"When everyone is expecting rates to trend back up, in that kind of environment it makes sense people will be more wary of credit," said Triet Nguyen, managing director of NewOak Capital about the decreased appetite for municipal high yield paper.

A year after high-yield municipal bonds rallied, some analysts say the market may be in for the first turn in the credit cycle in nearly three years.

They point to declining demand for high yield paper against the backdrop of rising rates and growing credit concerns. Yield spreads demanded by investors on lower rated credits remain wider than the historic average, though they've narrowed since the post-election selloff.

"When everyone is expecting rates to trend back up, in that kind of environment it makes sense people will be more wary of credit," said Triet Nguyen, managing director at NewOak Capital LLC. "Spreads have been widening out, so that's a sign also – people are not reaching for yield and they are getting more discriminating."

Nguyen has noticed a change in the risk appetite of municipal investors since the sell-off. "It's early and it's still unfolding, but we are looking for signs that the credit cycle has turned," he said in a Feb. 7 interview.

The first half of 2016 debuted with hearty demand for high-yield municipal bonds, which outperformed the high-quality sector and produced an 8.9% total return through July 22.

Though credit spreads have narrowed 15 basis points year-to-date due to inflows, the average is still 270 basis points over the generic triple-A scale – about 20 basis points wider than its 250 basis point long-term historical average, said John Miller, co-head of fixed income at Nuveen Asset Management.

"High yield is coming back faster than the general market in 2017, and outperforming year to date" as a result of higher income and early evidence of credit spread narrowing, Miller said.

The current 1.43% returns for the Barclays High Yield Muni Index – excluding Puerto Rico – indicates some outperformance over the general market in early 2017, he added.

"High-yield munis had a good bounce in January on the back of a big rebound in tobacco and transportation bonds – the two that got beat up a fair amount in the fourth quarter," Nguyen explained.

But he said a change in the direction of interest rates is usually a catalyst to increased wariness among investors.

The last time the market saw a turn in the credit cycle was in 2014 as a result of the Taper Tantrum, after the Fed signaled it would part back its economic stimulus. Before that the cycle turned after the 2009 financial crisis, according to Nguyen.

He said market participants have gotten pickier about their exposure to municipal high-yield since the end of the fourth quarter and may no longer be willing to reach for yield in the current environment.

He said last month's pricing of city of Chicago general obligation bonds showed how high-yield spreads have widened. Chicago had to pay a spread of 347 basis points on its 12-year bond and 339 basis points on its 21-year bond – despite some good news from three rating agencies after Mayor Rahm Emanuel pushed through tax hikes to improve pension funding.

"The perception was Chicago was modestly improving and had positive changes, but ended up getting priced to 275 basis points over the triple-A scale," Nguyen said.

The city hit a previous high of an almost 300 basis point spread to the MMD top-rated benchmark on its nine and 10-year maturities in deals in May and July of 2015 after Moody's Investors Service downgraded Chicago GOs to junk.

Back in the fourth quarter, average credit spreads widened as fund redemptions for the entire municipal industry totaled $25 billion – approximately half of which came from the high yield muni peer group in November and December, Miller said.

Excluding Puerto Rico, credit spreads became historically wide, increasing to plus-285 basis points from plus-225 basis points over the generic triple-A scale in the absence of any material change in the direction of fundamental credit trends and any new or major credit defaults, he said.

"We believe the spread widening was technical in nature, and was driven by fund flows," Miller said. "I think of this as representing an increase in liquidity premium, rather than an increase in credit default risk."

The Barclays High Yield Municipal Index returned 1.71% year to date in 2016. "These returns are higher than the general municipal bond market, even though high yield got hit harder than the general market in the fourth quarter sell-off of 2016," Miller said.

Despite the reluctance for risk observed by Nguyen, some are still looking for high-yield opportunities – albeit cautiously, given the political and financial uncertainties facing the market early 2017.

"I think our market now has discounted enough of the uncertainty to put it back on solid footing," even though some unknowns remain, Jim Colby, senior municipal strategist at Van Eck Global said in a Feb. 10 interview.

Some double-B and single-B rated securities are yielding 250 to 300 basis points more than investment-grade bonds, Colby said, adding that he has observed yields between 5.25% and 7% from new deals, some of which have been oversubscribed as much as 10 times.

Colby said he hasn't noticed a pullback in high yield demand, despite pending policy changes by the Trump Administration, including corporate and individual tax rate changes and deficit financing. He believes investors still want yield paper, and demand and valuations in the high yield market are being fueled by the underlying strength of the economy.

The return of positive inflows into municipal bond mutual funds, and attractive taxable equivalent returns, are also contributors to the strength of the high-yield market, Colby said.

The Van Eck HYD index is up nearly 1.75% year to date, indicating strong demand for yield product as the market awaits new tax policies by President Trump and additional Fed interest rate increases, Colby noted.

Even though the high yield sector is still credit sensitive, Miller said defaults remain low, and excluding Puerto Rico, the total par amount that defaulted in 2016 was $1.8 billion – less than 2015.

Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said the municipal high yield market may encounter some turbulence – especially in the second half of 2017 – if a less accommodative Fed tightens monetary conditions and raises the fed funds rate by 25 basis points in two hikes as expected.

"There may be additional risk by entering high-yield at this stage, but if you own it you're not selling it," he said last week.

Potential large price drops in high yield could tarnish their attractiveness compared with taxable counterparts for existing bond holders, Heckman added.

"The high yield market is much smaller than investment grade and one of the things the high yield market needs is ample liquidity," he explained. "When you get droughts of liquidity those bonds get very difficult to trade and you can see pretty big price swings."

Meanwhile, Colby said the relative value and attractive absolute yields on municipal high yield will eventually convince investors to stand pat after some consideration.

"Relative value has munis at a significant spread to corporates, giving investors better gross returns, so I think that does attract and give investors a better reason to recommit or stay invested in the product," Colby said.

Miller agreed there is value in the high yield sector and will keep his exposure intact.

"Spreads widened more for technical reasons than for fundamental reasons," he said. "With technicals improving, these elevated spreads should narrow back down."

Nguyen, however, said investors are getting a lot more cautious. He expects the overall credit spread widening in the last 12 months could have further impact as the year progresses.

"High-yield will start to underperform depending on what coupon structure you look at," he said. "If rates are going to continue to rise and you have a temporary lag in evaluations, high yield bonds tend to move more slowly," Nguyen said. "It gives you the illusion that high yield is outperforming when rates are going up but, eventually they will catch up."

The high-yield market usually behaves that way post-sell off, according to Nguyen, but additional high yield volume may be needed to gauge if the high-yield credit market could be poised for a transition.

"We suspect this is a turn in the credit cycle," he said, "but we need to see more evidence of that in the coming months."

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