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May 27, 2019

Risky municipal bonds are on a hot streak
Funds dealing in high-yield munis have drawn $8 billion as investors search further afield for returns

Investors seeking yield are piling into the riskiest corner of the municipal bond market at a pace not seen in decades.

They have poured $8 billion into funds that deal in high-yield muni bonds—or junk munis—this year, the most through May since at least 1992, according to Refinitiv data. Muni-bond funds overall have attracted $37 billion during that same period, the most in almost three decades.

There is “more demand than at any time in recent memory,” said Jeff Burger, a portfolio manager at Mellon Investments Corp., which oversees $25 billion in municipal investments.

Investors have jumped into the municipal-bond market in search of returns this year as Treasury yields have fallen and analysts’ expectations that the Federal Reserve might cut interest rates this year have risen. Recent changes to the tax code also gave an unexpected boost to the muni market since federally tax-exempt muni bonds have become one of investors’ few remaining tax shelters.

Now, the strong appetite for munis has extended to sometimes riskier borrowers in the historically safe market for state and local governments. That has translated to lower interest costs for some borrowers, money managers said. These include charter schools, retirement communities and some companies that aren’t backed by the taxing power of cities, states or essential entities like water and sewer utilities.

Bob Powell, chief of Brightmark Energy, recently oversaw an unrated $185 million bond deal to build a facility in Ashley, Ind., that would convert plastic to fuel and wax for the RES Polyflow Indiana Project.

“Investor reaction…was astounding to me,” said Mr. Powell, adding that there were more orders for bonds than the company was selling. “It was at a level where you say, ‘By golly.’”

The company sold the debt at interest rates close to 7%, far above what munis typically fetch but on the low end of what Mr. Powell said he initially expected.

The strong demand for muni debt has pushed down the yield on the Bloomberg Barclays Municipal Bond High Yield Index to around 4.54% late last week, near a 16-year low, FactSet data show. The yield on the Bloomberg Barclays Municipal Bond Index is hovering near its lowest level since 2017. Bond yields fall as prices rise.

A recent stretch of turbulence in the stock market has also helped drive interest, analysts said, pushing investors toward munis because of their stable returns and low default rates. Though muni defaults have become more common recently, the municipal default rate has been about 0.1% since 1970, according to Moody’s Corp.’s  analysis of its ratings. That is well under the 6.7% rate for corporate bonds.

The non-investment-grade or unrated munis can be riskier, however. About 2.5% of unrated bonds are currently in default, according to research firm Municipal Market Analytics.

High-yield munis outperformed corporate bonds, stocks and Treasurys last year and have returned 5.5% this year, counting price changes and interest payments, FactSet data show. High-yield corporates have returned 8%.

Virgin Trains U.S.A., backed by Fortress Investment Group, has benefited from high demand for munis. Also known as Brightline, the train seeks to connect Orlando, Fla., to Miami.

But it didn’t fill up its trains with as many passengers as expected in 2018 after station opening delays, according to bond-offering and financial documents. The company also faced losses, financial records show. A spokesman for the train said it had always projected a “multiyear ramp-up” for revenue and ridership.

Even so, in April, muni investors lent Virgin about $1.8 billion to expand, marking the largest unrated muni bond deal over the past five years, according to calculations by MMA.

Brian Wynne, head of public finance at Morgan Stanley , which underwrote the bonds, said high demand enabled the railway to sell $250 million more in debt than initially planned, with yields roughly a fifth of a percentage point less than expected. Virgin could issue $950 million more in the coming months, according to the Florida Development Finance Corporation.

Such bonds “enable the private sector to deliver critical infrastructure projects,” said Wes Edens, co-chief executive of Fortress and Chairman of Virgin Trains.

“All the stars have aligned for these types of loans,” said Rob Amodeo, head of municipals at Western Asset Management Co., which oversees about $22 billion in munis. He bought high-yield bonds in the primary market and sold them shortly afterward, once prices rose.

But he warns the streak can’t last: “It’s not sustainable.”

As investors keep piling into the sector and the rally continues, muni-bond yields keep falling and could grow less attractive relative to Treasurys, investors said. Additionally, if investors start pulling money from mutual funds, that could set off selling in muni bonds and bring the rally to a halt.

Nicholos Venditti, a portfolio manager at Thornburg Investment Management, said he is avoiding high-yield munis. “Any time in any market when price is as divorced from fundamental value…there tends to be a reckoning,” he said.

Article written by Gunjan Banerji for the Wall Street Journal.


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