Municipal Bond Insights and Charts: Seeking Value in High Yield Munis

Our experts offer five reasons why high yield municipal bonds may potentially represent compelling opportunities in the current market.

Read time: 4 minutes

Since the start of the Covid-19 pandemic, in the municipal bond market, high-grade bonds have continually outperformed high yield and lower-quality investment grade issues. Through May 7, the year-to-date total return of the broad investment-grade Bloomberg Barclays Municipal Bond Index was basically flat (-0.99%).  Over the same period, the ‘BBB’-rated segment of the index returned -7.64%, and the Bloomberg Barclays High Yield Municipal Bond Index posted a total return of -9.06%.

While some investors are clearly concerned about the outlook for lower-quality investments, we would argue that the difference in performance has created a lot of potential value in the high yield muni sector.  Although there could be additional volatility before the outlook changes, we think there are a number of reasons why this large performance differential could suggest some compelling future opportunities in the sector.   

1. The fear of increased defaults and ratings downgrades may already be reflected in prices.
Since the end of February, the extra yield demanded by investors in high yield municipals versus their investment-grade counterparts has risen from 200 basis points (bps) to 346 bps (see Figure 1). In our view, this rapid change has been the direct result of both the large outflows from municipal bond funds, especially high yield funds, and the costs for the liquidity which has been necessary to sell lower quality bonds in order for muni bond funds to have enough cash to cover investor withdrawals. The large liquidity costs have lowered prices so much–the average dollar price of the Bloomberg Barclays HY Municipal index was $64.25 (including zero coupon bonds) as of May 8–that they likely already more than reflect the potential downside impact from the weaker outlook for credit fundamentals.
 

Figure 1. High Yield Muni-Bond Spreads (ex-Puerto Rico) Recently Reached the Widest Level in Five Years
Data for the period June 1, 2015–April 30, 2020

Source: Bloomberg Barclays Indices. Data as of April 30, 2020; chart derived from the Bloomberg Barclays High Yield Index, excluding Puerto Rico-related bonds. Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

2. The impact of Covid-19 on the high yield municipal market likely will not be equal across all issuers.
While certain sectors such as senior living, student housing, and highly speculative project finance deals may face challenged fundamentals, the credit outlook for other parts of the market such as tobacco bonds or water/sewer bonds is largely unchanged, in our view. Despite this, all parts of the market have come under pressure during the recent sell-off. Strangely, some of the sectors with better outlooks have actually underperformed, despite unchanged credit fundamentals, because they contain larger, more liquid issues that are easier to sell.

While the sell-off in certain parts of the market may be warranted, a broad push for liquidity has resulted in limited differentiation among sectors and issuers (see Figure 2). We think this could be a tremendous opportunity for active managers who have the research and analytical capabilities to identify attractively valued securities from the diverse types of issuers within the high yield muni market.

Figure 2. Year-to-Date High Yield Muni Sector Returns May Signal Potential Misvaluations
Performance of subindices of the Bloomberg Barclays High Yield Municipal Bond Index for 2020 (through May 5)

Source: Bloomberg Barclays Indices. Data as of May 5, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

3. The high yield muni sector is diverse, and issuer revenues are less exposed to state and local government budgets than many people think.
The high yield municipal market is made up of 13 different sectors according to Bloomberg, but we would argue it’s significantly more diverse than that. As an example, the Industrial Development Bond sector includes corporate-backed municipals that range from publicly traded commodity-based companies to CMBS (commercial mortgage-backed securities) bonds secured by the World Trade Center with financial support from the Port Authority. High yield muni issuers have varied revenue sources and credit profiles, and generalizing all credit as the same can lead to unfavorable portfolio decisions. It’s also important to note that many high yield muni funds hold a substantial portion of investment grade securities, where historical default rates are close to 0%, based on Moody’s data.

While it’s likely that slightly more defaults will occur in 2020 than the extremely low number in recent years, we believe credit spreads already reflect expectations of elevated defaults--and investors may be overestimating that potential. At current spreads, according to our calculations, the high yield muni market is pricing in a default rate of around 10%.¹ We view this as highly unlikely. Historical default rates according to Moody’s have been much lower than what the market is pricing in, especially considering that Puerto Rico-related bonds represent the majority of the market value of municipal defaults over the last 10 years.

Figure 3. For 2020, Investors Appear to Have Priced In High Yield Muni Bond Defaults Far Above Historical Level
Average cumulative default rates, 1970-2018 (latest available)

Source: Moody's Investors Service. Data as of August 6, 2019 (based on the most recent edition of an annual study published by Moody’s).
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

4. The market has successfully navigated challenging environments before.
While there is still much uncertainty around how credits will manage the challenges of the current pandemic, the broad municipal bond market has made it through all past crises, and almost always staged strong subsequent recoveries, as shown in Figure 4.

Figure 4. Historically, the Municipal Bond Market Has Recovered after Periods of Selling Pressure
Data based on the Bloomberg Barclays High Yield Municipal Bond Index for the indicated periods

Source: Bloomberg Barclays Indices. Data as of May 5, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

5. New market participants are affecting the market’s liquidity, resulting in what we believe are unwarranted valuation dislocations.
Many of the issues in the high yield municipal market may have only a few holders at any given time.  Traditionally in challenging market environments, portfolio managers and traders take time to negotiate what both sides deem to be a fair price to complete a trade of a security. This process has come under pressure in the current environment where new products like high yield muni exchange traded funds force liquidations of infrequently traded bonds over short periods of time, with limited warning. These liquidations can result in “fire-sale” prices for some securities, in our view. These prices are not a reflection of true fundamental relative value, but simply the cost of immediate liquidity on a small issue at one point in time.  We think that over the long term, as the market stabilizes and liquidity pressures lessen, bonds will appreciate back to their appropriate valuations.

Summing Up
The high yield muni market faces challenges given the uncertain economic impact of the pandemic, but we expect that most of the issuers in the sector will make the necessary adjustments and manage through the current environment. To be sure, there likely will be additional volatility in the coming months, and there may be further selling and negative headlines. But for long-term investors, based upon how lower quality municipal bonds have performed historically—and how their credits look now—we believe high yield municipals present a compelling risk/reward profile.

¹Credit Spread = (1-recovery rate)*default rate.  The high yield spread over investment grade municipal bonds was recently 3.50% so we are using the Bloomberg Barclays Municipal Bond Index to represent investment-grade munis in order to factor in the muni market liquidity premium.