High-yield muni winning streak debunks naysayers
Q: What is behind the large inflows into high-yield municipal funds this year?
Large is not strong enough of a word to describe it. This year alone, investors have poured around $11 billion into this sector of the municipal bond market. At this rate, we could see the most inflows since the early 1990s. The main reason is a combination of yield and the realization that high-yield munis are less risky than their reputation. Year-to-date through July 17, the S&P Municipal Bond High Yield Index return (6.98%) beat that of the entire muni sector, measured by the S&P Municipal Bond Index (5.38%), by more than one and a half points. Puerto Rico is a big factor here. Its situation has improved, despite the political turmoil that led to its embattled governor resigning, with its bonds returning 9.15% in the same period. That added 36 basis points to the high-yield muni index, a surge mostly due to the resolution of some of its distress. In February, sales-tax bonds were exchanged for new bonds. In May, the Puerto Rico Electric Power Authority reached an agreement with creditors.
Q: The financial press has lately been focusing on the risk of high-yield bonds. What is the reality?
While it’s always imperative to remind investors of risks in any investment, municipal securities have favorable default experience relative to comparably rated corporate bonds. Since the 1980s, the difference has been significant for high-yield munis. Looking at 10-year cumulative averages, BBB- and BB-rated muni bond default rates compared to corporate bonds with the same ratings are 4.67% versus 14.40% and 10.92 versus 26.37%, respectively (S&P RatingsDirect). The story is similar with risk assets, where munis offer compelling diversification opportunities. In the 5-year period through the end of the second quarter, high-yield munis are essentially uncorrelated (0.03) with U.S. equities as measured by the S&P 500 (Morningstar Direct).
Q: Does the high-yield trend have room to run?
We think so. For one, the Federal Reserve’s dovish turn has made the longer duration profile of the high-yield muni market more attractive. This gives a boost to income-oriented investors who are primarily holding these securities to clip coupons. It is important to remember that the makeup of muni funds typically results in a lag in muni credit widening compared to corporates. Especially for tax-based borrowers, it takes a while for a slowing economy—even a recession— to have an impact on municipal balance sheets. Essential service sectors (e.g., water and sewer) tend to be somewhat impervious to cycles. All of this is gives credence that high-yield muni securities can enhance an investor’s portfolio, but the complex and wide-ranging market argues strongly for active management by an experienced team.