Muni Matters: Demystifying Non-Rated Muni Bonds

Here’s a closer look at this $82 billion segment of the tax-free bond market—and how portfolio managers might find opportunities in the sector.

In Brief

• Non-rated municipal bonds are a long-established segment of the high-yield municipal bond market, but investors may not be familiar with them.
• In fact, non-rated bonds now account for over 50% of the Benchmark Bloomberg Barclays High Yield Municipal Bond Index.
• While sales tax-backed bonds account for 29% of non-rated bonds, the overall composition of the non-rated universe is quite diverse.
• We believe these bonds have the potential to offer attractive yields to investors such as active fund managers with expert credit research and security valuation capabilities.

One of the big differences between the high-yield corporate bond market and the high-yield municipal bond market is that the muni side has a large number of bonds that do not carry credit ratings from Standard & Poor’s, Moody’s, or Fitch. Because these “non-rated” bonds have been around for decades, many high-yield municipal bond portfolio managers and traders are very comfortable buying and trading them. Still, many clients putting money into high-yield municipal bond funds may be unfamiliar with non-rated bonds, or even unaware of their existence. We thought it would be useful to take a closer look at this category of muni securities.

Why do some muni bonds not carry ratings? Issuers might not pay for ratings because they believe their borrowing rates will not change enough to justify the cost of the rating. Also, the agencies may not issue ratings in certain smaller segments of the muni sector because they may perceive little value in developing the extensive methodologies and capabilities necessary to participate in these niche areas.

Non-Rated Bonds: A Big Slice of High-Yield Munis
A small number of non-rated bonds might be considered to have comparable credit quality to investment grade bonds, but for the most part they align with the below-investment grade category.  Within the high-yield municipal bond market, non-rated bonds currently have a large weighting, although the level has fluctuated considerably in the past 10 years. More recently, the balance has shifted toward unrated munis, as seen in Chart 1.

Chart 1. Non-Rated Municipal Bonds Now Account for More than Half of the Benchmark High-Yield Muni Index
Percentage of non-rated municipal bonds in the Bloomberg Barclays High Yield Municipal Index, 2016-2018 (as of June 30) and 2019 (as of September 30)

*As of September 30, 2019.
Source: Bloomberg. Data as of October 1, 2019.
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 and expenses, and are not available for investment.

As of October 1, 2019, the market value of the Bloomberg Barclays High Yield Municipal Bond Index (high- yield muni index) was $125 billion. The non-rated market value is $68 billion. Also, there are about $14 billion in market value of bonds outside the index, primarily from issuers that are too small to meet the minimum requirements for inclusion, bringing the total non-rated market size to $82 billion.

For context, the amount of outstanding municipal bonds is approximately $3.7 trillion, according to Federal Reserve data. Therefore, the vast majority of the municipal bond market is rated, and is of investment-grade credit quality. The average size of a non-rated municipal bond issue in the high-yield muni index is $105 million. For comparison, the average rated high-yield issue is $144 million, while the average deal size in the investment-grade Bloomberg Barclays Municipal Bond Index is $163 million. Clearly, non-rated issues are smaller, but we believe they are sizable enough to have liquidity in many cases.

Reasons for the Rise
The main reason the non-rated portion has increased so much this year is because Puerto Rico restructured the sales tax-backed bonds issued by the specially created COFINA corporation, creating new out-of-default bonds. These bonds were previously rated before they defaulted a couple of years ago, but the restructured bonds were issued as non-rated. This was a very big issue which now represents 10% of the market value of the high-yield muni index.

The other reason for the changes in the non-rated bond weighting over the past 10 years is the movement of bonds from other categories in and out of the high-yield muni index. For example, a category called “tobacco settlement” bonds was investment grade originally, but was downgraded after consumption of cigarettes kept falling, causing repayment of the bonds to slow. When these bonds were downgraded, they were rated, but they suddenly represented more than 20% of the market value of the high-yield index so they caused the non-rated weighting to adjust lower. Some tobacco bonds have been restructured into investment-grade bonds during the past couple of years, so their weighting has fallen. The same thing happened when Puerto Rico bonds got downgraded to below investment grade because they had a similar market value and also were rated. With Puerto Rico, the weighting changed again a couple of years ago when almost all their issuers defaulted and fell out of the index.

One strange thing that happened to the high-yield muni index around the time of the 2008 credit crisis was that many insured bonds which had been “AAA”-rated dropped into the index. This was a situation where they actually were investment-grade bonds but because they had been supported by bond insurance, they were able to previously get AAA ratings without paying for an underlying rating away from the insurance. When the bond insurance companies lost their ratings, these bonds became non-rated and moved into the high-yield index even though they should have been investment grade. At that time, these bonds represented over 20% of the index, but over time they were called or matured, so their presence in the current market is minimal.

All the changes we’ve listed here underscore the key point that the weighting of non-rated bonds in the high yield-muni index fluctuates over time.

Non-Rated Munis: A Diverse Sector
One other important feature of the non-rated space is its diversity. Away from Puerto Rico-related issues, the composition of non-rated bonds is quite varied: Based on Bloomberg data, the largest non-rated sector is sales tax-backed at 29% (which includes COFINA’s 10% share of the index), second is development districts (real estate-backed) at 9%, third is senior living at 8%, fourth is tobacco settlement at just under 8%, fifth is miscellaneous taxes (typically payments in lieu of taxes for economic development) at 4%, sixth is General Obligations at 3.5% and seventh is hospitals at 3%. There are many smaller sectors such as multi-family housing, toll roads, charter schools, higher education, and student housing.

The breakdown by state is less diverse, although all 50 U.S. states are included, even if some of the amounts are well under 1%. The largest are Puerto Rico at 20%, California at 13%, Florida at 11% and New York at 6%. Recently some states that are growing faster than others have seen increased issuance such as Colorado and Texas. When looking back 10 years ago, Puerto Rico had a very small weighting while California and Florida were even bigger as they were having a lot of real estate development. This is part of the development district sector where the municipal bond proceeds pay for the infrastructure such as streets and sewers to prepare for houses to be built and then investors are paid back from taxes paid as houses are built. This sector was hit hard during the 2008 credit crisis but has come back strongly since then.

Another interesting reason why the non-rated component has grown over the past 15 years is because the high-yield municipal bond fund category has been growing at a rapid pace; this has brought in a lot of capital to develop projects around the country. Many of these investments likely would not have been made through municipal bonds in the 1990s because there wasn’t as much demand and would have had to use higher cost funding through other sources of capital such as banks and private investors.

With the largest non-rated issuer, Puerto Rico COFINA, representing 10% on the high-yield muni index and the next largest issuer accounting for just being 1.4% (3 World Trade Center in New York City), it is clear that the non-rated portion of the index is well diversified other than its largest component. Table 1 makes this clear: 
 

Table 1. Largest Non-Rated Issuers in the High Yield Muni Index (ex-Puerto Rico) Are a Diverse Lot

Source: Bloomberg and Lord Abbett. Data as of October 10, 2019.
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 and expenses, and are not available for investment.

With a good number of outstanding high-yield non-rated bonds, the size of the market is also growing. Through the end of September, non-rated new bond issuance year-to-date is about $5 billion. This compares to non-rated issuance for all of 2018 of $4.2 billion. To put this in context, overall municipal bond market issuance thus far in 2019 has been $275 billion; non-rated high yield represents approximately 2% of the total. The non-rated sector gets outsized attention because on average it offers higher yields than the overall muni market and can provide some compelling investments, but it is still a small component.

Summing Up: Non-Rated, Updated
Non-rated municipal bonds represent a large portion of the high-yield municipal bond market. They have been around for a very long time, so experienced professionals are comfortable investing in them.  Being unrated doesn’t make these issues any worse in quality than other high-yield bonds, in our view. Indeed, there are a lot of large, well-known issuers, so the market for non-rated bonds is active.

So while non-rated bonds may not be well known on Main Street, they have long had a presence within the municipal bond market. Mutual funds that focus on high-yield municipal bonds typically will have sizable non-rated muni holdings because they often represent attractive, unique investment opportunities available in that sector of the market. These bonds have the potential to offer attractive yields to investors such as active fund managers who have the expertise to research their credit quality and evaluate whether the yield is enough compensation for the risk.