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Muni High Yield Rally Should Have Legs

The recent rally in high-yield municipal bonds should continue, driven by a lack of supply, as investors reposition their portfolios, muni watchers say.

Industry pros, including Citi's George Friedlander, noted sizable drops in yields since their Sept. 5 peaks as investors looked to tobacco settlement bonds, Puerto Rico debt and other riskier credits to boost returns.

"Investors are always looking for yield; that's the biggest piece of the puzzle," said Cynthia Clemson, co-director of municipal investments at Eaton Vance. "There's been less and less true high-yield issuance in the last couple of years. It's somewhat of a supply-demand situation here. For those investors who want to be involved in the high-yield market, this is a good opportunity to get in."

To be sure, the tax-exempt market as a whole has shined. But the level of the recovery for high-yield credits has been noteworthy, Friedlander wrote in a research report.

High-yield munis have performed well since Sept. 5. Their yields fell as much as 44 basis points for intermediate maturities by Thursday's close, and as much as 30 basis points on the long end of the yield curve, Citi muni analysts wrote in a research report.

Meanwhile, yields on some Puerto Rico credits plunged between 50 and 80 basis points from recent highs over the period.

Through Tuesday, 10-year single-A muni yields have fallen 50 basis points since Sept. 5, to 3.33%. And 10-year triple-B munis over the period have plunged 40 basis points, landing at 4.04%, according to Municipal Market Data numbers.

By comparison, the 10-year triple-A yield has fallen 48 basis points to 2.56%.

Also, crucially, after 10 weeks of outflows, high-yield muni bond mutual funds recorded inflows for the week of Sept. 18. Those high-yield funds that report flows weekly had inflows of $181 million, Lipper FMI numbers showed.

Puerto Rico and tobacco bonds lit the fuse. "The combination of positive momentum in both Puerto Rico and tobacco paper led to a dramatic reduction in outflows from high-yield funds," Friedlander wrote.

What's more, Puerto Rico levels lured investors from crossover buyers from hedge funds and pension funds, he said, something that started to support the high-yield market, as well. But traditional high-yield issuers performed well, too, Clemson added, and are likely to continue to do so.

High-yield munis are known to suffer more than high-grade names in a sell-off, and the most recent slump exemplified this. The 10-year triple-A yield rose 138 basis points between May 1 and Sept. 5, MMD numbers showed. Single-A yields vaulted 152 basis points over the span, and triple-Bs leapt 147 basis points.

"The bottom line is that the high-yield sector fell much further and faster than high grades and thus had some room to catch up," Friedlander wrote. "After the dramatic rally in the high-grade sector, we would not be surprised to see some backing and filling from here, as individual investors respond to somewhat lower yields on bonds purchased directly."

The continuation of the sector's rally wouldn't surprise Friedlander, considering that flows to funds have turned positive and yields remain "distended."

The high-yield market requires an inflection point, which is difficult to identify ahead of time, before it makes any sharp price moves, said Tim Pynchon, a longtime muni fund manager in the space who recently joined Oppenheimer Asset Management as a managing director.

"It's hard to know if this is the true inflection point, because we still have noise in the marketplace," he said. "Puerto Rico offers a lot of noise. That was oversold and now has come in a little bit, as far as spreads are concerned."

The high-yield market is proceeding on a relatively positive direction, albeit modestly, he added. But the noise will continue. And retail investors, most of whom watch the market irregularly and in a reactive manner, will be the determining factor, as they are prone to move large amounts of money into and out of high-yield funds relatively quickly, Pynchon said.

"So, I don't think this is an upward trajectory from here yet," he said.

Risks for the market remain. For one, the high-yield market remains notoriously illiquid, according to investors, with limited followings and secondary markets for many of its credits.

Also, high-yield debt usually comes with high duration risk, a measure of a bond's susceptibility to changing rates. But investors have grown more aware of these risks during the recent selloff, Clemson said.

"Certainly," she added, "if you can buy bonds after a period where you've had the biggest trade-up in 20-some-odd years, you feel a little bit more comfortable taking on some of those risks than you do at the top of the market."

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