up value.”
While supply has been scarce overall, value has been available within the general market as well, according to BlackRock’s Hayes, who oversees the management of $102 billion in municipal assets, comprised of 84 funds, including tax-exempt money market assets.
He pointed to a new issue from the Illinois Health Facilities Authority for the Carle Foundation that was priced relatively attractively on May 10 as a double-A-minus credit that came at a slight discount with a 6% coupon.
Hayes also cited the Chicago deal for O’Hare International Airport that preceded the state deal the week before and had 6% yields and ratings of A1 from Moody’s Investors Service and A-minus by Standard & Poor’s and Fitch Ratings.
“The bulk of those deals were particularly well-received and performed quite well in the aftermath,” Hayes said. “Anything with yield has been oversubscribed.”
“Underwriters are pricing deals attractively to entice money from the sidelines,” Pynchon said.
“There is a lot of demand for yield, and spreads should continue to tighten in here,” added Hayes, whose group manages the $440 million MUA Muni Assets Fund and the $152.7 million National Municipal Fund.
He said one type of structure that offers value in his high-yield funds is 25-to-30-year paper with a 6% coupon, 10-year call protection, and a mid-to-high A rating. “On the long end, we are not as worried about rates spiking up dramatically from inflation as others are,” Hayes said.
Meanwhile, Friedlander said there is keen interest for both triple-B and A-rated bonds, such as those in the health care and tobacco sectors.
Tobacco bonds are secured by payments made to states and other issuers by tobacco companies under a master settlement agreement.
Much of the demand for such debtcomes from two types of institutional buyers: high-yield municipal bond funds and taxable crossover investors, like hedge funds.
“There are spaces where we do still see significant value, and interest from mutual funds and crossover buyers as outflows subside,” Friedlander said. “As mutual funds are coming back, they are looking at tobacco, which has underperformed.”
Investors are even looking at zero-coupon bonds, bonds that don’t pay interest until maturity. Santa Barbara Elementary School District zeros rated Aa2 by Moody’s Investors Service and A-plus by Standard & Poor’s due in 2041 recently offered a 7.11% yield, according to JJ Kenny Drake.
“If the fund flows become significantly more positive, then the high-yield sector has further to run,” Friedlander predicted.
But in the meantime, he and Pynchon agree that mutual funds are not out of the woods yet.
“It took three-plus weeks of a rally to get us back to a small negative” among the general market funds, Friedlander said. “June will be a good test as to whether the outflows are done.”
For the week ended May 18, muni mutual funds that report their flows weekly saw outflows inch up to $108.37 million from $94.55 million the week before, but those figures are down significantly from the $796 million that was yanked in the week ended May 4, according to Lipper.
Unlike corporate high-yield, which is characterized by credits that are rated below triple-B, Friedlander said municipal high yield can include A-rated bonds, paper subject to the alternative minimum tax, or speculative credits. The latter are often difficult to place as they are not rated but are not necessarily below investment grade in quality.
That paper, he said, is beginning to entice retail investors who are suffering from sticker shock in the current rally that has pulled high-grade yields down.
“The individual investor is exhibiting some rate shock in the general market,” Friedlander noted. “With the 10-year and lower part of the curve almost back to where it was in the fall of 2010 before the erosion, that is really causing some resistance.”
On Wednesday, the benchmark 10-year muni remained at 2.59%, its lowest since Nov. 9, 2010, and 68 basis points down from a recent peak on April 11, despite a pronounced sell-off in Treasuries. The 30-year triple-A general obligation scale, meanwhile, ended at a 4.31% on Wednesday, 77 basis points less than its peak of 5.08% on Jan. 14, according to Municipal Market Data.
But Pynchon noted that the transformation to high-yield paper by the retail market is occurring in baby steps.
“I think we have been experiencing a shift over the last three weeks, but it’s a slow, gradual shift, not an overnight phenomenon,” he said.
Whether the retail crowd will significantly increase their participation in the high-yield market in the coming weeks is “the $64,000 question,” according to Pynchon.
But he is optimistic.
“I don’t think our rebound continues back to pre-November levels without the active re-engagement of the retail investor,” he said.
“Brokers are much more receptive now to the story of high yield compared to January and February when the market was still bleeding dollars out and investors just weren’t ready to have that conversation,” Pynchon said. “People are starting to think more aggressively about what yield and what value is out there, and now we can have that conversation.”
“If the rally continues you are going to see some investors reach for yield,” Friedlander agreed.
Pynchon, meanwhile, is bullish on the airline sector, debt for continuing care retirement communities, and corporate-backed municipal credits, such as bonds sold for US Gypsum, OfficeMax, and Navistar.
Airlines and some corporate-backed credits have both been overlooked in the last six months, but are poised for stronger performance in the latter half of the year, he predicted.
He currently owns airline-related securities, including municipal bonds issued for JetBlue, Continental Airlines, US Airways, and Delta Airlines, and also favors debt for CCRCs because of their structure.
“It’s private pay and there’s not a Medicaid or Medicare reimbursement issue,” he said.
Overall, municipal experts say the high-yield segment of the market offers value, and it’s just a matter of how much risk investors want to take in exchange for extra yield at any given time.
“Our market moves in fits and starts, but when it moves, it moves fast,” Pynchon said. “We are waiting for the alignment of the stars when investors return and recognize the value in the high-yield sector.”
