Portfolio managers, like James Colby, say there is value in the high-yield municipal market because spreads are historically attractive.

When opportunity knocks in the municipal high-yield sector, municipal fund managers answer.

Even though they manage different categories of funds, Guy Davidson, director of municipal investments at AllianceBernstein, and James Colby, portfolio manager and senior municipal strategist at Van Eck Global, are both taking advantage of historically-attractive returns in the high yield sector, which continue to be available amid growing concerns over rising interest rates and anemic supply.

Davidson oversees AllianceBernstein's intermediate, high-yield, and investment-grade municipal bond mutual fund portfolios and works with a team that manages $31 billion in total municipal assets.

His $1.5 billion high-yield portfolio holds 75% in high-yield, triple-B-rated and long duration bonds.

He remains cautious on Puerto Rico, Detroit, and hospital bonds, but said he is overweighting high-yield credit overall in all his portfolios as the additional yield is attractive.

"Longer muni bonds and mid-grade and lower-rated paper remains very attractive in the market," Davidson said in a recent interview. "To varying degrees, we try to get them in the portfolios where they make sense."

Colby is currently boosting the value, diversification, and yield of his $975.4 million Van Eck High-Yield Municipal Index exchange-traded fund by adding a mix of Puerto Rico, tobacco, and other high-yield securities to capitalize on the rally in the municipal high-yield sector this year.

The opportunity has been a rare and welcome one, both managers said.

Colby oversees Van Eck's Market Vectors' suite of seven municipal bond exchange traded funds that total $2.01 billion in assets under management, as of May 1. Each fund seeks to replicate a different index in the Barclays family of indices.

The historically-attractive spread between high-yield and investment-grade, coupled with the strong flows into high-yield bond funds this year, fueled the sector's rally and continues to make it a compelling buy amid improving liquidity and default rates, Colby said.

"The muni high-yield space is not as dangerous as the headlines of the past year have suggested," he said. "It's not without risk - but I would also suggest there is far less than you think."

Although Detroit's bankruptcy has raised concerns, Colby said recent default studies show a significant decline in municipal bankruptcies in the last three years.

Davidson is also taking more credit risk than usual in his firm's $6 billion intermediate portfolio, which has a five-year average maturity and a third of its holdings in single-A credits, as well as the $1 billion national portfolio, which seeks to provide more income than the intermediate portfolio and has more risk, with single-A and triple-B credits comprising 50% of the portfolio's holdings.

"The longer the maturity and lower the credit quality, the more value there is in the market," Davidson said. "High-yield munis are still cheap relative to anything else," and are among the best performers in the firm's high-yield portfolio, which he said is up over 9% this year, versus a decline of almost 8% last year.

AllianceBernstein increased its staff and launched its high-income fund in 2010 "in response to what we viewed as a lot of opportunity in the market at that point," Davidson explained. "But, prior to the financial crisis in 07 and 06, we thought high-yield was very expensive, and focused primarily on high-grades.

"Today, it's the opposite," he said.

Colby said the spread between the Barclays High Yield Municipal Index and the Investment Grade Municipal Index reached a high of 410 basis points as of March 31 - only the second time it has been as high since October 2009. The spread is well above the average of 282 over the last 20 years, he added.

"There is 128 basis points of performance opportunity before you get to the long-term average relationship," Colby said.

Colby's high-yield fund has seen positive inflows this year, and has grown by $180 million year to date, in part due to the rally that followed the $3.5 billion Puerto Rico deal in March.

That deal also contributed to the growth of the ratio between the Municipal High Yield Index and the Corporate High Yield Index to 130% as of March 31, compared to the 20-year average ratio of 74.9%, Colby pointed out.

"We are very confident that we have seen inflows as a result of that particular relationship bringing cross-over buyers into municipal high-yield," he said.

Despite much market trepidation, the Puerto Rico deal's strong demand from cross-over buyers for yields north of 8% and healthy trading in the aftermarket caused non-traditional investors to migrate to municipal high-yield, according to Colby.

"That set the tone for investors recognizing the opportunity in the high-yield space this year," he said.

High yield municipal, Puerto Rico, and tobacco settlement bonds, though volatile this year, have shown strength as investors continue to seek incremental yield over low rate alternatives, J.R. Rieger, vice president of fixed income indices at S&P Dow Jones Indices, wrote in a weekly report last Friday.

Colby's high-yield ETF holds the 8% coupon Puerto Rico bonds due in 2035 that yielded 8.727% at the original pricing. The Barclays Municipal Custom High Yield Composite Index that Colby's high-yield fund seeks to replicate also owns Puerto Rico bonds, so it was a natural fit in his fund.

The high-yield fund's duration to worst case is 7.79 years - which is within 25 basis points of the index duration, according to Colby.

He said he holds over 1% of all the bonds in the index, which accounts for 550 different line items.

"We break those holdings into buckets representative of credit quality, duration, rating, geographical origin, and sector," he said, "and using all those metrics is a process of optimization to create a portfolio that acts like and looks as much like the index as we can make it."

That has been a little easier lately, as liquidity has improved in the municipal high-yield sector as a result of the recent rally, according to Colby.

"Over the last couple of months, there has been a two-way flow of muni high-yield in the secondary market," on hospitals, charter schools, tobacco, Puerto Rico, and others bonds that he uses to build diversification as a risk management tool.

For instance, he owns - and has recently added to his position of - Ohio's Buckeye Tobacco Settlement Financing Authority bonds with a 5 7/8% coupon due in 2047. "As cash has come into the portfolio we have added to the particular coupon because we are familiar with the credit and we are trying to bring the portfolio up to the representative valuation of the index," Colby said.

In recent weeks, tobacco bonds have fluctuated from 8% yields down to 7.35% in the secondary market, but Colby intends to hold the position because they, too, contribute yield and diversification to his fund.

"I am not counting on Puerto Rico or airline bonds to keep performance with the index. I'm trying to build a portfolio that replicates the index using as many different credits as possible."

Davidson, meanwhile, said he owns a small amount of Puerto Rico paper due to the volatility and uncertainty that presents a wide range of potential outcomes — even as Gov. Alejandro Garcia Padilla last week proposed a balanced budget and trading on bonds from the island's $3.5 billion issuance spiked.

Similarly, he considers himself largely a bystander when it comes to Detroit.

To buffer his portfolios from potential interest-rate volatility, Davidson is limiting exposure to bonds with a lot of call exposure, such as those with a 30-year maturity subject to a 10-year call. However, he will buy bonds with less call exposure, such as a 12-year maturity with a seven-year call.

Doing so "cost us a little in performance this year, but we made it up with our overweight to credit," he said.

In the short-term and intermediate portfolios, Davidson owns a small amount of two-to-three-year maturity corporate bonds to offset the expensiveness of the one to five-year slope of the municipal curve relative to taxable bond alternatives.

Likewise, Davidson is maintaining the posture of his funds, and grabbing available yield, while being mindful of volatility, rising rate, and supply concerns.

"Supply is light and that is supportive of prices, but redemptions of mutual funds can overwhelm the benefits of light supply," he said. "If we have signs of stronger economic growth, which signals the Fed may move sooner than expected, I would be worried about outflows out of funds again."

"If you get stability in demand, the lack of supply comes to the forefront, and we grind higher and rally more than you would expect," Davidson predicted.

Overall, he said he is positioned for the yield curve to flatten and high-yield to outperform.

"We expect volatility to remain going forward, and we want to make sure we are in a position to take advantage of it and not be a victim of it," Davidson added.

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