Take Another Look at High-Yield Munis

The palpable aversion to risk in the last nine months, particularly in the fourth quarter of 2008, even in the fixed-income markets, decimated both the corporate and municipal high-yield asset classes as investors fled from risk to the safety of liquidity and to only the highest of credit quality. Even high-quality, investment-grade municipal bonds saw dramatic underperformance relative to Treasuries in 2008 as institutional buyers fled the muni market, bond insurers blew up and the municipal auction rate failures added to longer-term municipal supply.

Today, as we put some distance between ourselves and late 2008, while risk-aversion remains quite high, we believe longer-term individual investors with a need for portfolio diversification should consider municipal high-yield bonds as an asset class for their portfolio.

We recently had a chance to talk with John Miller, the portfolio manager of the Nuveen High-Yield Municipal Bond A (NHMAX - commentary - Cramer's Take) fund. John's fund had a tough 2008, declining 40% in calendar 2008, which was at the low end of his peer group percentile, but it is one of three high-yield municipal bond funds we purchased for client accounts.

How large is the municipal high yield bond market relative to the municipal bond market in general ?

Miller: In normal times, muni high-yield issuance is about 10% to 15% of total municipal bond issuance, but the muni high-yield market hasn't been normal since the beginning of the fourth quarter of '08. BBB-rated issuance is about 7% of the muni market, and "non-rated" is about 5%, but again this is during normal times, and the muni market remains far from normal.

The Nuveen high-yield municipal bond fund is currently yielding close 9.4% on a tax-free basis. On a taxable equivalent basis, for an investor in the 35% tax bracket, that is a 14% taxable equivalent yield.

Miller: Relative to AAA muni bonds, municipal high-yield spreads are currently just under 600 basis points wider (and near 10% in absolute yields) than the AAA-benchmark and remain close to historic wides. In fact, muni high-yield spreads are twice as wide as the plus-300 spreads seen in 2002, or the previous lows for prices in high-yield munis. Historically, the municipal bond market yields are at unprecedented levels.

With the economy and the credit market disruptions, how bad will muni defaults be, and will the recently-passed stimulus package help?

Miller: The congressional stimulus passage earmarked for the states will help the general-obligations municipal bonds, the vast majority of which are investment-grade, while high-yield muni issues are typically revenue bonds, and by sector represented by health care facilities, industrial development bonds (IDRs), of which airline-backed bonds are the biggest part of the sector, long-term care (i.e., continuing care retirement communities), dirt bonds (infrastructure bonds for as yet-developed communities) and $35 billion of tobacco securitization bonds. Bottom line, John thought that the stimulus package wouldn't help the muni high-yield market very much, and of so only at the margin, although it will take some pressure off state budgets.

Using Great Depression default data, about 7% of outstanding muni debt defaulted between the years 1929 and 1937. According to John Miller, the current yield spread of 590 to 600 basis points in the muni high yield market is projecting a cumulative 70% implied default rate and a 50% recovery value in the municipal high-yield bond market, which is far in excess of the Great Depression data, although a case can be made that a comparison with the Great Depression today isn't appropriate.

From detail provided by the firm John Nuveen, the cumulative default rate for all speculative-grade municipal bonds from 1970 through 2006 was 4.3%, so, assuming a 50% recovery rate over time, the current 9.5% yield is about 700 basis points higher than the 2.125% expected loss (4.3% historical default times 50% recovery rate), so a fund investor looks to be well compensated.

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At the time of publication, Gilmartin was long NHMAX, NHYMX and GHYAX, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback; click here to send him an email.