Any Gas Left in the High-Yield Municipal Tank?

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  • A favorable credit environment and technical factors have contributed to strong high-yield municipal performance.
  • We see limited room for further appreciation with yields near historical lows, tighter credit spreads and a municipal curve as flat as it was pre-financial crisis.
  • Weaker relative value and the late stages of economic expansion argue for conservative high-yield muni positioning.

The average gross return for open-ended high-yield municipal bond funds was 5.15% in 2015 and 2.31% in Q1 2016. Some of this strong performance can be explained by a favorable credit environment. After peaking in 2010, defaults in the municipal market have declined in every year since. When you combine a favorable fundamental backdrop with strong investor demand and limited new issue supply, it is easy to see why high-yield municipals have done so well.

Strong flows have brought total high-yield muni fund net assets to an all-time high and the longest streak of positive inflows since 2012.1The limited number of high-yield deals that price every week are routinely oversubscribed and repriced to lower yields. These dynamics have resulted in tighter credit spreads and a flatter yield curve as the search for yield takes investors down in credit quality and longer in maturity.

Exhibit 1: High-yield muni mutual funds reach all-time AUM high
Exhibit 1_High-yield muni mutual funds reach all-time AUM high
Source: Morgan Stanley Research, EPFR, April 11, 2016

Investors are rewarded less for high-yield credit risk
Credit spreads have tightened to where they were just before the credit crisis in 2008. The spread reported below is likely skewed higher due to Chicago and Illinois — more recent deals in most sectors reflect even tighter conditions than what the chart suggests. Generally speaking, the overwhelming majority of BBB credits are approaching the narrow end of the 25-year historical spread range.

Exhibit 2: Credit spreads have tightened to pre-financial crisis levels
Exhibit 2_Credit spreads have tightened to pre-2008 crisis levels_rev
Source: Barclays Risk Analytics and Index Solutions, April 5, 2016

Using high-yield for longer maturity has become less attractive
High-yield bonds are typically issued at the long end of the maturity spectrum. The spread between the 1-year and 30-year AAA municipal bond has narrowed dramatically since 2013 (Exhibit 3). The municipal yield curve is now as flat as it has been since the 2008 crisis. Somewhat tepid economic conditions and the lack of any signs of inflation may not necessarily cause the curve to steepen anytime soon, but the value of going long to pick up incremental spread has lessened.

Exhibit 3: Spreads between 1-yr and 30-yr AAA munis have narrowed dramatically since 2013
Exhibit 3_Spreads between 1-yr and 30-yr AAA munis have narrowed dramatically since 2013
Source: Columbia Management Investment Advisers, LLC, Thomson Reuters, April 8, 2016

The tax-equivalent yield advantage of munis is diminished
A year ago, municipal high yields were equivalent, if not higher, than taxable high yields on an absolute basis. Since then, however, the markets have since disconnected, with energy wreaking havoc on the taxable high-yield market and shifting value toward taxable high yield. As such, municipal high yield is no longer flashing the strong buy signal relative to taxable alternatives (Exhibit 4).

Exhibit 4: Yields on high-yield munis have tightened considerably vs. high-yield corporates
Exhibit 4_Yields on high-yield munis have tightened considerably vs. high-yield corporates_rev
Source: Barclays Risk Analytics and Index Solutions, April 5, 2016

Time for a more conservative high-yield muni strategy
Entering the seventh year of recovery from the great financial crisis, we think it may be time to consider a more conservative exposure to high-yield municipals. An improving economy tends to be good for high-yield credits as underlying revenues and fundamentals of much more economically sensitive projects improve. However, the opposite is also true. As the economy slows or enters a recession, economically sensitive municipal bonds such as toll roads, housing-related sectors and other project finances can come under pressure and cause credit spreads to widen.

We still believe high-yield municipals are an attractive diversifier that can add yield in today’s low-rate environment. While the next recession or major disruption in interest rate markets may not be imminent, several indicators lead us to believe that we are in the later stages of the current cycle. How long this stage lasts is up for debate, but it is probably time to consider dialing back the risk. A more conservative high-yield muni strategy (less interest rate exposure or leverage, ample liquidity and the flexibility to adjust the portfolio’s credit quality) may be a better choice when it is unclear how close we are to running on empty.

1 Morgan Stanley Research, April 11, 2016

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