Bond Yields

Lower-Rated Debt Gets Its Chance

As midnight approaches, standards fall. And so it is with municipal bonds: Investors seeking high-grade debt are finding the best products already taken. Higher-yielding, low-investment-grade bonds, once shunned, suddenly look attractive.

Yields on Municipal Market Data’s triple-A curve dropped to 2011 lows on Wednesday, led by the 10-year spot descending 12 basis points to 2.26%.

Much has been written about this flight to quality the last two weeks. In the case of munis, maybe too much has been written. That’s because, relative to corporate bonds, the higher-yielding muni sector has continued to perform alongside safe havens.

“It’s a flight to yield,” said Matt Dalton, chief executive at Belle Haven Investments. Retail investors “are so desperate for any yield here” because rates on Treasuries and top-rated municipal debt have plummeted.

“When you have the 10-year Treasury bond zip from 3.10% down to 2.14% and it drags MMD with it, you lose the retail buyer for anything double-A and higher,” he said. “They aren’t going to buy a muni for 1.5% if they see something at 4%.”

MMD bears out the increased appetite: The triple-B 10-year yield fell 12 basis points Wednesday to 4.19%, a 2011 low. The triple-B two-year yield fell to a calendar-year low of 1.94%.

The triple-A curve strengthening has been dramatic, causing 10-year and 30-year triple-B spreads to widen five and 17 basis points from last Friday to Wednesday, MMD shows. Yet relative to corporate bonds, those moves are minor.

Janney Montgomery Scott corporate credit analyst Jody Lurie noted in a Thursday report that high-yield corporate spreads jumped more than 100 basis points over the previous four sessions.

That kind of panic is unseen among triple-B munis.

“If we hit recession, corporate high-yield spreads are going to widen,” said Janney’s Alan Schankel, noting investors would worry about the ability of companies to produce profits. “Muni high yields are a little more insulated because so much of it is tobacco [bonds].”

Tobacco bonds — some rated in the junk category — are backed by payments made by major tobacco companies under the Master Settlement Agreement to states and other municipal governments.

The trend confirms an axiom Dalton has witnessed for two decades: “When there is no yield to be found, the acceptance of a little lower quality just gets broader.”

So has Belle Haven been jumping into higher-yielding bonds? Quite the opposite.

“If anything, we’ve been selling into it,” Dalton said. “You can step out of a piece that’s been sitting in the portfolio at a loss for two years, at a profit, so it’s pretty good. You feed the fish when the fish are hungry.”

What Dalton calls the “flight to yield” has extended to the primary market.

When the Puerto Rico Public Buildings Authority floated $308 million of bonds guaranteed by the commonwealth earlier this week, it locked in lower yields than the general obligation credit had just six weeks before — even though Moody’s Investors Service downgraded Puerto Rico on Monday to Baa1 from A3.

The bonds, rated BBB by Standard & Poor’s and BBB-plus by Fitch Ratings, offered a 5.54% yield for a 2030 maturity, 21 basis points lower than the commonwealth’s pricing on June 29.

“We are seeing pockets of strength within the high-yield sector,” said Yaffa Rattner, managing director of high-yield municipal analytics at Piper Jaffray. “It really requires a focus on individual credit and expectations of bond performance.”

While Rattner doesn’t advocate bulking up on Puerto Rico debt due to unfunded pension liabilities, she said the market is seeing appetite for high-yield bonds “within certain names and sectors when the analysts can successfully distinguish between headline risk and default risk.”

Speaking of all high-yield bonds, she added: “At the end of the day, the question is, what is the expectation of debt service payment on time and in full?”

The jump into high-yield munis could only happen after the muni market established a robust defense against the late 2010 warnings of widespread default from banking analyst Meredith Whitney.

From November 2010 to May, the high-yield sector had become a no-man’s land. With daily headlines about the possibility of defaults, it was the first sector to sell. But it’s a different game now.

“It’s the middle of August and she is way behind on her projections, so every month that goes by, people get more comfortable,” Dalton said. “They are willing to step down the credit curve. Some are even forced to step down the curve to pick up yield — the headstrong ones who need a certain yield.”

Jason Hannon, senior trader at Arbor Research & Trading, said the search for yield generally doesn’t extend below the low-investment-grade strata to junk.

“That’s a very niche sector, only for hedge funds and other alternative yield buyers,” he said. “The flight to yield probably won’t affect that part of the market much.”


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