With near-record low yields in 2021, high-yield municipals have been the bright spot for returns for investors who took the risks associated with junk-rated debt.
As a result, high-yields have been the most sought-after munis and the hardest to find as the credit picture continues to improve for all.
High-yield returns are 6.26% so far in the year, with a 1.27% return in June alone, according to Bloomberg Barclays High-Yield Index data. High-grade municipals have returned 1.14% so far in 2021.
The sector has rebounded exponentially from the March/April 2020 COVID-led selloff that led to extreme volatility in all parts of the municipal market with many questioning how far and how fast all municipal credits, particularly junk-rated and nonrated, would sink, how many defaults would be logged, and how much investors might lose.
High-yield took the hardest hits in March 2020, when total outflows of all muni funds were $46.128 billion according to Refinitiv Lipper. In just two weeks of that month, high-yield lost nearly $10 billion.
Turn the calendar page, and high-yield inflows are breaking records in 2021.
Since the start of the year, high-yield inflows total $13.4 billion, the highest coming on April 14 at $1.27 billion, according to Refinitiv Lipper data. Municipal bond mutual funds make up more than 25% of muni holdings.
The spreads between triple-A credits and junk have tightened considerably with the rapid vaccination- and federal aid-led recovery from the pandemic and the resulting economic rebuilding. The lowest-rated debt Refinitiv MMD tracks is BAA, which currently is spread plus-63 basis points to AAA in 10 years and longer. They were between 96 basis points and 108 basis points to start the year. Most expect
"If credit concerns were front and center last year, they have largely dissipated for most sectors, with high-yield munis and the low end of investment grade outperforming the rest of the market and credit spreads pretty much returning to pre-crisis levels," said Barclays strategists Mikhail Foux, Clare Pickering and Mayur Patel in a July 2 report.
Now, Nuveen, already running the largest high-yield municipal fund with more than $23 billion of assets under management, is expanding its reach in the space. Last week the investment behemoth introduced the first high-yield municipal "interval fund" — the Nuveen Enhanced High Yield Municipal Bond Fund — in another example of how the market has evolved since COVID led to those
The new fund, which will focus primarily on non-investment grade municipals, “seeks to provide a high-level of tax-exempt income and attractive total return,” according to Nuveen, an arm of TIAA.
Interval funds are closed-end funds that do not trade on any exchanges. John Miller, head of municipals at Nuveen and portfolio manager of the new fund, said the fund is structured as a perpetual fund and has no foreseeable limits on capacity. It will focus on monthly tax-exempt income to help investors meet goals for income and tax efficiency.
At least 75% of the fund’s net assets are in municipal securities that are rated BBB/Baa or lower or are unrated but judged by Nuveen to be of comparable quality, said Miller, who is joined by Steve Hlavin, high yield portfolio manager, in managing the fund. With its tax-exempt focus, it targets U.S. retail investors.
To protect against a selloff of the proportions seen in March/April 2020, Miller said a quarterly shareholder redemption feature of the fund provides “a certain amount of shareholder protection during fund outflow periods.”
Nuveen's new fund has the ability to repurchase between 5% to 25% of its net asset value on a periodic basis, but it will target repurchasing 7.5% of its net assets on a quarterly basis, Miller said. It will offer repurchases during the months of February, May, August and November.
“Periods of muni fund outflows can be swift and, often, short-lived, therefore, we believe our fund may act as a source of liquidity and can act as a counter-cyclical buyer,” Miller said.
If the data is any indication, high-yield municipals will continue in the near-term to outperform their high-grade counterparts, though some caution performance might have peaked.
"In the push for spread of any kind, high-yield munis are enjoying their moment," said Kim Olsan, senior vice president at FHN Financial. A 6%-plus gain this year stands despite a mid-March selloff and caps a 10-year cumulative return of 94%, 37% above the broad market, she said.
Olsan said one of the benchmark high-yield names is NR/BB Chicago Board of Education. March pricing had a 5% due 2029 indicated at a 2.10% yield (+129/AAA) but recent trading at 1.25% was spread +42/AAA. Likewise, Puerto Rico’s GO 8% due 2035 moved to an average price of $80.50 in June, up from $63.00 during last year.
A 391-basis point outperformance of Baa-rated munis over the AAA-rated counterparts is at its widest for midyear since 2014, when the delta between the indexes was 562 basis points, noted Bloomberg Intelligence's Eric Kazatsky.
"Since 2011, the decade-long average difference between the indexes is 123 basis points, putting the latest outperformance by lower-grade munis almost one standard deviation higher than 'normal' times," he said.
"Fear of higher taxes and a crush of fund flows have been primary factors in lower-rated entities outperforming in the past year," Kazatsky said. "Throw in a dash of federal stimulus and it has created a perfect storm for spread tightening."
But Kazatsky and others say caution is warranted and as rates rise and aid dries up, credit concerns are worth considering.
"If you believe that statistics should revert to the mean over time, and we're setting new record tights on spreads, the gap in credit could prove unsustainable," he said.
"I think a vast majority of the good news has been priced in to high yields," said US Municipal Bonds Managing Analyst Greg Saulnier at Refinitiv MMD.
"For example, we have not really seen a shift in IL GO spreads since the Moody’s upgrade because we often find spreads and trading to be a leading indicator of ratings actions," Saulnier said. "That being said, high-yield muni fund flows have decreased for four straight weeks. I think what slows the momentum is the fact that Treasury yields eventually need to rise and the relative value of munis, and high-yields, won’t justify the cost at some point."
Barclays also noted higher rates. "The road ahead will be more challenging — a lot will depend on rates, as well as whether tax reform is passed later this year," the strategists wrote. "Moreover, resurgence of the Delta strain of coronavirus may negatively affect some sectors that are sensitive to reopening."
Nuveen's interval fund, all else being equal, hopes to provide more liquidity to a market that generally lacks it.
“Launching the first high-yield municipal bond-focused interval fund allows us to deliver our market-leading strategy in a structure that has the unique ability to capitalize upon certain market anomalies that may not be fully capitalized upon in more liquid structures,” Miller said.
