Download The Case for Investing in High Yield Municipal

The Case for Investing in High Yield Municipal Bonds
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April 2017
Ryan M. Schultz
High yield municipal bonds have historically offered investors significantly less default risk for like-rated
issuers relative to corporate high yield bonds. Less default risk is accompanied by a yield advantage, when
evaluating yields on an after-tax basis.
The asset class offers investors added benefits from diversification due to the composition of the issuing
entities in the market place being different from the investment-grade municipal universe.
Historical risk-adjusted returns for the asset class are comparable to those of high yield corporate bonds
before accounting for tax efficiency, and even more compelling when including the tax benefit.
Active management gives investors more opportunity for outperformance in the space due to the highly
fragmented nature of the asset class, making indexing the space more difficult.
For taxable clients, investment-grade municipal bonds (munis) have long been a key allocation in portfolios as the
asset class offers investors capital preservation, investment income that is tax-exempt from federal taxes, and
limited credit risk. Given these attractive traits, the investment-grade municipal space has been much of the focus
for investors looking for an “anchor” in their taxable fixed income portfolio. These bonds are often secured by
property taxes (such as general obligation, or “GO”) or high quality revenue streams (such as public utilities and
transportation), and give investors exposure to historically very small levels of default risk.
To diversify outside of investment-grade munis, investors often utilize parts of the taxable market for
diversification benefits. However, by seeking diversification in corporate bond markets, investors forego the tax
advantages that make the muni market so attractive for tax-focused investors. The high yield muni market offers
diversification and potential for yield enhancement while also maintaining the tax advantages of investment-grade
munis. Despite more credit risk than the investment-grade universe, high yield munis exhibit credit risk that is
comparable to some segments of the investment grade corporate bond market. In fact, default rates for BB-rated
municipals have been similar to those of BBB-rated corporates:
Historical Default Rates (%)
Aaa / AAA
Aa / AA
A/A
Baa / BBB
Ba / BB
B/B
Caa-C / CCC-C
Investment Grade
Non-Investment Grade
1
2
3
Moody's
Municipal1
Corporate1
0.00
0.40
0.02
0.81
0.07
2.31
0.38
4.03
4.24
16.45
17.88
39.28
26.03
48.03
0.09
2.45
8.18
29.42
Standard & Poor’s
Municipal2
Corporate3
0.00
0.86
0.03
1.09
0.11
1.95
0.45
4.64
4.73
15.27
11.77
27.46
38.49
55.84
0.15
2.72
8.96
24.17
Moody’s Investor Services – U.S. Municipal Bond Defaults and Recoveries, 1970-2015
S&P – US Public Finance Cumulative Average Obligor Default Rates, 1986-2015 (10-year average cumulative default rates)
S&P – US Corporate Average Cumulative Default Rates, 1981-2015 (10-year average cumulative default rates)
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
1
Moving down the ratings spectrum, high yield municipals carry approximately 25-70% of the default risk of likerated corporate securities.
In addition to the credit risk advantage maintained by lower-rated municipals over like-rated corporates, high yield
municipals have generated higher yields than their corporate counterparts at various times. In fact, when
evaluating yields on an after-tax basis, assuming a 39.6% marginal tax rate, high yield municipal securities
maintain a comparable yield advantage over corporate securities.
Yield-to-Worst Comparison
25%
20%
15%
10%
5%
Jan-96
Aug-96
Mar-97
Oct-97
May-98
Dec-98
Jul-99
Feb-00
Sep-00
Apr-01
Nov-01
Jun-02
Jan-03
Aug-03
Mar-04
Oct-04
May-05
Dec-05
Jul-06
Feb-07
Sep-07
Apr-08
Nov-08
Jun-09
Jan-10
Aug-10
Mar-11
Oct-11
May-12
Dec-12
Jul-13
Feb-14
Sep-14
Apr-15
Nov-15
Jun-16
Jan-17
0%
Source: Barclays
Data as of: 3/31/2017
BBgBarc US Corporate High Yield
BBgBarc HY Muni
After-Tax BBgBarc HY Muni
In addition to less credit risk exhibited by high yield munis relative to high yield corporates, diversification benefits
also exist. The long-term correlation of high yield munis to the investment-grade muni universe is approximately
41%, which we view as an attractive diversifier over time for taxable investors to consider. Despite diversification
benefits not being quite as attractive as the 17% historical correlation between investment grade municipals and
corporate high yield, the addition of high yield munis to investment grade munis remains compelling in our view.
Correlations (11/1995 - 12/2016)
Benchmark
1 BBgBarc US Agg Bond
2 BBgBarc US Corporate High Yield
3 BBgBarc Municipal 5 year
4 BBgBarc HY Muni
1
1.00
0.18
0.75
0.30
2
3
4
1.00
0.17
0.44
1.00
0.41
1.00
Source: Morningstar
Qualitatively, the diversification benefits offered by high yield municipals can be examined when evaluating the
constituents of the market relative to the investment grade muni universe. Within the investment grade muni
universe, general obligations (GO) (27%) and transportation bonds (16%) account for a considerable portion of
the opportunity set. However, GOs and transportation bonds only account for 5% and 2% of the high yield
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
2
universe, respectively. Instead of GOs and transportation bonds, the high yield universe is made up mostly of
revenue-based bonds, specifically in industrial development revenue/pollution control revenue (IDR/PCR),
hospital, and special tax sectors which account for 39%, 21% and 17% of the universe, respectively. The
underlying revenues securing high yield municipal bonds are often insulated from broader GO credit risk and
these revenues cannot be appropriated for any other means outside of supporting these entities. This differs from
a high yield corporate bond, which is simply secured by the cash flows of the issuing company. For example, a
high yield special district, such as a water & sewer district, could issue a bond that is secured by the revenues
generated from constituents of the municipalities utilizing the service. The cash flow stream generated by the
district cannot be used to support other parts of the municipality and therefore theoretically reduces investor’s
exposure to default risk.
High Yield Muni Sectors
Investment Grade Muni Sectors
GO
GO
Electric
0.2%
8.2%
9.6%
27.1%
Hospital
IDR/PCR
1.0%
Transportation
4.5%
Education
8.5%
5.3%
6.7%
Electric
0.3%
Housing
6.4%
8.5%
2.6%
1.3%
17.4%
Housing
20.5%
7.7%
2.6%
Water & Sewer
Leasing
Special Tax
15.5%
Source: Barclays
Data as of: 12/31/2016
4.6%
Hospital
0.1%
Resource Recovery
PreRefunded
Insured
IDR/PCR
Transportation
Education
2.3%
39.2%
Water & Sewer
Leasing
Special Tax
The high yield municipal bond market is concentrated in several sub-sectors and issuers that have generated
negative headlines in recent years. As of December 31, 2016, Puerto Rico accounted for approximately 12% of
the high yield municipal market. Puerto Rico has experienced bouts of financial turmoil for much of the 21st
century as a fallout has occurred from its heavy borrowing and tax policies that were designed to attract larger
corporations through tax-based incentives. Much of Puerto Rico’s obligations do not actively trade as speculation
regarding congressional support dominates investment theses for holding the bonds. Another headline grabbing
entity is the city of Chicago, particularly Chicago Public Schools (CPS). Chicago has different challenges, which
include underfunded pensions, but similar to Puerto Rico in that these holdings are often speculative and are not
often traded. Outside of those two headline grabbers, much of the high yield market remains more resistant to
default than the corporate credit market for like-rated issuers.
The structure between the high yield muni and investment grade muni asset classes also differs in relation to the
maturity profile. Investment grade muni bonds are issued with varying maturities from short-term (1-3 year)
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
3
financing to long-term (greater than 20 years) with a fair amount of consistency across all maturities. Conversely,
high muni yield bonds are often issued with longer maturities and approximately 48% of the market currently has
maturities of greater than 22 years.
Maturity Distribution
60%
49%
40%
20%
23%
17%
11%
1%
13%
3%
12%
3%
9%
4%
24%
14%
16%
0%
0%
0%
1 Year (1-2)
Source: Barclays
Data as of: 12/31/16
3 Year (2-4)
5 Year (4-6)
7 Year (6-8)
10 Year (812)
BBgBarc 1-15 Yr Muni
15 Year (17- 20 Year (1722)
22)
BBgBarc HY Muni
Long Bond
22+
Duration Comparison
12
10
8
6
4
2
0
Feb-97
Sep-97
Apr-98
Nov-98
Jun-99
Jan-00
Aug-00
Mar-01
Oct-01
May-02
Dec-02
Jul-03
Feb-04
Sep-04
Apr-05
Nov-05
Jun-06
Jan-07
Aug-07
Mar-08
Oct-08
May-09
Dec-09
Jul-10
Feb-11
Sep-11
Apr-12
Nov-12
Jun-13
Jan-14
Aug-14
Mar-15
Oct-15
May-16
Dec-16
Modified Duration (Years)
Accompanying this longer maturity profile of the high yield market is a longer duration profile. The Barclays High
Yield Municipal benchmark has a duration of 10.5 years as of 12/31/16, which is 6.0 years longer than the
Barclays U.S. Corporate High Yield benchmark. Historically this relationship has held as well. As such, high yield
municipal bonds are much more sensitive to changes in interest rates relative to their corporate bond
counterparts.
Source: Barrclays
Data as of: 12/31/16
BBgBarc HY Muni
BBgBarc US Agg Bond
BBgBarc US Corporate High Yield
BBgBarc Muni 1-15 Yr
High yield municipal bonds have historically offered investors more return accompanied by increased risk relative
to investment grade municipals. While the risk and reward profile certainly lags that of corporate high yield
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
4
securities, the tax-advantaged characteristics of the returns compensate investors for the give up in absolute yield
compared to corporates. For example, the chart below compares trailing returns of high yield municipals relative
to high yield corporates:
Annualized Returns (%) as of 12/31/2016
Index
1-Year
BBgBarc US Corporate High Yield
17.13
BBgBarc HY Muni
2.99
3-Year
4.66
6.08
5-Year
7.36
5.91
10-Year
7.45
4.04
15-Year
8.35
5.65
S.I.
7.29
5.53
Source: Morningstar
Barclays HY Muni Inception: October 1995
Corporate high yield bonds have outperformed high yield municipals by a significant margin over each trailing
period, especially in 2016, when high yield bonds rallied over 17% on the heels of a rebound in the energy,
materials and industrials sectors. To add to the differential, high yield municipal bonds experienced the worst
negative month since the financial crisis in November 2016, following President Trump’s surprise election victory.
Despite these results, these figures are presented on a pre-tax basis. From an after-tax point of view, high yield
municipals become much more attractive to a taxable investor. Assuming an investor pays taxes in the highest
marginal bracket of 39.6%, the long term after tax return would be: 5.53% / (1-0.396) = 9.15% annualized if an
investor assumed 100% of the return was generated from income. When evaluating annualized total returns since
the index’s October 1995 inception, the portion of return generated from income has historically accounted for
greater than 100% of total return. While we do not have reason to believe that this return pattern will continue in
the future, it is safe to assume that total returns will continue to be driven largely from income. When one includes
the tax benefit, high yield munis become more in line with corporate high yield in many regards.
When comparing the two asset classes from a risk-adjusted perspective, the two asset classes are similar. In
fact, since October 1995, when examining rolling 3-year Sharpe Ratios, a measure of an asset class’s absolute
excess performance relative to its risk, high yield municipal bonds have a more attractive Sharpe Ratio in 130 of
the 219 trailing periods, or about 59% of the time.
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
5
Sharpe Ratio Comparison
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
Source: Morningstar
BBgBarc US Corporate High Yield
BBgBarc HY Muni
Since indexing the space is difficult given limited liquidity in the secondary market, we believe active management
is preferred. In this space, a good portion of the value added by an active manager is to limit defaults and
downgrades when compared to a passive methodology. High yield munis are also different from corporate high
yield since the corporate market is composed of often large and mid-sized corporations. In high yield munis,
smaller issuers accessing the capital markets could simply be rated as “high yield” due to the size of the tax-base
from which the municipality draws. As a result, a significant portion of the high yield municipal market is “not
rated” relative to the corporate high yield market.
Credity Quality Comparison
45%
50%
38%
40%
30%
26%
35%
22%
16%
20%
6%
10%
11%
1%
0%
0%
BB
Source: Barclays
Data as of: 12/31/2016
B
CCC
BBgBarc HY Muni
CC
NR
BBgBarc US Corporate High Yield
This significant portion of unrated bonds within the municipal market opens the door for active managers to
identify mispriced securities and generate excess returns. In our view, the lack of public information has led to a
less efficient and more fragmented market place. We believe active managers that have established the ability to
implement effective trading strategies after conducting credit analysis can establish a competitive advantage and
generate excess return over a full market cycle.
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
6
Conclusion
We believe high yield munis are an attractive asset class for taxable investors to add to their portfolios. The asset
class has exhibited several advantages relative to corporate high yield securities since its inception. High yield
munis have historically exhibited less credit risk, with a comparable yield advantage over similar credit-risk bonds
when evaluated on an after-tax basis, which has resulted in an attractive risk-return profile, especially from an
after-tax perspective. The asset class also offers investors diversification benefits due its low correlation to
investment-grade munis. Because a majority of the asset class is not-rated by any major credit rating agency, the
high yield muni market is highly fragmented and provides an attractive backdrop for active managers to
outperform over a full market cycle.
About the Author:
Ryan Schultz, Research Associate
Ryan researches and performs operational due diligence on core investment
managers. He is a team member of our Core Investment Strategy Group. Prior
to joining the firm in 2014, Ryan served as a Research Assistant in U.S. Public
Finance for S&P Ratings Services. He received a BS in Management from
Indiana University’s School of Public and Environmental Affairs. Ryan is a
Level III CFA Candidate in the CFA Program. Ryan is a member of the
Children’s Research Fund Junior Board and enjoys competing in triathlons.
This white paper is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any
dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Any forecast
represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance and historical metrics do not indicate future
performance or metrics. This white paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate,
regarding specific advice.
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