High Yield Munis: Risky Business

Jobs Report Boosts Equities, Sinks Bonds

Equity markets started the third quarter in positive fashion, fueled by better than expected economic data. The S&P 500 rose 1.6% while the Dow Jones Industrial Average climbed 1.5%. The yield on the 10-year Treasury backed up sharply during the week, rising more than 20 bps to 2.73%. That is the highest level in almost two years.

The week’s headline report was the Labor Department’s nonfarm payroll and unemployment surveys. Nonfarm payrolls came in 25,000 ahead of economists’ estimates, rising 195,000 during the month of June. Moreover, April and May were revised upward by a combined 70,000 jobs. This led to broad gains in the S&P on Friday, with the index rising more than 100 bps.

Gains were concentrated within the leisure & hospitality, professional & business services, and retail trade sectors. More specifically, food & drinking places experienced a gain of 52,000 jobs, while temporary help services expanded by 10,000. Goods producing sectors such as construction and manufacturing saw limited gains. These results continue to bring into question the quality of the jobs that are being added to the US economy.

One positive development from the establishment survey was the increase in average hourly earning for all employees from $23.91 to $24.01. The 10 cent gain was the largest one month increase since November 2008. Average weekly hours were unchanged at 34.5 hours. Improvement in hours and earnings are preliminary indicators of labor demand that often foreshadow additional job growth.

In the household survey, the headline unemployment rate remained unchanged at 7.6%. The labor force participation rate – which has been the root of some recent changes in the unemployment rate – was essentially unchanged in June, ticking up by 0.1%. The labor force increased by 177,000 during the month, while 160,000 new persons reported themselves as employed.

A concerning development in the unemployment data was the sharp increase in the U-6 rate, or underemployment. This additional measure includes persons marginally attached to the labor force and those working part-time for economic reasons (but who prefer to be full-time). After a long downtrend, that metric jumped by half a percentage point to 14.3%. While one month does not make a trend, the figure removes some of the luster from an otherwise very strong government jobs report.

A few other important indicators were released last week, including twin reports from the Institute of Supply Management (ISM).

On Monday, ISM reported that its manufacturing index improved more than expected. After falling into contractionary territory in May, the diffusion index jumped 1.9 points to 50.9. Gains were broad-based within the index, as seven of the 10 components improved. Encouragingly, new orders and production experienced some of the biggest gains, increasing 3.1 and 4.8 points, respectively. The trend in new orders often portends the direction of the overall index in future months.

The less heralded but just as important ISM non-manufacturing index declined by 1.5 points in June, although it remained in expansionary territory for the 42nd consecutive month. The measure of service sector activity experienced mixed results, with half of its component indices slowing during the month. Unfortunately, the two most important components saw the biggest decreases. Business activity and new orders declined by 4.8 and 5.1 points, respectively, and now stand just above the expansion/contraction demarcation line. Both of those indicators have expanded for 47 consecutive months.

The other significant economic report from last week was US trade data for May. The Census Bureau reported that the US trade deficit widened by $5 billion during the month, as exports slipped by $0.5 billion and imports increased $4.4 billion from the prior month. The data will likely lead to reductions in economist estimates of second quarter GDP.

Some may find May’s trade data more encouraging than at first glance, however, as the rise in imports was not concentrated in petroleum goods. This indicates stronger domestic demand from US companies.

High Yield Munis: Risky Business

We shine a spotlight on the obscure market of high yield municipals this week. In the current fixed income selloff, the market has been among the worst performing with a drawdown of 6.1%. Investors could not get enough of the sector in 2012 as they chased yield; the Barclays high yield muni index returned over 18%. Investor sentiment has turned sharply, however, on this asset class. Funds experienced significant outflows over the last couple of months, which is especially troubling for a small and retail dominated market. Why did this onetime darling asset turn into a pariah so abruptly?

A quick review of the virtues (and vices) of the sector would be helpful in answering that question. For taxable investors, this sector offers a compelling way to generate yield in a market that is currently bereft of it. The Barclays high yield muni index yields 6.1%, which is over three times the 1.9% offered by the Barclays 1-12 year blend index (a proxy for investment grade intermediate munis). For another comparison, the taxable equivalent yield of high yield munis, assuming the top tax bracket of 39.6% along with the 3.8% ACA surcharge, is 10.7%. The Barclays high yield corporates index offers a less compelling 6.6%.

In contrast to the dynamic in corporate bonds, high yield munis tend to have significantly longer durations than their intermediate investment grade peers. The average duration of the index stands at 10.5 years, which magnifies price swings as yields change. From a fundamental vantage point, the 10-year probability of default for high yield munis, as calculated by Moodys, is around 8%. This is significantly more than the 0.1% predicted for investment grade munis, but less than the 34% probability of default for a high yield corporate bond.

Unlike in the corporate space, investors in high yield munis are generally investing in fundamentally different industries and sectors relative to their investment grade counterparts. The highest rated munis are state GOs, large localities GOs, and essential services. These large issuers are well known and come to market frequently so their fundamental standing is relatively transparent. Investors in high yield munis are lending money to charter schools, land development projects, retirement communities, casinos, etc. Many of these issuances are small and nonrated – the small size of borrowing makes it uneconomical for the issuer to pay for a rating agency assessment. These bonds will trade infrequently after issuance and managers are dependent on pricing services to evaluate performance.

As a result, the high yield muni market is small and retail dominated. Per Morningstar, there are 37 high yield muni funds with $67 billion of AUM (these funds also allocate to IG munis), which alone consume the approximately $63 billion in high yield muni markets. Making matters worse, assets are extremely concentrated in a handful of big funds. A problem arises when these large funds are hit with redemptions, which is what occurred in May and June when the average fund experienced outflows between 5%-9% of AUM. With a limited audience to step in and provide liquidity for these obscure securities, drawdowns for the category were in the 6%-8% range over this timeframe.

Over the long run, investors are taking on substantially more risk to generate higher returns in the sector. The 10-year volatility of the index is more than double that of intermediate investment grade munis, as represented by the Barclays 1-10 year blend index. Higher annualized returns for high yield munis of 6.2% versus 3.8% for intermediate investment grade munis seemingly compensates investors for this added risk, as Sharpe ratios were roughly equivalent. However, high yield munis have significantly more tail risk; the maximum drawdown experienced over the 10-year timeframe of (30.4%) was more than ten times that of the Barclays 1-10 year blend index (2.6%).

In summary, high yield munis can offer very attractive tax adjusted returns, but are best suited for risk tolerant investors. The challenging liquidity and long duration of the market make for a bumpy ride.

The Week Ahead

This week is light on economic data, but look for Wednesday’s release of FOMC meeting minutes to dominate the financial media dialogue. Additionally, NFIB’s Small Business Optimism index and producer price inflation are on tap.

In Europe, two major meetings of EU leaders occur, with the Eurogroup meeting on Monday and the ECOFIN meeting on Tuesday. Topics likely include the recent stress in Portugal as well as continued discussion of a banking union.

On Monday, corporate earnings season officially kicks off with second quarter results released by Alcoa. Other major companies reporting include Wells Fargo and J.P. Morgan.

On the central bank front, Russia, Brazil, Thailand, Serbia, Japan, Indonesia, and Mexico meet this week. Brazil is expected to raise rates by 50 bps. The Bank of Japan is not expected to enact further monetary accommodation at this time.

© Fortigent


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