Yield-hungry investors should be wary of indulging in triple-B bonds in the current municipal market when looking for extra yield as they are fully valued relative to high-quality bonds, according to Dorian Jamison, municipal analyst at Wells Fargo Advisors.
Spreads on 10-year triple-B and triple-A bonds have tightened to a six-year low, he said in a Jan. 29 weekly Municipal Market Update.
"The current spread relationship suggests that investors may not be compensated for the added credit risk that triple-B bonds can represent," he wrote.
Since peaking at an all-time high of 354 basis points on March 31, 2009 the credit spread between 10-year triple-B rated municipal bonds and triple-A municipal bonds has tightened to 97 basis points as of Jan. 27 - a six-year low, he wrote.
The trend of credit spread tightening took shape in 2014, Jamison pointed out, as municipal bond outperformance and historically low yields led many investors to move down the credit scale in search of yield.
That discovery caused the difference between yields on lower-quality bonds and high-quality bonds to narrow, according to Jamison's report.
It noted that "a preference for lower-rated bonds is not without risk in a still-challenging credit environment, since lower-rated credits might experience weak performance should spreads widen back to their recent averages."
Triple-B rated bonds, as tracked by the S&P BBB Bond Index, have returned 1.6% year to date and returned 12.5% in 2014, outperforming the broader municipal market, which has returned 1.5% year to date and returned 8.8% in 2014, as tracked by the S&P National AMT-Free Municipal Bond Index, the report stated.
"Value conscious investors may want to consider locking in gains and reinvesting in higher-quality bonds, with the understanding that it may not be possible to find the same kind of yield after a rebalance," Jamison continued.
He also suggested that investors look for other yield opportunities outside of the triple-B sector.
For instance, those that live in states that do not tax out-of-state municipal bonds may consider looking across state lines to add value to their portfolios.
Elsewhere in the report, Jamison also pointed out the spread compression in the high-grade market - some hovering near record levels.
For instance, he noted that that spread between the Municipal Market Data 10-year triple-A benchmark yield and the MMD 30-year triple-A benchmark yield fell to just 76 basis points on Jan. 14 - the smallest spread since late October 2008.
Since Jan. 1, the MMD 10-year triple-A benchmark yield has fallen 22 basis points to 1.78%, down 69 basis points year over year, as of Jan. 29, the report stated. At the time of the report, the 10-year yield, meanwhile, remained 31 basis points higher than its all-time low of 1.47%, which was set on Nov. 28, 2012.
Besides spreads, Jamison also discussed the strong seasonal reinvestment demand, which he said helped offset January's supply surge to "the most prolific level in five years."
Demand has recently been led by U.S. municipal bond funds posting inflows in 27 of 28 weeks, Jamison noted.
