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Fixed-Income Insights

Certain trends have helped bring improved liquidity, transparency, and investor breadth to the high-yield muni market.

In Brief

There has been an evolution in the market for high-yield municipal bonds since 2007, as evidenced by changes in the components of the Barclays High Yield Municipal Bond Index:

  • The market is now composed of many sizable issuers, when previously there were very few.
  • The market value of bonds in the high-yield municipal index has increased substantially.
  • More than half of the bonds in the high-yield municipal index were previously investment grade, but now have fallen to below investment grade.
  • The weighting of the high-yield municipal index in non-rated bonds has decreased materially.
  • The municipal high-yield market has become more liquid and has more daily volatility.
  • There is a wider range of bondholders.
  • The key takeaway—The high-yield municipal bond market has evolved since 2007 and is now a more active and sizable market for investors who want to take advantage of its relative value.

The high-yield municipal bond market had a rough 2013, with the representative Barclays High Yield Municipal Bond Index losing 5.5% for the year, based on data from Barclays; by comparison, the Barclays Municipal Bond Index (a broader market measure) lost only 2.6%. But since the end of third quarter 2013, the high-yield index has been rebounding. In fact, momentum has picked up in 2014, with a year-to-date return of 5.4% for the high-yield municipal index (through February 28), versus a gain of 3.1% for the broader index.

But this impressive rebound isn't the only reason the high-yield muni market has been in the spotlight of late. It turns out that the high-yield muni club has gained some large new members. Puerto Rico and related issuers were downgraded by the three major rating agencies during the first half of February 2014. As a result, many Puerto Rico issuers have moved from the investment-grade Barclays Municipal Bond Index to the Barclays High Yield Municipal Bond Index. Given how large some of these issuers are, bonds from Puerto Rico will now represent approximately 20% of the market value of the high-yield index, based on data from Barclays.

With this latest development, and many other significant changes in the Barclays High Yield Municipal Bond Index over the past few years, we thought it would be a good opportunity to review the high-yield market through the lens of this widely followed benchmark. Specifically, we'd like to illustrate six significant ways that the index, and by extension the market, has changed since 2007, just prior to the start of the financial crisis.

1) The market is now composed of many sizable issuers, when previously there were very few. There are now 13 obligors or issuers that have more than $1 billion in market value of bonds in the index, compared with just two in 2007, according to Barclays Point. The issuers are certainly more diversified, since the only two in that category in 2007 were American Airlines and Continental Airlines (muni bonds are issued for airlines for purposes such as construction of airport facilities). In addition to the Puerto Rico bonds cited above, the list now includes airlines, tobacco-settlement bonds, Jefferson County (Alabama) sewer bonds, and tax-exempt bonds of the Iowa Fertilizer Co. The top 10 issuers have $28.1 billion in par value outstanding, as of February 28, 2014, compared with $9.4 billion for the top 10 at the end of 2007, according to Barclays Point.

2) The market value of bonds in the high-yield municipal index has increased substantially. The market value of the holdings in the entire high-yield municipal index was $81.9 billion, as of February 28, 2014, compared with $41.6 billion at the end of 2007, according to Barclays Point. The majority of the increase has been due to credit rating downgrades of large issuers (see number 3), but there also have been a good number of sizable new issues.

3) More than half of the bonds in the high-yield municipal index were previously investment grade, but now have fallen to below investment grade. Many of these issues have been actively traded for a number of years and are not new to the overall market. After 2007, the first large set of bonds downgraded was due to weak bond insurers losing their investment-grade ratings; some of the insured bonds did not have underlying ratings of their own. These downgrades were not due to the bonds being below investment grade in most cases but simply that they had only paid for the insured rating and not a rating for the underlying credit. When the bonds were first downgraded, they represented about 20% of the index; but since then, the percentage has fallen to approximately 10%, based on Barclay's data.

Other key developments in this regard include the June 2012 downgrade by Moody's of bonds issued by California Redevelopment Agencies as the state changed the structure of financing for these areas. This had a minor impact on the overall market value of the high-yield municipal index, but the Moody's move still added a whole new group of issuers to the index. Also, tobacco-settlement bonds were downgraded in the fourth quarter of 2011, as the ultimate driver of their underlying revenues, cigarette consumption, continued to fall well below projections. This is a large sector and represented more than 20% of the index after the bonds were downgraded, according to Barclay's data. Finally, the February 2014 Puerto Rico downgrade shifted many bonds associated with the commonwealth into the high-yield muni index.

Each change diluted the impact of the previous large changes, but taken together, they have changed dramatically not only the benchmark but also the market’s awareness of the issuers in the high-yield market. Fourteen of the top 15 issuers currently in the index were not in the index in 2007, with Continental Airlines (now called United Airlines) as the only holdover, according to Barclays Point.

4) The weighting of the high-yield municipal index in non-rated bonds has decreased materially. At the end of 2007, 55% of the holdings were not rated by credit rating agencies, while the index is now comprised of 33% non-rated bonds, according to Barclays Point. This is significant because a much larger portion of the high-yield market's credit quality is now tracked by the credit ratings agencies, meaning that much more credit information is available to potential or existing investors in these issuers.

5) The municipal high-yield market has become more liquid and has more daily volatility. With the increased number of large issuers, many dealers make markets each day in their bonds. This means they provide a bid to buy bonds, or an offer to sell bonds, or both. By doing this, bond prices are marked to market more frequently and trading activity increases because dealers are looking to take positions in these bonds. This means that it can be easier to buy or sell, but it also means that there can be more steady pricing volatility because bonds can trade each day rather than a few times a year.

With more active markets, more market participants are following the credit news, so any change in projected credit quality can have an immediate impact upon valuations.

6) There is a wider range of bondholders. In 2007, when bond issues were smaller and many were non-rated offerings that only a small number of market participants followed, many issues only had a small number of bondholders. Today, with all the large issuers in the market and the increased availability of credit information, there are many more buyers. One reason for this was the launch of the Build America Bond (BAB) program in 2009 in response to the financial crisis of 2008–09. This program created a whole new type of municipal bonds that were taxable, and the volume of issuance was large during the two years it existed. This opportunity led many new buyers who typically focused on other asset classes to increase their expertise in analyzing municipal bond issues. These "crossover" buyers have continued to participate in the muni market, including the high-yield segment, even though the BAB program expired in 2011.

With all these factors, today's high-yield municipal bonds are held not only by traditional mutual fund and insurance companies but also by other vehicles, such as taxable total return funds and hedge funds. They have become active buyers, especially during periods of municipal bond fund outflows, like the one witnessed in 2013, and are stepping up to replace retail investors who chose to reduce their exposure to munis.

Summing Up
What should investors take away from all these changes? One at least would be that the high-yield muni market is now characterized by greater liquidity, larger issuers, and more credit rating information, and another that there is broader participation compared with that in 2007. Reviewing the changes within a wider context may lead an investor to conclude that this portion of the municipal bond market presents a more interesting and compelling opportunity for investors than it did in the past.

 

 

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