Could the robust performance delivered by high-yield municipal bonds in the first half of 2016 soon be coming to an end?
The credit-sensitive sector probably is headed for a slowdown in the second half of the year, after outperforming for the first six months, municipal experts said.
Market conditions such as interest-rate sensitivity and global concerns could curtail performance of the high-yield municipal market, and therefore, boost performance in the high-grade tax-exempt sector through year-end, according to reports from Anthony Valeri, fixed income and investment strategist at LPL Financial, and Bob DiMella, co-head of MayKay Municipal Managers.
Valeri of LPL said there is reason to be cautious in the high-yield municipal sector as valuations have grown richer because of narrower yield spreads and record low yields, as well as the absence of Puerto Rico bonds from a benchmark index.
Those factors could inhibit the future performance of a sector that produced an 8.9% total return through July 22, according to Valeri.
"Above-average yields are offset by a smaller yield advantage to comparable maturity AAA bond yields and greater than market interest-rate sensitivity," Valeri wrote in a Bond Market Perspective report entitled "High-Yield Municipal Update," issued on July 28.
"A small number of high-yield municipal sub-sectors, including tobacco bonds, have benefited from outsized gains over the first half of 2016, which we believe are unlikely to be repeated," Valeri said.
Valeri said the sector has already demonstrated comparably low yields now that the bulk of Puerto Rico municipal bonds have been omitted from the Barclays Municipal High-Yield Index after a $20 billion July 1 default.
"The sharp drop in yield in July 2016 reflects the exit of Puerto Rican bonds and reveals how low yields are absent the riskiest segment," he said. The average current yield is 5%, he said, below that of early 2007 and mid-2013 just before the bonds sold off on concern the Fed would taper its quantitative easing program.
Though its prediction for high-yield municipal outperformance in the first half became a reality, MacKay Municipal Managers said the expectation for a slowdown of that performance through year end could make way for outperformance of the high-grade sector in the second half.
"We believe it will do well, but not as well as investment-grade going into the second half," DiMella said in a mid-year update released on July 28.
MacKay Municipal Managers, which manages $18.7 billion as of June 30, is the municipal bond team of fixed income investment advisory firm MacKay Shields LLC. It is the sub-advisor for the MainStay High Yield Municipal Bond Fund, as well as four other municipal funds.
The municipal bond team, co-managed by DiMella and John LoFreddo, have favored the compensated risk they have earned from municipal high yield over the past three years as spreads were wide and attractive.
The team will now start to reduce its slightly overweight position in the credit-sensitive sector on concerns over rising interest rates, liquidity, and potential spread tightening, as well as global factors, including Britain's exit from the European Union.
John Mousseau, director of fixed income at Cumberland Advisors, agreed that performance of the high-yield sector is vulnerable to expected changes in market conditions through year end.
While the sector should continue to perform well due to overall historic low yields driving the demand for income, performance of municipal high yield will decelerate from its earlier pace, Mousseau told The Bond Buyer in an interview on Tuesday.
"I think we see a second half of the year which treads water at best," he said even though he believes municipals will continue to outperform Treasuries.
"People gravitate towards the yield when there is none to be had," he said.
High-yield prices are subject to interest-rate sensitivity, and valuations will remain expensive in the absence of a notable increase in rates, Valeri said.
The average maturity of high-yield municipal bonds is about 20-years, which makes prices very sensitive to interest rate changes and helps explain the rise in prices given widespread yield declines over the first half of 2016, he said in his report.
Despite his concerns and expectations for lower returns from high yield municipal bonds in the second half, Valeri remains neutral on the sector and believes default risk should remain subdued absent an economic recession.
He also believes credit quality underlying the sector is firm.
"Although the dollar amount of defaulted municipal bonds has spiked due to Puerto Rico, the number of municipal defaults is on pace to fall below 2015's already low number," Valeri wrote, citing Municipal Securities Rulemaking Board data.
"An increase in defaults or downturn in the economy could lead to wider yield spreads and weigh on high-yield municipal bond prices," Valeri said. "Although we do not see either posing an immediate risk, higher valuations mean room for error has decreased and investors need to be cautious."
High-yield performance was still positive heading into August, despite falling tax-exempt yields, Stephen Winterstein, managing director and chief strategist at Wilmington Trust, said in a weekly municipal market update released on Monday.
The S&P High Yield Index ended the past five days on positive ground, producing 0.229%, he said. The index has performed well over the last decade, producing 12.78%, 8.25%, 8.44%, and 5.35% over one, three, five, and 10 years, respectively, according to S&P Dow Jones Indices LLC.
By comparison, the S&P Municipal Bond Index returned 0.247% last week, while the Intermediate, Short Intermediate, and Short indices ended with positive returns of 0.285%, 0.212%, and 0.152%, respectively.
"High-yield municipal bonds have benefited from broad bond market strength in 2016, but are now more subject to the path of interest rates over the remainder of the year," Valeri wrote.
