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Investment Strategy

Looking Down the Credit Curve

With tax-exempt yields at or near 2011 lows, investors have been balking at stingy nominal yields in recent weeks. But ­strategists say buying ­opportunities abound for those willing to buy lower-rated bonds.

The two-legged rally that began in January has pushed the benchmark 10-year yield down 83 basis points, according to Municipal Market Data’s triple-A scale.

The five-year yield is 69 basis points lower, 20-year yields are down 105 basis points, and 30-year yields are down 85 basis points.

Anyone holding tax-exempt paper in 2011 has been paid handsomely for doing little more than sitting on their hands. Jumping into high-grade munis now might seem expensive, and other safe-haven options are no better: the 10-year Treasury opened below 2.90% Monday, its lowest in 2011, and gold prices are at historic highs.

MMD analyst Daniel Berger calls it “challenging” to recommend triple-A municipals “of any maturity for investors seeking outperformance,” given that tax-­exempt valuations versus Treasuries are currently lower than 12-month averages.

The benchmark 10-year muni offered 2.63% Monday, which translates into a muni-Treasury ratio of 88.9%, versus an average of 91.2% over the past year, or 87.8% since 2000.

But step down the credit curve and it’s a different game: the 10-year single-A muni offered 3.72% last week, or 127% of the comparable Treasury rate. Its decade average is 99%.

Retail Takes Notice

Peter Hayes, head of municipals at Blackrock, said retail appetite for lower-rated debt has been apparent in recent weeks as investors begin taking note of the wider spreads.

“There’s real step-down in quality, not necessarily to true high yield, but in general there’s a slide down the credit curve to capture more income,” he said.

“Most investors are probably more willing to take more credit risk than duration risk,” Hayes continued. “They are more worried about interest rates going up than they are about potential credits blowing up — especially in the A-rated space.”

In an oft-cited study by Moody’s Investors Service, single-A rated municipal bonds from 1970 to 2009 defaulted  10 times less frequently than gilt-edged corporate bonds.

There has been some questioning in recent years as to how reliable that data is today given the severity of the ongoing financial crisis, but Hayes said it remains potent.

“That’s a lot of history through a lot of economic cycles,” he said. “I think it has a lot of validity.”

Part of the reason credit spreads are attractive right now is that the rally over the last few months has been lopsided, with appetite most centered on high-grade paper.

While the triple-A rated 10-year bond yield is down 83 basis points in the last five months, comparable single-A and triple-B yields have fallen 74 and 73 basis points, respectively, over the same period.

“We have not seen the compression of spreads that we would normally expect in a rallying market,” Berger wrote last week.

The 10-year A-rated bond was offering 113 basis points over the triple-A bond, he noted, implying a near-20-point outperformance should levels revert to their mean.

But the attraction of single-A bonds also goes well beyond what did or did not happen in the last five months.

Triple-B Spreads Widen

As muni strategists Peter DeGroot and Josh Rudolph at JPMorgan noted recently, triple-B spreads are currently “wider than at any point prior to the credit crisis.”

Startling as that may be, the analysts are actually understating the situation: spreads are nearly triple the average of the previous decade. MMD’s triple-B yield in the years leading up to the financial crisis offered between 34 and 108 basis points over the triple-A scale, with an average of 73 basis points.

Today the spread is 200 basis points.

“Not only are both spreads at multiples of their respective long-term averages, but A-rated paper is also above the long-term average of the triple-B category,” noted John Dillon, chief muni bond strategist at Morgan Stanley Smith Barney. “We continue to view these stubbornly wide-A spreads as an extended window of opportunity for those willing to tolerate the additional credit risk.”

A chart of the last decade shows single-A muni yields were nearly always lower than Treasury yields until scared money flooded safe-haven markets with the onset of the financial crisis. Almost three years later, the relationship has yet to normalize.

Higher Yields can Outperform

DeGroot and Rudolph believe the wider spreads, and recent underperformance of lower-grade municipal debt, gives higher-yielding bonds plenty of room to outperform.

“We believe credit spreads will grind tighter as buyers increasingly move down the credit ladder in search of returns,” they wrote in a note published June 10.

Dillon places the timeline for a 20-basis-point tightening within the next two months.

“We’ve started to see tightening in the five-year range and the 30-year range, but the benchmark quote is the 10-year mark and we just haven’t seen it,” according to Dillion. “They’ve just been sitting there. … As the market tone gets better, we should see a significant tightening, it’s just hard to pinpoint exactly when it’s going to happen.”

Dillon said that for a few months now his team has been expecting spreads to tighten in the summer, as much of his logic deals with state governments balancing their budgets and adding certainty to the municipal marketplace.

“In most years it’s a given— it’s not even a question in most years,” Dillon said of states submitting balanced budgets. “But given the state bankruptcy talk and congressional testimony, people are concerned about it. Once they see the states are putting their houses in order, a degree of comfort should be added to the market.”

Not everyone sees it this way. In her latest warnings, bank analyst turned muni bond provocateur Meredith Whitney spoke of “defaults in a variety of forms” as state and local governments will have to make painful spending decisions in coming years.

Her view is that politicians could soon choose to stiff bondholders instead of, say, public workers. But public finance professionals tend to see it the other way.

“The things that people are worried about are actually credit positives for bondholders,” Dillon said. “There are lay-offs, expenditure cuts, tax hikes — these are all credit-positive events. They aren’t happy events, by any measure, but they are credit positive. If you don’t take those steps, how are you going to get your house in order?”

Philip Condon, head of muni bond portfolio management at DWS Investments, also recommends going down the credit scale and taking advantage of the yield curve.

He expressed caution, however, lest investors become too aggressive in the climate of fat spreads.

“The most aggressive high-yield paper will not do well in the sluggish economy,” Condon said last Wednesday at a press briefing held by DWS parent group Deutsche Bank. “It’s a very dangerous place to be.”

He singled out high-yield tobacco bonds in particular as a dangerous bet.

“It’s funny, you can tell people for 20 years that smoking is bad for you, but only in a severe recession do you have a decline in consumption,” Condon said, noting that cigarette consumption was down 9% two years ago and another 6% last year.

“But we think single-A, triple-B, and in some cases double-B types are very attractive right now,” he added. “That’s where we’re positioned in our portfolios.”

One credit he highlighted as a buy: revenue bonds from Chicago O’Hare International Airport.

With a single-A rating from all three agencies, O’Hare sold $1 billion of tax-exempt debt in late April, yielding as much as 5.92% for a 2035 maturity or 6% for a 2039 maturity.

“That’s a very attractive yield relative to almost any market,” Condon said.

Lower Credits’ Good Reception

According to Dillon, the strategy of buying up lower-rated credits receives a good reception from clients who are comfortable starting at the mid-single-A range and diversifying up the credit curve from there.

“We do have clients that want to go down a little further, but they usually do so with bigger credits, the more liquid names who have better disclosure,” he explained. “Some will pepper in some triple-B bonds, but people are still concerned.”

Dillon said investors are still adjusting to a market offering far fewer insured bonds than in the past.

The concerns over lower-graded bonds don’t relate to how they will trade, but to the threat of losing principal.

“They are worried about defaults,” Dillon said of his clients. “But I’m not overly concerned about defaults at the A-level. ... I think it makes sense for someone with the risk tolerance to go out there and grab that spread.”

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