Joseph Darcy’s first task upon becoming manager of the Hartford High-Yield Municipal Bond Fund this year: resisting temptation.
The 30-year industry veteran joined Hartford Investment Management in January after stints with BNY Mellon Asset Management and Merrill Lynch.
With $407.2 million in assets, the high-yield fund owns 193 investment-grade, barely investment-grade, sub-investment-grade, and no-grade bonds, ranging from hospital debt to charter schools to full-faith-and-credit pledges from governments with weaker finances.
The fund’s biggest holdings are bonds secured by settlement payments cigarette manufacturers agreed to make to Ohio and Wisconsin under the 1998 Master Settlement Agreement, and debt from the New York City Industrial Development Agency and the Illinois Financial Authority.
This is not exactly an ideal time to be managing a high-yield municipal fund.
Money has been flooding the industry for the better part of a year, dragging down yields on the types of bonds high-yield funds buy.
Investors stuffed high-yield funds with more than $7.4 billion last year, according to Lipper FMI, helping propel the industry’s assets by more than 50%, to $46 billion.
The money is still coming, with about $1 billion in additional cash entrusted to high-yield funds this year.
With yields on high-quality bonds sinking throughout most of 2009, Darcy said investors began looking to pick up extra yield by extending maturity and assuming more credit risk.
That means more and more money is elbowing its way into the high-yield space, leaving scarcer opportunities to pick up valuable bonds at a good price, he said.
While there is no standard measure for high-yield muni spreads, Darcy said looking at the yield on triple-B rated munis over triple-A munis can suggest the general direction of spreads.
And the general direction of spreads has been straight down.
The spread of a 10-year triple-A over a triple-B bond collapsed from 350 basis points in April 2009 to around 200 basis points today, according to Municipal Market Data. It is still well above its historical average.
“In 2009 you had a tremendous rally in spread product,” Darcy said. “As a result of very significant increase in demand that’s come into the market in general, availability is challenging.”
New supply is not helping much, either. Last year, municipalities sold $182.8 million of bonds rated junk by Moody’s Investors Service, the puniest total since 2003.
In an environment where junk bonds are harder to find and the high-yield sector as a whole offers so much less yield than it did just a year ago, Darcy said discipline and conservatism become that much more important.
“It’s very important that you not assume a yield-at-all-costs attitude, and begin to compromise your investment standards,” he said.
Darcy and his portfolio co-manager, Christopher Bade, have a team of five analysts who help look for attractive credits using a top-down approach, beginning with a broader economic outlook, picking which sectors are likely to thrive under that scenario, and then foraging for issuers within those sectors.
Because much of the high-yield sector is thinly traded, the team does not have the luxury of selecting a desirable credit and then going out and finding it. It has to pick from the credits available on the market.
Last year — before Darcy joined — the fund opted to reach a bit further out in maturity and shun weaker credits. Both strategies hindered the fund relative to its benchmark, the Barclays Capital Non-Investment Grade Municipal Bond Index, in the fourth quarter, as the yield curve steepened and junk bonds continued to outperform the broader market.
Darcy right now likes bonds issued by charter schools and health care, though he cautions against generalizing too much in such a heterogeneous market.
The fund is leaning mainly toward the higher end of the high-yield credit spectrum, Darcy said: sub-investment grade, as opposed to nonrated.
He finds the superior liquidity of rated debt important.
As for credit quality, Darcy does not see defaults in the high-yield space drifting too far from their historical pattern.
According to a Moody’s study released last month, from 1970 to 2009 the default rate on speculative-grade municipal credit was 4.6%.
The default rate on speculative corporate credit was 34% during that period.
The fund is paying a 5.1% 30-day SEC yield, a standard way to measure the yield on a mutual fund. Assuming a 35% tax bracket, that translates into a 7.8% taxable-equivalent yield.
Darcy said the fund is considering utilizing inverse floaters to boost yield, in absence of eye-popping opportunities in junk bonds.
This strategy entails playing long-term municipals against short-term munis to profit off a yield curve some people consider abnormally steep.
This type of arbitrage did in dozens of funds during the credit crisis. Darcy said this was in part because funds were implementing the arbitrage with lower-quality bonds.
That layered additional volatility into the strategy. If the fund does use inverse floaters, it will play the yield curve only on high-quality municipals, choosing to put the “high” in high yield from leveraging the steepness of the yield curve rather than on bonds with high yields because of weaker credit.
