Why insufficient issuance is an issue
High-yield fund managers and investors are craving more lower-rated paper than is currently available in the market, keeping spreads tight and pent-up demand alive for high-yield deals of any size.
Declining yields in the high-grade market are contributing to the continued strong demand for high-yield paper, while consistent year-to-date flows into high-yield funds are supporting strong technicals in the speculative sector. Yet fund managers are largely left empty-handed when it comes to supply.
“We, in the high-yield space, are having a hard time managing the incoming cash flow with what little new product there is to build into the portfolios,” Jim Colby, senior municipal strategist at Van Eck Securities, said on Tuesday.
“We have seen spreads hold very firm — if not narrow — because of the lack of new-issue supply,” he added. Colby is portfolio manager for the VanEck Vectors Short High-Yield Municipal Index [SHYD] and an all-maturity high-yield muni ETF, VanEck Vectors High-Yield Municipal Index [HYD].
This week, the arrival of a large, triple-B quality Maryland port deal was a welcomed sight in a market deficient of the quality and quantity of paper that high-yield investors seek for its attractive, taxable equivalent returns, fund managers said.
In the absence of increased supply, the return of a large speculative player earlier this year helped firm the high-yield market and temporarily improve availability and liquidity.
“There’s an inherent disparity between cash flow coming from maturities, sinking funds, bonds calls, and coupon calls and the new-issue calendar,” Colby said. “The issuers are not coming to market the way they would need to in order to normalize that relationship.”
A Chicago high-yield banker agreed.
“Right now there is a lot of demand because the bond funds have been taking in a lot of cash over the last 14 weeks,” he said on Monday. So far in 2019, the supply in the high-yield world has been down, while the demand has been up, he said.
“If you have high-yield deals, now is the time to bring them,” the banker said. “Money is flowing into the funds and there is nowhere to spend it, so any new deals are being devoured by high-yield funds.”
Besides availability, other supply-related problems, according to Colby, include difficulty for managers to ascertain valuations on bonds they own. High-yield bonds are typically buy-and-hold securities that lack daily or frequent trade data.
“Valuations can be tricky and lead to a bottleneck for managers doing trades between portfolios,” Colby said.
In addition, the supply crunch can be more concerning for managers of ETF funds, which consist of a basket of specific securities that track an underlying index, than actively managed portfolios that can build significantly large positions from diverse credits.
“I don’t really have that luxury because I am trying to create positions that relate to the weights in the indices I manage to,” Colby said, noting that he aims to avoid the risk of tracking errors — or under-performance in the event of a credit issue or rising yields.
“I have to be a bit more cautious and remain aligned with index weights,” which is more challenging given the limited supply, he said.
Large Maryland deal
A $105 million Maryland Economic Development Corp. financing on behalf of Ports America Chesapeake LLC for dredging 50 feet of one of the berths and funding specialized equipment, including cranes to maximize port efficiency, was viewed as attractive for its yield, size and timing amid strong year-to-date fund flows, managers said.
Rated Baa3 by Moody’s Investors Service, the deal was priced on Wednesday by Piper Jaffray & Co.
The 2019 Series A tax-exempt bonds are subject to the alternative minimum tax and mature in 2049, while the 2019 Series B taxable bonds mature serially from 2022 to 2034, with a term bond due 2042.
The tax-exempt AMT portion, $41 million, saw 5s of 2044 priced to call yield 3.20% while the 5s of 2049 yielded 3.25%. The long taxable bond, a tranche of $29 million out of the $62$ million total, had a 4.75% coupon and was priced at 99.582.
“It's a large Baa3 credit with a stable financial management team, solid location, and strong debt service coverage — both historically and projected — which should make this an attractive investment," Yaffa Rattner, managing director and head of municipal special situations and high-yield credit at Piper, told The Bond Buyer last week ahead of the pricing.
The Baa3 rating was issued in 2018 and affirmed last month, she said.
Its timing, in addition to a well-received marketing call with investors last week, solidified the expectation for "tremendous" demand, according to John Pellicci, a managing director and head of municipal special situations and high-yield at Piper.
"I would expect it to have a significant amount of interest because it is low investment-grade, which is of strong interest to investors," Pellicci, also a municipal high-yield trader, said.
The deal kicks off a “solid pipeline” of “well structured” upcoming deals from Piper, Rattner said last week.
“There’s a lot of redemptions as well as positive fund flows creating a good demand component in the market,” Pellicci added. “Coupled with lighter new-issue supply, it’s been a favorable environment for borrowers.”
Among its characteristics, the size of the Ports deal stands out amid a handful of high-yield deals in the $15 to $20 million range recently, the Chicago banker said.
While its size is noticeably larger than typical lower investment-grade deals, it is standard for Ports America Chesapeake as well as similarly rated health care and higher education deals he has worked on, Pellicci of Piper said.
The last time Ports America sold debt was at year-end 2017 when many issuers rushed to market ahead of tax reform, he said.
High-yield fund managers agreed that the scarcity of lower investment-grade paper should heighten demand for the Ports deal — and any others like it heading to market.
The Baa3 rating makes it a widely held and accepted security for many investors, and should be easily snapped up, Colby said.
“Bonds could fit into both investment-grade and high-yield scenarios, so you have two different entities vying for the same product,” he said.
“Unless there is something fundamentally wrong with the structure, it will do very well,” Colby said the day before the issue priced. “The demand seems to be coming unabated” for lower investment-grade paper, he added.
While the high-yield sector in general has inherent risks, fund managers and investors are still hunting for new paper, encouraged by other economic and market developments, especially declining yields and narrowing spreads in the generic market.
The 30-year triple-A GO scale yielded 2.44% on May 8, after narrowing from 2.99% on Jan. 2, according to MMD.
“Although there is widespread concern about credit quality at this late stage in the credit cycle, the stock market rebound in quarter one of this year, and consistently strong economic growth numbers at least to date have emboldened market participants to continue to reach for yield,” Triet Nguyen, managing director at Axios Advisors, said on Tuesday.
Nguyen and Colby said other market factors, such as the February restructuring of Puerto Rico’s Sales Tax Financing Corp. bonds, breathed some life into the high-yield market.
In the biggest restructuring in municipal debt history, COFINA swapped what had been about $17.6 billion in bond par value to about $12 billion in new COFINA bond value.
The 5% bonds of July 1, 2058, dated Aug. 8, 2018, traded on Feb. 15 at a price of 95.055, and yield of 5.30%, and ended at a price of 98.637 and yield of 5.08%, EMMA reported.
“Puerto Rico came into the marketplace at the right time,” Colby said, noting the restructuring allowed active fund managers to get “back into the game” as they participated in the new COFINA bond transaction.
It gave exchange-traded fund managers like himself an opportunity to add and reposition existing bonds without compromising his strategy of managing to a weighted benchmark.
“I was able to seize the moment to build in some health care, charter schools, and other high-yield products that might not have otherwise come into the marketplace” during the time of the large restructuring, Colby added.
Nguyen, meanwhile, said the rally in Puerto Rico paper contributed to the firm tone in the high-yield market, “with the restructured COFINA paper as the trading vehicle of choice for many crossover investors.”
While the appetite for high-yield paper remains hearty, managers said investors should be wary of risks and monitor any new opportunities.
For instance, Nguyen said the housing and hospital sectors could indicate some concern.
“Certain sectors that have seen a surge in supply two to three years ago, such as new senior housing projects, may be challenged by the softening tone in some local housing markets as they begin commercial operation,” he said. In addition, the Trump Administration's assault on the Affordable Care Act also “raises uncertainty” in the hospital sector, Nguyen added.
Overall, the fundamental reasons that justify the value of owning municipal high yield have and continue to attract investors to the sector, managers noted.
Despite the scarcity expected through year end, Colby said the significantly low default rates compared with corporate high-yield bonds or equities, as well as the attractive taxable equivalent returns, continue to be fundamental reasons investors want to own high-yield paper.
“Take those two features alone and the risk return profile of muni high-yield is gainfully higher than corporate high yield,” Colby said.
His own HYD and SHYD ETF funds have seen positive flows so far this year, he said.
The demand for municipal high-yield explains why cash still comes into the sector, he said. In addition, Colby said the Federal Reserve Board’s pause on rates for the remainder of 2019 further supports strong demand for high-yield paper.
“I suspect we’ll continue to see good action and solid returns in muni high-yield for the foreseeable future.”