Uncertainty surrounding Federal Reserve interest rate policies and negative municipal headlines related to Detroit's bankruptcy proceedings, Puerto Rico's deteriorating fiscal situation, and Illinois' pension reform issues made for a volatile 2013 in the retail driven municipal market. A meaningful sell-off began in May in the municipal market resulting in yields that continue to trade above taxable equivalents. While volatility remains, this dislocation has led to a potential investment opportunity, particularly in high yield municipal credits.
Municipal yields are typically compared to the taxable market by using an investor's tax rate to "gross up" the tax-free yield to its taxable equivalent. For example, assuming a 6% yield on a high yield municipal bond and a 35% federal tax rate, a taxable bond would need to yield 9.23% to equal the yield on the municipal security. Today, 6% yields are a reality in the high yield municipal market, and look attractive versus taxable alternatives, even before taking taxes into consideration. Comparable yields on taxable high yield bonds are currently 5.6%.
While high yield municipals are subject to interest rate, credit, liquidity, market and call risk, and typically have longer durations than their taxable counterparts, at current levels taxable investors may be well-compensated for these risks and may want to consider the investment for some portion of their fixed income portfolios. Below we review the characteristics of the municipal high yield asset class, the opportunity and considerations, and our recommendations on implementation.
While the major municipal indices characterize the high yield market in the traditional sense (non-rated or BB+ or below), in practice most high yield municipal managers consider the opportunity set to include BBB-rated bonds. This subset of the market (BBB and below) represents approximately 10% of the overall municipal market. High yield municipal bond issuance has trailed off in recent years from over $50 billion in 2007 to approximately $15 billion in 2013, as municipal issuers continue to deleverage.
Sectors typically represented in high yield portfolios include general obligation or tax backed issuers rated BBB or below, healthcare and senior living facilities, land secured, tobacco, utilities, education and charter schools, transportation, multi-family housing developments, and some private corporations who have access to tax-exempt financing. Examples in today's market could include a non-rated American Airlines – JFK Airport revenue bond and a City of Detroit Water Supply System bond rated B1/BB-.
High yield municipal bonds tend to have significantly longer durations than other fixed income asset classes. As of 12/31/13 the Barclays Municipal High Yield Index had duration of 10.6 years, compared to the Barclays High Grade Municipal Index and Barclays U.S. Corporate High Yield Index at 8.4 and 4.2 years, respectively.
History tells us that municipal defaults are rare; a recent study from Moody's Investor Service found that during 1970–2012 the average one-year default rate for Moody's rated municipal securities was .012%. While the number of defaults has increased since the financial crisis, even during the period 2008–2012 the average one-year default rate rose to only .03% across all ratings. While the composition of defaults has shifted to include a greater proportion of general government issues in recent years, the vast majority of Moody's-rated municipal defaults occur in the lower rated healthcare and housing sectors.
Further, historical default rates for high yield municipal bonds are significantly lower than their corporate counterparts. Over the ten-year period ending 12/31/2012, average default rates of Baa municipal bonds were actually lower than Aaa corporate bonds, at .30% and .50%, respectively.
Figure 1: Moody's Cumulative Historical Default Rates — 10 Year History
Recovery rates for defaulted municipal issuers are also higher than those of high yield corporates. Over the time period from 1970-2012, the average recovery rate for defaulted municipal issuers was approximately 60% versus 49% for corporate senior unsecured bonds. It is important to note that recovery rates for municipals can be highly variable. For instance, the 1994 default of Orange County, CA pension obligations bonds ultimately returned 100%, while the Las Vegas Monorail project which defaulted in 2010 only reported a 2% recovery for bondholders.
Looking ahead, there are numerous reasons to expect default rates to remain low. The recession forced governments to address some challenging issues. Spending restraint and fiscal stability has improved fundamentals, including 15 consecutive quarters of state revenue growth. Further, the crisis heightened the awareness of problematic pension liabilities and has led to important developments in regards to pension reform. That said, challenges remain in the market. The City of Detroit's bankruptcy case has called into question the payment priority of general obligation debt and whether pensions are protected under bankruptcy law. While no decision has been reached, investors should monitor the precedents set by the ultimate rulings, and be aware that the historical incidence of municipal bankruptcy and recovery may not be predictive of future events.
It was a rough road for the municipal market in 2013 and, as a result of the volatility, both investment grade and non-investment grade municipals look attractive versus their taxable counterparts. Lower rated sectors were hit especially hard and through the end of 2013, the high yield municipal market was down 5% following a 12% sell-off in the middle of the year. As shown in the table below, municipal taxable equivalent yields are significantly higher than corporates, and the ratio of the Barclays High Yield Municipal Index yield to the Barclays U.S. Corporate High Yield Index yield is at an all-time high.
A significant contributor to negative returns during 2013 was the cash flows out of municipal mutual funds. As shown below, the correlation between the monthly rolling 6-month returns of the Barclays Municipal High Yield Index and the net fund flows of municipal high yield mutual funds was 0.73 over the period 2004–2013. While there is potential for further outflows, this appears to be an attractive entry point.
In addition to typical fixed income risks such as rates and credit; municipals have some unique market dynamics that can drive returns. This was evident in 2013 when headline risk contributed to significant fund outflows. Puerto Rico, which faces unresolved economic and fiscal challenges and is frequently in the headlines, could cause volatility to persist into 2014. Further, liquidity is a concern as it is less robust in high yield municipals than other institutional fixed income markets.
Figure 2: Relative Value Comparisons
From a fundamental and technical standpoint, however, there are many factors that may be supportive of the municipal high yield market in 2014. Lower issuance and supply coupled with a demand increase from investors looking for tax-exempt income in light of increased tax burdens could be a positive. If rates do move higher, high yield municipals could outperform higher quality paper as improving fundamentals and attractive yields should help mitigate the negative impact of higher rates. Finally, away from the specific distressed credit situations mentioned above, overall municipal credit quality appears to be improving due to increasing revenues on both a state and local level.
Figure 3: Municipal Monthly Net New Cash Flow and Rolling 6 Month Returns
Why now? Investor realization of higher taxes and an attractive entry point support the case for an investment in high yield municipals. Investors should, however, approach the opportunity with a mid- to long-term investment horizon given the lack of liquidity in the municipal market. Volatility should be expected given higher interest rate sensitivity due to long dated issuance, credit risk, and retail flows. Given these market characteristics, targeting a manager with extensive credit research capabilities and strong market access is critical, as the municipal landscape has evolved in recent years.
While manager selection is important, vehicle choice is equally important. Given the correlation of returns to retail flows, an investment vehicle that can be somewhat insulated from this effect is preferable. Rocaton would advocate for either a separate account or a commingled vehicle with somewhat limited liquidity. A vehicle that has significant diversification of holdings is also critical given the liquidity and volatility risk of the asset class.