The municipal high-yield sector is outperforming all others as rates globally are at historic lows, municipal ratios to U.S. Treasuries dip to near 20-year lows and investors clamor for any incremental yield.
High-yield — despite its inherent risk — is returning above 1.75% so far in 2021, following a strong end to 2020 at a 6% return.
Record high inflows into high-yield municipal bond funds over the past 11 weeks as of Jan. 25 demonstrates the overwhelming appetite for yield paper on the buyside, according to Refinitiv/Municipal Market Data.
Most recent deals “fit right into the buyer wheelhouse offering some size and varied credits, most of which will offer wider spreads than what is available today,” Refinitiv analyst P. Franks said in a Jan. 25 report.
Municipal performance compared to U.S. Treasuries posted the best outperformance for tax-exempts in the 30-year slope, according to Eric Kazatsky, senior strategist at Bloomberg Intelligence. Though Kazatsky said investment-grade returns pale in comparison to those for municipal high-yield.
The Bloomberg Barclays Municipal Index, with a double-A credit quality, has year-to-date returns of just 0.25%, which trails longer-dated municipals, with returns of 0.40%. Triple-B municipals are returning at 1.09%.
The Bloomberg Barclays Municipal High Yield Index has posted historic returns of 1.77% so far in 2021, a record.
“Prices for municipal high-yield bonds continue to hit new highs, despite the havoc COVID-19 has caused in the muni market and unknown risks over the next year,” he said in a report.
The low default rate and high performance of municipal high-yield paper in 2020 translates into potential value and opportunity ahead in 2021, said Phil Toews, chief executive officer at Toews Asset Management, in a recent interview.
“Because high-yield bonds typically move lower along with equities, we haven't suffered a lot of default risk for high-yield muni bonds,” he said.
Toews manages $2.2 billion of total assets under management, including $800 million of high-yield bond assets in its funds. The firm offers high conviction tactical models, most of which have some exposure to high-yield bond instruments. When in a bullish posture, they attempt to track market indices and may gain some exposure through high-yield bond exchange-traded funds.
He is optimistic on the sector, especially since investment-grade bonds “are a very poor source of returns because we are in a negative real return environment with interest-rate risk.”
Toews referenced the 3% to 4% spread between the high-yield and investment-grade sectors.
His expectations for returns are much higher on a 12- to 24-month forecast, especially since municipals are outperforming taxable bonds so far in 2021.
High-yield has been trading with attractive spreads in the secondary market of late, according to the Refinitiv data.
A $5 million block of New Jersey general obligation emergency COVID-19 bonds traded recently with a 4% coupon due in 2032 at a 1.50% yield. New Jersey is rated A3/BBB+/A-/A, one of the lowest-rated states.
That spread was 64 basis points over the generic, benchmark, triple-A GO scale at the time, even though it was slightly tighter than where it traded at 68 basis points a week earlier, the data showed.
In addition, a $5 million block of New York State Metropolitan Transportation Authority revenue bonds were sold at a 2.31% yield. The spread was 93 basis points higher than the generic triple-A scale, which was on top of recent levels, though more than 50 basis points tighter than where it traded in December 2020, Refinitiv data showed. The MTA, rated A3/BBB+/A-/AA-, is facing severe budgetary pressures from knock-on effects on ridership from COVID-19.
Yields are attractive when compared to the low absolute yields in the high-grade market and performance continues even after the volatility last spring, analysts noted.
“For an outsider looking at risk pricing in our market, it appears the pandemic never happened,” Kazatsky said. “While some of this is based on the resiliency of the muni market, much of the price improvement has been technical in nature as strong inflows and little yield have dictated the direction and strength, especially when it comes to more bespoke trading credits with low or no ratings."
Others agreed that the high-yield sector offers value for yield-starved investors in the current market.
“We remain constructive on high-yield municipals for their diversification benefits, high levels of income, and the potential to be rewarded for superior security selection,” Peter Hayes and Sean Carney of BlackRock Inc. wrote in a Jan. 19 municipal market 2021 outlook report.
The high-yield sector finished 2020 with a strong gain of 6% and outpaced the broader S&P Municipal Bond Index by 1.05%, even though that performance came on the heels of a dramatic drop of 11.2% last March and April by the S&P Municipal High Yield Index, the analysts pointed out.
“We anticipate that high-yield will outperform again in 2021 with the tailwinds of low rates, limited supply, improving fundamentals, attractive credit spreads, and the reversal of flows alongside investors’ increased risk appetite,” Hayes and Carney wrote.
Looking at the potential value in the sector, the pair recommend credits with measurable cash flows, such as tobacco, Puerto Rico Sales Tax Financing Corporation [COFINA], corporate bonds, and established retirement community bonds.
“We believe there is significant value in the Puerto Rico general obligation and Puerto Rico Electric Power Authority [PREPA] bonds, which are expected to be restructured this year,” they said.
But, the sector is not without risk, analysts warned.
“There is a very good reason to look to high-yield muni bonds for additional yields, but you need to approach that marketplace with reasonable agility,” Toews said.
He said the proxy risk in the high-yield municipal sector can be gauged by looking at the valuation of stocks because they are similar to corporate high-yield.
“When stocks are falling, the proxy risk is relatively high, and when spreads are low and equity valuations are higher, the risk is higher in municipal high-yield bonds,” Toews said.
Since high-yield corporate and municipal bonds move similarly during risk events, investors need to be selective when searching for opportunities in the high-yield municipal sector, he noted.
“With the forward valuation on the S&P 500 over the next year near 23, we feel there is a significant possibility of an equity deflation risk event and, therefore, the risk to principal on high-yield bonds, including high-yield muni bonds, is high as well,” he said.
Looking back at the fourth quarter, Toews said high-yield spreads were around 7% to 8% above investment-grade bonds.
“What that tells you is the return potential is higher historically when spreads have been 8% or more,” Toews said. “That has led to strong returns for high-yield bonds, but at the same time, high-yield spreads are under duress.”
Meanwhile, the pandemic’s impact on the municipal high-yield sector should also be considered a potential risk, according to Hayes and Carney of BlackRock.
Extra due diligence is needed on credits affected by COVID-19, such as long-term care facilities, small universities, and highly speculative start-up projects, the BlackRock analysts warned.
Both stock and economic risk could creep up over the next 12 months and impact municipal high yield, Toews added.
“If the momentum ebbs for the equities market and we see a bear market play out in 2021, then high-yield munis will be directly affected by that,” Toews said. “They will realize the equity proxy risk and move lower along with stocks.”
“If the economy continues to grow and the vaccine continues and there is no risk event that affects equities over the next 12 to 24 months, we will see spreads continue to narrow and a mild appreciation in high-yield municipal bonds and decent yield relative to the investment-grade marketplace,” he said.
Toews’ advice to high-yield municipal investors going forward?
Be agile.
“Understand that while yields are at an acceptable level, you’re accepting economic risk and with that having the ability to de-risk and change allocations is highly desirable,” he said.
“Now is a good time to think unconventionally,” he suggested, adding that investors should include “loss avoidance strategies that help address falling markets.”
“We believe we are 95 basis points away from a range where we would move to a more defensive posture,” such as Treasuries or short duration investment-grade bonds or cash instruments, he said.
If, for instance, high-yield bonds move lower by 50 basis points that would be an exit signal for de-risking municipal high-yield positions, Toews said.
But, for now, he doesn’t see an immediate or short-term impact from negative interest rates in municipals or corporate bonds.
For the remainder of the quarter, Toews expects to continue his existing strategy of staying fully invested with a bullish posture in all of his high-yield municipal allocations, barring any change or loss in momentum or trend in the sector.
