One of the basic tenets of securities investing is the concept of risk/reward. The appetite for risk differs across the spectrum of investor cohorts and, admittedly, certain investors should steer clear of high-yield municipal bonds. Less sophisticated investors and those with rigorous account suitability standards should maintain a conservative bias.
Individual investors may be hard-pressed to assemble a municipal high-yield component to a portfolio given diversification and allocation constraints. Exchange-traded funds may offer a solution to creating a professionally managed high-yield sleeve within an individual portfolio.
The market for high-yield is quite active. Although relatively small, municipal high-yield securities represent a segment of the market that can potentially provide above-market returns as compensation for assuming above-average credit risk with reduced marketability and liquidity. Essentially, high-yield munis represent the intersection of alpha and beta.
According to CreditSights, the market cap of the Municipal High Yield Index is 3% of the size of the ICE Muni Index (all investment grade), while the high yield Corporate Index is 16% of the size of the Investment Grade Corporate Index.
Alpha generation, or excess return above anticipated performance, can derive from an active security and sector selection strategy, effective curve positioning, rigorous credit research and sound trading and relative value acumen. Adding certain types of high-yield municipal bonds to a diverse portfolio can offer risk mitigation against equity market volatility and can balance out a broader fixed-income portfolio.
High-yield municipal bonds are rated below investment grade (speculative) by the established rating agencies generally because of weak credit fundamentals or the absence of an adequate track record for a bond-financed project. A non-rated bond may also be considered high-yield if it has an above-market spread to a comparable Treasury instrument.
Away from these generic labels, I would point out that certain investment-grade securities actually possess high-yield attributes. For example, while I view the
Investment-grade bonds can be downgraded to speculative grade and would be considered "fallen angels," given enough credit erosion. The high-yield muni market would certainly capture those securities viewed as "distressed." These bonds have typically entered technical default where secondary market pricing and liquidity have been compromised, and the risk of monetary default has grown considerably.
Non-rated bonds are seeing broader capital market access where historically such access had been limited or excluded for certain sectors. Over the past 25 years, the universe of high-yield issuers has evolved with wider and greater relative value opportunities. As the scope of high-yield borrowers has evolved, so too has the breadth and depth of high-yield investors. Given the expanding buyer base for taxable municipals and the material 2013 market displacement of Puerto Rico securities, a broader audience of foreign, hedge fund and distressed buyers emerged in the municipal high-yield space.
Institutional investors represent the primary buyers of high-yield municipal securities. This space is largely composed of mutual funds and high-net-worth money managers that typically have higher levels of risk tolerance than individual investors. They tend to be more sophisticated and often possess greater credit expertise with a rigorous investment process centered upon ongoing surveillance that allows for proactive portfolio management as well as credit, sector and geographic diversification. Further, the institutional investor is better able to anticipate and avoid distressed situations. Overall, the institutional buyer sets the standard and typically negotiates bond covenants with the issuer.
Individual investors should carefully consider their investment objectives with particular attention given to risk appetite and the potential for active price volatility, limited liquidity and full loss of principal. Capital preservation would not necessarily be a primary investment objective within a high-yield strategy.
Although high-yield municipals are a riskier segment of the broader municipal asset class, historically they have demonstrated a lower default experience and higher recovery rates compared to comparably rated corporate bonds. Like the broader municipal market, high-yield municipals offer both general obligation and revenue bond structures. Typical sectors include hospitals and life-care/nursing facilities, student housing, tobacco securitization, special revenue airline, transportation, electric and various project finance. High-yield municipals tend to be issued with intermediate to long maturities, generally having 10-year call protection.
When structuring a portfolio of municipal high-yield securities, a key objective is to provide the highest tax-exempt yield possible. Apart from sector- and credit-related events, performance may be impacted by changes in interest rates and economic conditions. Any of these scenarios can result in wider spreads. Spreads can generally change very quickly and prices on high-yield securities could drop just as fast.
While there are clear benefits to investing in high-yield municipal securities, there are various inherent risks that must be evaluated prior to making an investment. Certain factors may adversely affect the value of municipal securities and have a significant impact on the yield. Individual investors should become familiar with the risks associated with a specific security prior to purchase, as high-yield municipal bond ownership is generally a long-term commitment.
Current high-yield municipal bondholders are advised to frequently review their holdings and should understand that a sale prior to maturity may be necessary. Those credits that do not make economic sense and that do not appear to have sufficient cash flow to meet operating and debt service expenses and perhaps rely on very questionable assumptions, tend to fail.
A well-structured transaction can mitigate high-yield credit risk with appropriate bondholder covenants and rights and remedies. Consider:
- Economic viability of the underlying project can be more important than transaction structure as there needs to be a feasible deal. A professional and comprehensive feasibility study can offer key insights and guidance.
- The availability of capitalized interest, a mortgage pledge, reserve funds, an equity contribution and other sources of support revenue should be clearly stated.
- The role and powers of the indenture trustee should be expressly spelled out in the bond documents and continuing disclosure requirements must be included.
- New project financing requires a thorough evaluation of the construction risks with consideration given to performance guarantees and the overall track record of the contractor, as well as the obligor/project operator. Environmental issues and pending litigation can produce delays, and may be sufficient cause to avoid investment.
Municipal securities do not trade on an orderly exchange and high-yield municipals specifically may often trade on a "best efforts" basis. Certain credits may demonstrate an even greater degree of illiquidity and a bid or offer may not be readily available. Accordingly, the spread between the bid and offer price may be relatively wider compared to other markets. High-yield municipal securities can often trade on market technicals, just like the broader municipal market. Different sectors of the municipal high-yield market may outperform other sectors based on technicals, perception and overall historical credit trends.
5 types of risk associated with high-yield municipal securities
The following risks are not intended to be a complete list. Other risks relating to a specific issue may exist and are generally disclosed in the security's official statement.
Default/credit risk — Given the more speculative nature of municipal high-yield securities, the risk of credit erosion including technical and/or monetary default rises considerably. Particular attention should be paid to economic, financial and political fundamentals that may impact credit quality. Exposure to default/credit risk can result in a sharp decline in a security's market value and the potential loss of full principal investment. A way to mitigate this type of risk would be to have a diversified portfolio containing more conservative, higher-quality municipal bonds. Diversification of high-yield investments could provide further risk mitigation.
Market risk — High-yield municipal securities tend to be more illiquid with less price transparency than investment-grade municipal securities and therefore could have limited secondary market trading opportunities. Largely, this is due to much smaller investor participation in this space and the fact that municipal bonds are essentially traded over-the-counter and not on a specific exchange. There are no guarantees the underwriter of a high-yield security will make a market for their deals, as no such obligation exists.
With the relatively small size of the municipal high-yield sector, market or liquidity risk could be significantly elevated given a high profile credit event that may result in headline exposure. Although this may not result in a systemic impact across the municipal high-yield sector, episodic disruption may occur. Unrated securities may trade less actively than rated bonds. Generally, spreads and prices can shift very quickly.
Interest rate risk — Changes in interest rates impact the value of fixed-income investments. When interest rates rise, the value of fixed-income investments tends to fall and vice versa. Reinvestment risk can occur if an investor needs to reinvest bond proceeds in a lower interest rate environment. Interest rate risk is generally higher for fixed-income securities having longer maturities or duration. Longer-duration high-yield municipals could see a greater price decline given a rise in interest rates. Interest rate risk can accompany Federal Reserve Board shifts in monetary policy.
Call/redemption risk — Many municipal securities have call features that allow the issuer to repay principal prior to the maturity date of the security. These calls typically occur at par and may be linked to a specific event that triggers redemption. Thus, event and call risk can go hand in hand. Catastrophe calls can result from certain events — including a "natural disaster" — that result in damage, destruction, or condemnation of the bond-financed project. "Taxability calls" result from certain events where an Internal Revenue Service ruling may render the bonds retroactively taxable. An example would be the improper use of bond proceeds that does not meet certain IRS tests for tax-exemption.
The sale or merger of not-for-profit institutions to or with for-profit enterprises, a change in governance structure, or the taking of property through eminent domain could also result in an early call. Of course, issuers may choose to call bonds early at a stated price (perhaps at a premium) in order to refund higher interest cost debt at lower rates. Certain classes of taxable municipal securities, such as Build America Bonds, are subject to "make-whole" calls that reflect a set spread to Treasuries.
I would point out that IRS challenges are rare, although audits are conducted episodically. At times, certain types of bonds can be subject to a broader IRS audit. Here, a close look at private-use standards are examined as well as possible violations of arbitrage rebate guidelines and use of bond proceeds. Typically, retroactive taxation does not result from these types of violations. The IRS and issuer would enter into a closing agreement whereby the issuer pays a settlement with the tax-exemption preserved.
Disclosure risk — Generally, municipal high-yield security valuations reflect the existing credit profile of the investment. However, current information may be difficult to obtain, which could impact liquidity and pricing. Many municipal high-yield securities trade infrequently with challenged price discovery and, therefore, pricing may not accurately reflect a security's current credit standing. While disclosure and transparency in the municipal market have substantively improved over the past 25 years, they are still less efficient and less frequent than what is commonly available in the corporate high-yield space.
Final thoughts
Muni high-yield significantly outperformed the broader index in May. A still-favorable credit climate and disproportionate spread tightening within lower quality buckets drove outsized returns. I would point out that there is often greater spread to recover for the high-yield sector during periods of sharp yield movements.
The muni high-yield index returned 62 basis points in May, with year-to-date (May month end) performance of 2.72%. Much of this performance was driven by carry attribution. High-yield general obligation and certain essential purpose revenue bonds outperformed the broader high-yield index last month, as speculative buyers turned to predictability — an area of more substantive spread-tightening opportunity. It was not a surprise that although positive returns were delivered by the high-yield electric, hospital, housing and education sectors, these cohorts underperformed the broader high-yield index.
As we head into the third quarter, high-yield munis are well-positioned for continued outperformance (both within and outside of the muni asset class) and I expect demand to hold given very attractive taxable equivalent yields and technical tailwinds. Despite noted spread tightening, high-yield muni yields remain compelling.
Even if rates trade sideways, high-yield will likely pick up decent basis points of carry each month. However, investors are likely to become more discerning about high-yield credit and I continue to view careful security selection and critical portfolio surveillance as the primary strategy necessary to book favorable returns. Elevated long-end yields should continue to attract duration-appetite investors.
