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October 19, 2012 at 10:29 AM
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.
