Investors can harvest attractive opportunities in the municipal high-yield market after cash flow and positive returns surfaced for the first time since before the second quarter, municipal analysts said this week.
"The activity and flows that had been decent up to that point in time for 2015 abated," said Jim Colby, senior municipal strategist at Van Eck Global. But municipal high yield has since benefited from a rebound in cash flow from levels that had been modest at best for all categories of municipal funds and exchange traded funds, Colby said.
He credits the rally, which began in October, to improved price performance on Puerto Rico bonds, as well as an Oct. 20 ruling ending a dispute between New York Attorney General Eric Schneiderman and the big tobacco companies.
That settlement will release $550 million from an escrow account to the state.
"I think it was because of a very narrow view and performance in a narrow sleeve of the municipal high-yield universe that contributed to more positive cash flow for high-yield funds and ETFs," Colby said.
Colby pointed to evaluated pricing from IDC that showed a trade of Puerto Rico bonds with an 8% coupon due in 2035 at $72.625 at the end of October, after the credit had fallen as low as $67.50.
Colby said many of Puerto Rico's bonds were hit hard and are showing signs of recovery as the restructuring of the island's bonds takes shape.
"It wasn't just that bellwether credit," Colby explained. "We saw improvement in valuations of prices in a variety of coupons and issuers."
Prices began improving, he said, as legislation to aide Puerto Rico was introduced in U.S. Congress and as talks between the Puerto Rico Electric Power Authority and its bondholders moved toward a resolution.
The improvement in Puerto Rico bonds is helping the commonwealth regain some of its stature as a significant player in the sector and boosting the high-yield sector out of its recent doldrums and, Colby said.
The commonwealth encompasses almost a quarter of the S&P Municipal High-Yield Bond Index and therefore has a large influence on the performance and relative value of the municipal high-yield market, according to Stephen Winterstein, managing director of research and chief strategist at Wilmington Trust Investment Advisors, Inc.
Puerto Rico represents the largest state exposure – 23.25% -- in that benchmark index, which had a market value of approximately $112 billion as of Nov. 4, according to data provided by Winterstein.
Using Investortools Custom Index Manager, he re-created the S&P municipal high-yield index eliminating Puerto Rico to demonstrate its impact on the benchmark.
Winterstein found that, with Puerto Rico eliminated, the trailing 12-month period ending Oct. 31 generated a 7.225% return. The return was 3.468% when the commonwealth was included.
The contrast on a year-to-date basis is similar, Winterstein noted. While the published high-yield benchmark returned 1.967% through October, the same benchmark returned 5.568% -- a 3.601 percentage point difference -- when Puerto Rico was omitted, according to his custom model.
Puerto Rico was also a primary catalyst this year in public power, accounting for over 96% of the total par value, and contributing to it being the best performing municipal high yield sector in 2015, according to Winterstein's data.
Without Puerto Rico factored into the high-yield benchmark, public power posted a moderate total return of 4.13% year to date through October, Winterstein noted.
But with PREPA included, the sector delivered an "outsized" 18.06% return as of Nov. 4, Winterstein said.
That was a contrast to last year when Puerto Rico comprised over 92% of the par value of the public power sector, which ended as the worst performing sector in 2014 with negative returns of 10.62%.
"Last year we saw PREPA dollar prices go from the mid-60s and 70s, to end 2014 in the low 50s," Winterstein said.
"With the current proposed restructuring on the table, PREPA has snapped back thus far in 2015 to the mid-60s," Winterstein added.
Using option-adjusted spreads, Winterstein said the spreads are also highly sensitive to the presence or absence of Puerto Rico.
An option-adjusted spread is the spread relative to a risk-free interest rate that equates the theoretical present value of a series of uncertain cash flows of an instrument to its current market price.
It is also viewed as the compensation an investor receives for assuming a variety of risks, such as a liquidity premium, default risk, or call feature, net of the cost of any embedded options.
Over the past three years, the S&P Municipal Bond High Yield Index shows the published index averaged about 394 basis points of OAS, and a high of 423 basis points of OAS, according to Winterstein's customized index.
As of Oct. 31, the OAS for the high-yield index stood at plus-401 basis points. But, stripping Puerto Rico from the benchmark index shows that the average three-year OAS is about plus-344 basis points, with a published OAS at plus-268 basis points – just five basis points off its richest point, he said.
"It's almost impossible to ignore the sway of Puerto Rico on high-yield municipal returns – specifically when a manager is using the index as a landmark," Winterstein said.
Colby said the overall rally in municipal high-yield is bringing the sector "back to the attention of investors who were looking for someplace to gain a little bit of positive price performance."
One of the bonds Colby cited as attractive is New York's TSASC Inc. 5.125% coupon bonds due in 2042 with a B-minus composite rating, which rose in price to $92.559 as of Oct. 30, up from $86.155 as of Aug. 31. He currently holds the bonds in Van Eck's Market Vectors High-Yield Municipal Index ETF.
He said due to positive performance, such as that of the New York tobacco bonds, the municipal high-yield sector was three times more attractive at 122 basis points of positive returns than the Barclays general municipal index for the month of October.
"The positive events in tobacco and positive price performance in Puerto Rico helped to push performance to that number," he said.
Tobacco settlement is the largest sector represented in the S&P Municipal Bond High Yield Index at 15.71%, and was the second best performing sector so far in 2015, returning 12.81%, according to data provided by Winterstein.
Puerto Rico represents about 15.66% of the tobacco sector, with California representing approximately 26%.
Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said the high-yield municipal sector currently offers an attractive entry point for investors looking for relative value based on its tightening spreads and positive fund flows.
"If you understand the risk and nuances of the market, on a relative basis, we think it looks better than the general market," he said.
Heavy exposure to the energy sector, as well as headline issues, pension problems, and struggling economies hurt the sector earlier in the year, but Heckman said he now sees a path to "tremendous value," especially given the level of the triple-A market.
On Tuesday, the generic triple-A general obligation scale in 2045 yielded 3.20%, according to Municipal Market Data.
"Are there still problem areas in the high-yield muni space? Yes, but fundamentally we think things look more positive now," he said.
"We see potential there for some credits that have really been strained," given the strong economy and municipalities' improved balance sheets, Heckman continued.
He cited Chicago's recent decision to raise property taxes as a fundamental, contributing factor to the rally in the last month.
After its rating was cut to non-investment grade earlier this year, Chicago is another large component in the high-yield market. "They have had a positive influence on that market due to addressing the tough issue of pension funding coupled with spread tightening of those bonds," he explained.
Others, meanwhile, are looking beyond tobacco, and say there is value in new corners of the municipal high-yield market.
Triet Nguyen, managing director and co-head of municipal and corporate credit solutions group at NewOak Capital LLC, has identified distressed local GO bonds, like Chicago, and local school districts, such as Chicago Public Schools, as "the best potential credit opportunities" on a risk-adjusted basis in the current market.
He said the recent trend of spread-widening in the corporate high-yield sector has largely by-passed the high-yield municipal sector.
"Even after the recent 100 basis point rally, Chicago GOs are still trading cheaper than most CCRC names," Nguyen said. "Budget stalemates in states, such as Pennsylvania and Illinois, will continue to put pressure on local school districts."
Nguyen agreed that Puerto Rico remains a major component of high-yield, but said that a lull in trading activity has decreased its impact.
"We do expect volatility to return, however, once debt restructuring negotiations begin in earnest between the Commonwealth and its creditors," Nguyen said.
In the meantime, Heckman of U.S. Bank said now is the time for investors to take a hard look at the municipal high-yield market and add – or slightly increase – exposure wherever appropriate.
"We think the people who have a level of risk appetite should be looking at municipal high yield for a portion of their portfolio," Heckman suggested.
Besides being attractively-priced, the high-yield sector should perform better than the general municipal market if the Federal Reserve Board elects to raise rates, he said.
The presence of higher coupons would help offset any price decline, which adds to the attractiveness, he said.
Whether or not the Fed decides to act by year end, Heckman predicted that the sector will continue to sustain its value in the remainder of 2015.
Colby expects the allure of the municipal high-yield market to grab reinvestment cash from investors who want to finish the year out in a positive fashion.
"The general lack of volatility and low level of default activity are at the forefront of decisions among asset managers," he said.
Overall the strong performance and positive returns of municipals on a year to date basis, including municipal high-yield, provide a strong case for investing in the asset class, especially due to its taxable equivalency, according to Colby.
"The returns on income alone are unmatched compared to the rest of the muni sector," Colby said of the municipal high yield market. "There is ample opportunity for moderate returns, but I expect them to be positive returns through year end."
