Checking the Outlook for High-Yield Municipal Bonds

What is the outlook on high-yield municipal bonds relative to high-yield corporates?

-- David Blair

David,

High-yield municipal bonds benefit from the same general conditions that high-yield corporate bonds benefit from: strong economic growth, healthy corporate balance sheets and rising stock prices. So if you believe the 8-year-old expansion can continue, it stands to reason that muni high-yields should also do well, right?

Partially.

Last week's column explained that many strategists consider taxable high-yield bonds a buy because, even though yields have come down from the super-high levels of last fall, they continue to offer a substantial premium over the alternative -- risk-free Treasury bonds.

The chart below illustrates the phenomenon. The difference in yield between the average taxable high-yield fund and the average Treasury bond fund tracked by Lipper is at levels not seen since 1991.

With municipals, the comparison is different. High-yield munis are compared not with Treasuries (since it's assumed that if you're buying munis, it doesn't make sense tax-wise for you to buy taxable bonds) but with top-quality munis. Of course, even top-quality munis aren't considered as safe and liquid as Treasuries. Still, on the tax-free side of things, they are the alternative to high-yield.

Top-quality munis are a much more attractive alternative than Treasuries are to taxable high-yield, as it turns out. In stark contrast to the situation on the taxable side, the yield premium that the average high-yield muni fund offers over the average insured muni fund (a proxy for the top-quality sector, since insured munis carry the highest rating) is slimmer than it's been at any time in the past nine years. Compare this chart with the first one:

The difference exists for several reasons, muni market participants say.

First, taxable quality spreads widened out in the fall not just because high-yield bond prices crumbled, but because long-term Treasury yields dived to 30-year lows as investors reached for safety and liquidity. Top-quality munis may offer safety and liquidity relative to other munis, but they're not Treasuries. Also, the tax exemption that makes munis so valuable to wealthy Americans isn't worth a dime to anybody else, so munis lagged while foreign buyers helped propel Treasury prices higher.

At the same time, the supply of high-yield munis has been shrinking as strong economic growth has improved the credit quality of many municipal issuers. A measure of this, the ratio of upgrades to downgrades by credit rating agencies has been positive for four years running and hugely positive for each of the past two years. At Standard & Poor's in 1998, the dollar volume of upgrades exceeded that of downgrades by a ratio of nearly 9 to 1. "There's not a lot of traditional munis in a distressed state these days," says Richard Ciccarone, co-head of municipals at Van Kampen.

Also, whenever interest rates in general are falling, as they have been for the past several years, demand tends to grow for the highest-yielding issues, which causes further spread compression. "Investors look for return anywhere they can find it," says Chris Dillon, municipal strategist at J.P. Morgan. "People are adding exposure to high-yield in pursuit of more income."

Bottom line: Even if you think a strong economy will continue to benefit high-yield munis, they simply don't offer much value right now. That's certainly the view Vanguard Group is expressing by running (VWAHX)Vanguard High-Yield Tax-Exempt with an average credit rating of A-plus. When high-yield munis offer good value, portfolio manager Reid Smith says he'll drop the fund's average quality as low as A-minus.

And if you are at all concerned, as Smith is, that the economic expansion may falter, causing high-yield muni spreads to widen further, you really might think twice about buying them now. High-yield taxable bonds, by contrast, are at least compensating you for that risk.

Bond Funds Down Under

I was surprised that in discussing the risks of First Australia Prime Income (FAX), you did not mention that it employs substantial leverage.

You also did not mention Kleinwort Benson Australia Income (KBA), which is trading at a 20% discount as opposed to FAX's 14%.

Finally, you didn't mention that Prudential Securities, whose analyst you quoted as recommending the fund, is the fund's underwriter.

These all seem to be important facts for your readers to know in understanding FAX.

--Alexis Aniatis

Alexis,

All true, but I believe I can redeem myself.

First let me say that it will not always be possible for me to explain every aspect of every investment I write about, and that no one should buy anything solely on the basis of what he or she reads here.

Yes, FAX employs leverage, and yes, that increases its volatility, but the fund's leverage ratio actually dropped after its rights offering, from about 31% to about 26%, since the new assets are not being leveraged. That makes it less leveraged than most leveraged closed-end funds, which typically leverage themselves up to their limit of 33% or 40%, says Mariana Bush, closed-end fund analyst at Everen Securities.

As for KBA, yes, it trades at a steeper discount (15.6% as of last Friday, vs. 9.54% for FAX), but it's a different kind of fund and it has a much lower yield. Because it sticks to Australia and New Zealand government bonds and doesn't employ leverage, it yields 7.18% vs. 12.26% for FAX. Discounts are typically wider for lower-yielding funds.

Finally, yes, Prudential is the fund's underwriter, and I ought to have mentioned that and will in the future, but analyst Kristoph Rollenhagen's view on the fund doesn't stand out. The other two firms that follow the fund -- Everen and Gruntal -- also strongly recommend it, and Rollenhagen (who downgraded the fund to hold in December 1997) was the last of the three to act.

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Elizabeth Roy answers your bond fund questions every Friday. Dagen McDowell answers general mutual fund questions Monday through Thursday. Send questions on either topic to [e-mail], and please include your full name.

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