Impressed by High-Yield Muni Bonds

Includes: MLN, MUB, TFI
by: Russell Bailyn

2010 has been pretty volatile so far for most asset classes. Stocks and bond have traded all over the board and May was particularly ugly for global stocks and the corporate bond market. But one sector has held up really well: high-yield municipal bonds. I actually did a post on this a year ago and this space has been really interesting to follow since then. Prices for high-yield municipals fell off a cliff in late 2008 due to a liquidity crunch and heavy flight-to-quality trade. In May, during intense volatility, credit spreads on the benchmark high-yield corporate bond index widened by another 141 basis points to almost 7% above treasuries. However, the yield difference between investment-grade munis and high-yielding munis widened by only 2 bps to about 3.5%.

I think part of the reason this opportunity presents itself right now is because the fears in this space are constantly exaggerated. The default rate on investment-grade municipal bonds is under 1% and it’s been that way for a long time.* Default rates on higher yielding munis are higher than that, but still nowhere near the levels which are continuously priced in. A friend of mine and former bond trader once explained to me that if a municipality defaults on their debt, it becomes near-impossible for them to raise money again. For this reason, not only does an unusual amount of due diligence go into many of these issues, but they will do almost anything to pay their bondholders.

What’s also impressive is that high-yield municipal bonds tend to hold up better during periods of rising interest rates than other bond classes, making this space even more interesting over the next year or so. From 2004 to 2006, a period in which interest rates climbed regularly, the high yield municipal sector climbed by nearly 10% per year.

Will Municipal Defaults Rise?

First, despite the headlines, it’s interesting to note that investment-grade municipal bond defaults have not risen over the past year. However, with states desperately needing to both cut their budgets and increase tax revenues, it’s hard to imagine the rates of default not increasing over the next twelve months. My feeling is that because states are well within investment-grade bond range the real risk are the local municipalities that may struggle with raising revenues. As usual, investors will want to do their homework on the details of a bond issue before jumping in simply for yield. While a 6% tax-free coupon on a local housing community may look appealing, you’ll want to consider the fact that defaults on housing-related bonds has been considerably higher than other sectors during 2010.

In closing, it would be appear that lots of money has flowed into the short-term municipal bond space by people worried about rising interest rates. It also seems money has poured into the highest-grade municipal space by investors who have feared defaults and others disgusted by the lack of yield in the treasury market. The opportunities in the muni market right now seem to be both in the higher yielding, lower graded issues and on the long end of the curve.

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