Municipal bonds tied to the tobacco settlement have been smoking lately, returning over 19% so far this year, but that doesn’t mean investors should inhale. Indeed, all the smoke may be beginning to suppress investor appetite for the high-yield segment of the muni market, which in the aggregate has notched a 15% year-to-date return.
“This is a yield-driven marketplace. Investors are looking for yield. When you have a supply and demand imbalance, you see demand driving prices,” says J.R. Rieger, S&P Dow Jones Indices’ vice president of Fixed Income Indices, in an interview with AdvisorOne.
While Rieger does not make investment recommendations, the analysis he offers paints a picture of yield-hungry investors driving the value out of high-yield munis.
“The question investors should ask is: ‘Am I getting compensated for the risk?’ The yields have compressed to historic lows. That compression tells us that we may be bouncing off the low end of the yield,” he says.
“If investors are worried about higher-yield bonds weakening, credit spreads widening and interest rates eventually rising, they should be looking to shorten their duration,” Rieger says.
“Tobacco bonds are long-duration, higher-yielding bonds, they’re definitely risky,” he says, adding the clarification that the sector itself is risky, though individual bond offerings may be worth the risk. “I’d leave that [individual bond selection] to the professionals.”
Like tobacco bonds, other high-yield sector munis have also performed well this year. Land-backed and health care muni bonds have returned just short of 11% and 10%, respectively. But all of these, for the same reasons as tobacco bonds, are likely areas of declining opportunity.
“A majority of defaults come from that kind of single-revenue sourced project,” Rieger says. “Really to understand how you’re going to get paid, the individual investor has to understand the credit. That should be left to institutional investors.”
Where yield-hungry investors should be looking is the investment-grade muni sector, particularly at state munis, the S&P analyst says. The majority of state revenue comes from income taxes and corporate taxes, and Rieger says the U.S. Census Bureau has confirmed at the end of September that those revenues are rising.
Take the much-maligned, budget-constrained state of California, for example. California munis have returned nearly 8% year to date. The current weighted-average yield on all quality California municipal securities, including distressed bonds, is currently 3.33%, Rieger says.
While that may the lack the excitement of the high-yield sector, Rieger calculates that the tax-equivalent yield for an investor with a 35% marginal tax rate would be 5.12%. Investors looking for an investment grade bond with that kind of yield and relatively low-risk profile would be looking at U.S. corporate bonds in vain, Riger says.
“You can’t find that bond,” he says. “Everyone’s looking for yield today. Prices have come down.”
In general, the S&P bond analyst says states are good credit risks, in part because they are constrained by “handcuffs,” as it were, to impose fiscal discipline.
“You’ve got to be able to run the business of the state. You need to lever taxes and attract businesses.”
And despite a spike in credit defaults for California municipalities in 2012, municipal bonds are generally safe, with a minuscule 0.58% default on the par value of bonds in a market worth $1.4 trillion, Rieger says. “Compared to corporate, that is quite low,” he adds.
And despite warnings of future municipal bancruptcies from analysts like Meredith Whitney, Rieger says the evidence suggests cities, like states, are being forced to get their acts together.
“We can see how municipalties are managing. They’re reducing the numbers of teachers, renegotiating pension obligations. The vast majority are managing their budgets. Services are being reduced and the classrooms are getting larger. It has to happen,” he says.
The S&P analyst also points to Census Bureau-confirmed rising levels of tax collection (back up to 2008 levels) and a bottoming out of defaults on first and second mortgages. Also, rising real estate prices will drive future assessment revenue.
While Riesling sees greater value in general obligation bonds, which have the full faith and credit backing of the state versus riskier, single-sourced but higher-yielding revenue bonds like tobacco and health care bonds, he did make a useful distinction.
Some revenue bonds, such as water and sewer and electrical power bonds, are for essential services and thus safer and more stable than specific projects like multifamily housing that might more readily lose rental revenue.
“Very few have incidents of distress because they are for an essential purpose, so they therefore have a lower default-risk profile,” he says.