Sophisticated investors are grabbing for high-yield municipal debt whenever they can find it, creating demand for alternatives beyond the Puerto Rico, Detroit, and tobacco bonds that dominate the non-investment grade segment of the secondary market.
Inflows into high-yield municipal bond mutual funds, which grew last week to $235.79 million from $104.1 million the previous week, according to Lipper FMI, demonstrate investors' willingness to seek more attractive returns than currently available in the high-grade market, according to municipal experts.
Generic, triple-A general obligation bonds due in 30 years held steady at a 3.20% yield for much of this week, while the triple-B curve in 2044 yielded a 4.16% as of Thursday, according to Municipal Market Data.
While the current 96 basis-point spread is historically narrow, it is still turning heads among yield starved investors, municipal experts said. The spread has historically been closer to 150 to 160 basis points, a trading manager at a large New York underwriting firm said on Friday.
Similar spread compression within the investment-grade sector itself has "increased the desirability for yield among sophisticated retail investors and institutional accounts," which are "generally being selective, seeking income and credit diversification," said Jeffrey Lipton, managing director and head of municipal research at Oppenheimer & Co.
"The appeal of the HY muni asset class is the very fact that it is comprised of disparate sectors, all marching to their own drumbeats, leading to pricing inefficiencies that can be captured through canny research," Triet Nguyen, managing partner at Axios Advisors LLC, said in a recent weekly municipal report.
In addition, high-yield returns have shown less volatility and better historical returns than equity index returns on a risk-adjusted basis, he wrote.
For instance, as of Aug. 31, the tax-adjusted annualized returns for high yield munis over the past three and five years were 13.1% and 14.6%, respectively -- exceeding most other fixed-income asset classes, including corporate high yield, and trailing only equity market indices.
This a "remarkable feat," Nguyen said, given that the entire Puerto Rico bond complex migrated into the high yield universe within that time frame.
"The case for high yield munis is even more compelling on a tax-adjusted basis," Nguyen said, referring to the ratio of the Barclays Muni High-Yield Index, which currently stands at 125% of its Corporate High-Yield Index.
That ratio is near all-time highs, wrote Barclays analysts Thomas Weyl, Ming Zhang, and Sara Xue in a weekly municipal report on Sept. 12.
The extra yield is especially appealing to investors lately, experts said.
The most-active CUSIP list in the secondary market for the week ending Sept. 12 was dominated by higher yielding and lower-rated bonds, according to the Barclays analysts' report.
The most actively traded bond, the Puerto Rico GO with 8% coupons due in 2035, jumped 15 basis-points in yield to 8.95%, the analysts noted.
"In light of this year's drastically reduced new issue volume, the bond funds are very reluctant to trade any of their high yield holdings for fear of not being able to replace the income, which leaves PR bonds as the only sector of the market with any trading flows and 'liquidity'," Nguyen wrote.
Puerto Rico bonds rebounded in August, posting a 9.50% positive return year-to-date on the heels of negative 20.8% last year, Nguyen pointed out, citing the Barclay's index.
Since the city's bankruptcy filing, Detroit related bonds have recently been in high demand due to their attractive yields. For instance, the $1.8 billion sale by the Michigan Finance Authority on behalf of the Detroit Water and Sewerage Authority was oversubscribed at $7.6 billion. In addition, yields on the 5% coupon bonds due in 2044 rallied by 35 basis points to 4.50% in secondary trading the day after the Aug. 26 pricing.
"I don't think that there is the selling pressure on smaller deals -- most holders are staying put," said David Tawil, co-founder and portfolio manager at hedge fund Maglan Capital.
He said large hedge funds like his often demand issues larger than $500 million, which have been few and far between lately.
Lipton said certain segments of the investment-grade market, such as airports and health care, contain high yield-like credit qualities and have been in high demand lately.
"While the investment-grade healthcare sector has seen some pushback and very selective buying, active interest remains for the larger, multi-state, multi-site systems with flexible balance sheets, stable margins and secure competitive positioning," Lipton said.
On the lower credit spectrum, bonds for continuing care retirement communities and charter schools are among speculative grade credits that require extensive research yet can offer value, Lipton said.
To date, the water and sewer sector led the pack of top performing individual high-yield sectors, posting a 20.3% return, followed by tobacco, special tax, industrial revenue bonds, and hospitals. The electric utilities sector - probably hurt by Puerto Rico Electric Power Authority's deteriorating credit -- was the worst performing at negative 11.8%, Nguyen noted.
Still, Nguyen said Puerto Rico dominates the secondary market. "The Puerto Rico sector is, for all practical purposes, the entire high yield muni market at this point," he said.
While there is value to be had in the sector overall, municipal experts warned that investors should be cautious.
"This is the ideal time to know what you own and to get rid of all the dogs in your portfolio, while the market is still hungry for paper and the bid side is still strong," Nguyen said.
Christine Albano is a reporter for The Bond Buyer
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