The Bond Buyer, 4 May, 2007
The continuing high performance of high-yield municipal mutual funds over general municipal funds has created a high demand for the strategy.
However, some investors say the investment category may be a victim of its own success. The heightened interest in these investments is compressing yields.
The 94 high-yield muni bond funds that Lipper Inc. tracks soundly outperformed the 248 general muni bonds funds Lipper monitors. The high-yield portfolios, which collectively manage $49.6 billion of assets, posted a 6.29% total return over the past three years. In comparison, the general funds, which together total nearly $82 billion of assets, notched a 4.05% performance measure since April 2004.
This year’s performance through April 26 has paced at 1.18% and 0.72% for the high-yield and general muni bond funds, respectively.
While a number of factors have been behind this trend for past few years, industry players said the healthy national economy has driven high-yield performance.
“We are in a relatively positive economy, so when you have a pretty good economy out there and you don’t have recession, then, even in the high-yield world things can look pretty good and defaults are much lower,” said Chip Norton, managing director of research and portfolio manager for Fortigent’s tax advantage debt fund. “We have these little recessionary pockets, of course, in various industries like the real estate market right now, but it has never been prolonged and it wasn’t widespread enough to affect these securities.”
Dan Loughran, a vice president and portfolio manager at OppenheimerFunds Inc. agreed. “With the economy humming along, corporate profits are up, and then investors require less yield premium to lend money, the muni market is correlated to the corporate world, so you are seeing that with a little bit of lag,” he said.
With a generally strong economy, healthy equity markets tend to follow. Senior Lipper analyst Jeff Tjornehoj said a recovering or strong equity market also bodes well for high-yield credits. As of yesterday, the Dow Jones industrial average closed at a record high for the third day in a row. It finished yesterday at 13,241 points.
“People treat high-yield as a middle ground, they are definitely not a stock, but they have the volatility associated with equities, and so they tend to run along with them,” Tjornehoj said.
A stable economy tends to help investors feel comfortable with risk, which is good for the sector because the historically flat yield curve and low rates overall have forced many investors to dig into the lower realms of credit quality for yield. Loughran said the bear markets at the turn of the century created very wide credit spreads that, as with any cycle, went in the other direction in 2003.
“It was only a matter of time that they narrowed,” he said. “Since credit spreads have narrowed so much over the past couple of years, it has encouraged people to reach for yield. With absolute interest rates still relatively low, some investors are hungry for yield and they will go down in rating to get that.”
Looking at changes in the slope of the municipal yield curve show how investors in the market today aren’t getting value by taking on as much risk as they once did. The basis point spread from one-year debt to 30-year bonds on the Municipal Market Data’s triple-A general obligation yield curve on Wednesday was 50 basis points. The spread between those maturities on a single-A housing sector, a typical credit found in a high-yield muni fund, was 81 basis points, indicating a little more value for the risk.
Compare this to May 1, 2003, around the time that high-yield muni funds began to greatly outperform the muni alternatives. The triple-A GO curve spread from one year to 30 years was 351 basis points. The single-A housing curve had a 363-basis point spread over the same time period. Two years later, on May 4, 2005, each curves’ spread was reduced to 174 basis points, leaving many investors no choice but to turn to high-yield accounts to meet their needs.
Many buyers have bought in to the trend, and as a result, it has increased demand for the strategy. As a result, yields on many lower-quality securities have come down as well.
Looking at the yield of a 30-year single-A housing bond on Wednesday, it yielded 4.61%, according to MMD’s curve, and on May 4, 2005, it yielded 4.67% and on May 1, 2003, it yielded 4.96%. This process of lowering yields is a result of more demand for the product, Tjornehoj said. He noted that there is a certain amount of “sticker shock,” as many investors are not happy with how they are being compensated for taking on low-rated paper.
Loughran’s fund has done the same.
“There have been times where we’ve analyzed a credit and were satisfied that the borrower was credit worthy, but we just weren’t offered enough yield to lend them money,” he said. “We’ve done that several times in the past six months — there is nothing wrong with the credit, it was just not enough yield for that credit risk.”
As yields on lower-rated paper have also begun to dip, it has led some managers to diversify their holdings.
Take Nuveen Investment’s high yield municipal bond fund that has $5.3 billion of assets that since mid-2004 has reduced the fund’s stake in nonrated debt from 56% to 40%, according to a Morningstar Inc. January report. Norton added that with the popularity of many high-yield funds, many have such high inflows that they will invest more in high-quality credits until they see value coming.
“Many of these portfolios have strategically decided that rates are too compressed so they dump it in high-quality credits,” he said.
While some fund managers are moving part of their assets into safer credits, it is unclear how long this trend will last. Tjornehoj said he saw yields trading in a range-bound setting through 2007 and said this strategy might very well “have legs” going in 2008. Norton, on the other hand, said he really couldn’t put a finger on it.
“I talk to managers on a regular basis, and every time we speak I ask them what they think is going to derail this market and lift the yield curve,” he said. “There are no indicators that this environment is going to change, no one can really put a finger on it, but it is cyclical, as all things, and can’t last forever.”
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