High-yield munis: The defense takes the field
- Jittery investors run for the muni market exits on rate hike fears.
- As we discussed in December 2012, a bond market reversal was inevitable.
- We believe the current environment may be creating opportunities.
Michael J. Walls
The investor flight out of fixed income securities that occurred both before and after the June Federal Reserve (Fed) meeting had a significant impact on the municipal bond market. Fueled by what we saw as a misguided fear of a Fed rate hike and a muddled message from Fed officials, including Fed Chairman Ben Bernanke, the municipal bond sector saw abysmal outflows due to some forced selling amid a significant flight by retail investors.
We are very confident that the municipal bond market remains fundamentally sound and, we believe, high-yield munis continue to offer value, especially for investors seeking the benefits of tax-free income.
Responding to panic
Over the four weeks ending June 19, municipal bond mutual funds had net outflows of more than $9 billion, according to Investment Company Institute (ICI) data, with more than one-third of that total occurring the week ending June 19. Although outflows across the fixed income market challenged fund managers, the municipal bond market – and especially the high-yield municipal bond market – can become highly illiquid, which means that a wave of forced selling has the potential to have an enormous impact on prices.
We wrote in a December 2012 Portfolio Perspective (High Yield Munis: Is the best offense a strong defense?) that we believed the bond market had entered bubble territory and that while the market could remain at or near its then-current levels, a reversal was inevitable. As a result, we had moved the Fund into a more defensive stance, purchasing higher coupon bonds priced to shorter call dates. This move was in line with our overall strategy about the amount of risk we are comfortable with and the importance of credit selection in a high-yield municipal bond fund.
To implement a more barbell-style approach, we were purchasing tax-exempt floating rate securities at a time when there was not significant market demand. That environment, however, has changed dramatically in recent weeks as the liquidity of these securities has become increasingly valuable to the market. As a result, we were able to sell these securities at more attractive prices to meet our liquidity needs while also maintaining our core portfolio structure.
The Fund does not hold large amounts of what we view to be especially volatile credits, particularly those related to prepaid gas and tobacco. Relative to the Fund’s index, we have also been underweight in categories such as industrial development revenue bonds, which have performed well, but which we believe posed an unacceptably high risk. Finally, we believe the Fund has benefitted from a lack of leverage.
The Fund’s core portfolio strategy remains unchanged. We are currently looking to take advantage of valuation opportunities that the current environment has created in fixed rate bonds with lower prices and higher-yielding credits. We believe the market is now extremely oversold and, as a result, we have turned very bullish on the space.
As we have previously said, our focus is on positioning the Fund for the longer run and recent events have only further supported our view. The interest rate picture has become increasingly clouded by the public comments of Fed officials. Although we do not believe a rate increase is imminent, the June market turmoil was clear evidence that the market has a heightened sensitivity to the risks that are posed by a rising-rate environment.
Although the recent focus has been on interest rates, it is important to note that market fundamentals remain strong. Although we have seen another round of high-profile municipal budget struggles – as is unfolding in Detroit – the issues continue to be isolated, based on local management problems and well-known in advance within the municipal bond market. Certainly, the problems in Detroit have been well documented for decades. Fears of a wave of municipal defaults remain unwarranted, with first-quarter state and local tax revenues increasing 6.8% from the previous year, according to Census Bureau data. The increase marks the 14th consecutive quarter of positive year-over-year tax revenue growth.
Regarding the muni market, by late June there were signs that investors were regaining their appetite for tax-free debt, particularly higher-yielding debt. The state of Illinois, which has the lowest credit rating of the 50 states, had $9 billion in bids for $1.3 billion in state general obligation bonds, according to Bloomberg.
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