Municipal bond investors worried about the risk of default may be looking in the wrong direction.
Sure, investors were spooked by Meredith Whitney‘s prediction in December 2010 that the muni market would see hundreds of billions in losses. But now, they don’t see what is actually a much greater risk on the horizon, according to Priscilla Hancock, a J.P. Morgan Asset Management client portfolio manager and fixed income strategist with a specialty in municipal bonds.
While the vast majority of traditional, plain-vanilla muni bonds carry virtually no risk of default, the real danger lurking in muni bonds comes from low-quality, high-yield municipal bonds, Hancock said Wednesday in a phone interview.
Hancock, who served as head of strategy for Standard & Poor’s and global product development for Moody’s before joining JPAM, pointed to risky high-yield munis, especially highly illiquid, thinly traded private activity bonds.
“In the rare cases where traditional muni borrowers such as state and local governments do default, the recovery rate is very high,” Hancock said. “Those are not the same issuers that you find in the muni high-yield market, where 41% of the market is private activity bonds. The payor on those bonds includes corporate entities such as airlines or the flow of funds from a tobacco company.”
Within the private activity market, 55% are tobacco bonds. A Moody’s report published July 12 says declining rates of cigarette consumption in the U.S. pose a major credit risk to tobacco settlement bonds. As smokers quit their habit in ever greater numbers, tobacco settlement bonds are seeing a greater risk of default.
“Under our projection of an annual [drop in smoking] of 3% to 4%, bonds constituting 74% of the aggregate outstanding balance of all tobacco bonds we rate will default,” Moody's reports. “This finding is consistent with the bonds’ current ratings, 79% of which are B1 or lower.”
What does this mean for high-yield muni investors? Now is a good time to sell off.
“Maybe it’s time to book your profits, especially if you think taxes are going to go up next year,” Hancock said. “Illiquidity is a terrible risk, particularly today when we are at what may be the end of a bull-market cycle.”
High-yield munis are risky for these three reasons, according to Hancock:
- Concentrated credit risk. These bonds are nondiversified and generally dominated by risky sectors such as nursing homes, health care centers and “dirt bonds,” meaning speculative real estate projects.
- Illiquidity. Relative to the high-yield corporate debt market, which exceeds $1 trillion, the muni high-yield market is incredibly small, at only $65 billion, with an average issue size of $23 million. That means it has virtually no active secondary market and little opportunity to liquidate loss-making positions if an investor gets stuck with unsellable bonds.
- Duration. The average duration in high-yield munis is nearly 10 years, compared with just four years for corporate high-yield bonds. Duration has a direct correlation to interest rate sensitivity, so when rates start to rise, investors are setting themselves up for a painful reckoning.
Yet in their search for yield, investors have been pouring money into long-term muni bond mutual funds all year. Lipper data show that long-term fund flows have almost reached $14 billion, the most since 2007. During the same period in 2011, investors fearing plain-vanilla bond defaults were pulling their cash out of muni funds in droves.
Since the beginning of this year, the flows have been extremely disproportionate into high-yield municipal bonds versus the stock of money in high-yield funds. Currently, about 12% of assets under management in the muni space are in high-yield funds, but more than 30% of the flows in the second quarter went into muni high-yield funds.
“As investors see a lack of income in fixed income, they’re reaching, and they’re reaching farther out the curve, maturity-wise, taking on more duration risk, and farther down the credit curve,” Hancock said. “You have all this money chasing high yield. In fact, we’re seeing these high-yield funds having to buy slightly higher quality paper because it’s the only thing out there. There’s not a big enough supply of bonds, and there’s illiquidity because the deals are so small.”
A white paper published this week by Charles Schwab fixed-income strategist Kathy Jones says munis remain relatively attractive overall.
“Nominal muni yields are greater than yields on Treasuries of comparable maturities,” Jones wrote. “And we believe that bankruptcies of municipal governments will remain relatively infrequent events. Many municipalities are taking the steps needed to address strained budgets by cutting spending and raising revenues. In our view, the revenue picture for state and, to a lesser degree, local, governments is generally stabilizing.”
According to “The Untold Story of Municipal Bond Defaults,” a commentary posted Wednesday on the Federal Reserve Bank of New York’s website, S&P rated municipal bonds defaulted only 47 times from 1986 to 2011. Similarly, Moody’s indicates that its rated municipal bonds defaulted only 71 times from 1970 to 2011.
For investors, Hancock prefers corporate high yield over muni high yield.
“On a risk-adjusted basis, we think the corporate high-yield market is a better place to go today if you’re taking additional risk in your portfolio. Since 2008, high-yield corporate issuers have firmed up their balance sheets, reduced leverage and extended out maturities. They’re in a very good financial position, and that position is poised to do better if the economy starts getting better.”
She noted that JPAM manages the Tax Aware High Income Fund (JTISX), which offers exposure to higher-quality housing and health care bonds and taxable leveraged loans that are liquid in the secondary market and have shorter durations. In this period of market uncertainty, investors increasingly want large asset management firms to do their credit research for them, Hancock said.