By Triet Nguyen, Axios Advisors
(August 23rd, 2012) So you’re the proud owner of a few shares in a high yield municipal bond fund. Congratulations. You have invested in one of the best, if not the best, performing domestic asset classes over the past 5 years, in terms of tax-adjusted returns. While high yield municipals did suffer a short-term hiccup in late 2010, along with the rest of the tax-exempt market, they have staged a complete recovery (and then some) over the last 18 months.
This year’s performance has been even more impressive. According to the Bond Buyer, the muni industry’s trade paper, “muni bond funds rank among the highest-performing bond funds so far this year, according to preliminary Lipper data as of July 31. Total returns, calculated as changes in net asset values with reinvested distributions, for the high-yield municipal group stand at 10.6% for the year to date. Municipal bonds rated BBB have returned 8.6 percent this year through Aug. 13, compared with the 5.6 percent gain of the $3.7 trillion market for all municipal debt, Bank of America Merrill Lynch data show”.
Much of this outperformance can be attributed to the most favorable supply/demand conditions in years. Since the 2008 crisis, new issuance of lower-rated paper has dwindled to practically nothing. Issuance of speculative-grade debt in 2012 has dropped to about one-fifth the average of the previous five years. Yet, the demand side of equation has never been stronger as investors reach for yield in a historically low rate environment. Again, according to the Bond Buyer, “high-yield muni funds added about $1.1billion in the five weeks through Aug. 8, the most since December 2010, Lipper US Fund Flows data show. They have attracted $5.4 billion in 2012, compared with $31.7 billion in outflows over the same period last year”.
This favorable technical picture has created a virtuous cycle in which strong historical performance attracts more inflows into the mutual funds which in turn will bid up the price on existing high yield bonds. It’s fair to say things don’t get much better than this.
Clearly, we’re bound to have a market correction of some sort. September and October have always been tricky months for the muni market. Many major market participants, particularly on the broker-dealer side, have fiscal years that end in October. This usually means that their trading desks will start to lock in gains and reduce risk positions for the year in anticipation of bonus time. This will result in a temporary loss of whatever little liquidity the market has during much of the fourth quarter.
Nonetheless, there are reasons to believe that high yield muni funds will hold up better than their high grade counterparts in the event of a short-term market correction. A common mis-perception on the part of investors is that high yield funds have more “duration risk”, i.e. they exhibit greater sensitivity to overall changes in interest rates. On the contrary, its’ been shown that high yield tax-exempt bonds have a lower “market beta” than their higher-rated brethren. High yield prices tend to be “sticky” on the downside because fund managers typically “sell what they can, not what they should”. Most of the time, they prefer to sell their high grade holdings for liquidity purposes and then hold on to their higher-yielding bonds to protect the fund’s dividend. As a result, there tends to be less selling pressure on the high yield names in the short-term.
There is another reason why the high yield funds may outperform in a market selloff and it’s rather bogus: since most high yield issues are infrequently traded, the pricing services usually refrain from changing their evaluations for high yield paper until they have a good reason to. As a result, the net asset value (“NAV”) of the high yield muni funds always look artificially stable. In fact, the funds with a high concentration in illiquid, unrated paper will always exhibit very stable NAV characteristics, at least until something blows up (That’s why many high yield muni funds tend to have favorable Morningstar ratings: the Morningstar system, which is based on risk-adjusted returns, tends to reward funds with lower return volatility).
At the end of the day, in order to protect her hard-earned returns, the investor should ask herself the following question: Am I in the right high yield muni fund? Since a rising tide lifts all boats, it probably hasn’t mattered much which fund you’ve invested in. They have all done well, probably. However, the funds that are having a blowout year in this very favorable market are the ones you should be wary of. In my book, “Investing In The High Yield Municipal Market”, I highlighted the risk of investing in a fund with an “outlier” performance, i.e. a fund with an abnormally high tax-free dividend versus its peers or one which is currently ranked #1 in total return. While the fund manager could be doing an excellent job (miracles do happen), such outperformance is almost always the result of taking an outsize risk position. It could be an over-concentration in a volatile high yield sector, such as tobacco bonds, or an over-concentration in illiquid, unrated securities which may or may not be fairly valued. The best fund to own is not last year’s #1 fund. It’s the fund that consistently delivers top quartile yield and above average total return performance year in and year out against its competitive universe (readers who wish to learn more about how to select a high yield muni fund can find a more extensive treatment in Chapter 5 of my book).
Since the fund with the higher risk profile is likely to be an outperformer year-to-date, there is no better time than now to cash out of that fund, lock in your gains and re-invest into a more consistent performer. Your risk profile is improved and you’re still positioned to benefit should the high yield rally resume later.
If this sounds like I’m advocating active management of your muni fund exposure, that is absolutely correct. But, aren’t we paying those high fees to mutual fund managers for active management? Yes, but most open-end tax-exempt funds are marketed on the basis on yield, so they are forced to be fully invested at all times, regardless of the market outlook. As a result, they will just go up and down with the market. In other words, they probably won’t do a good job protecting your principal in down markets, At the end of the day, it’s really up to the investor to do his own total return management.
This begs another question: Why pay high management fees to a mutual fund for what is basically index-like performance? Why not use ETFs for this purpose? Those are great questions and a great topic for another post.
Triet Nguyen is a veteran of the fixed-income markets and a high yield/distressed municipal bond expert. Over his 32 year career, Triet has designed, marketed and managed every type of buy side investment products, from mutual funds (open and closed-end) to managed accounts and hedge funds. He is currently the managing partner of Axios Advisors LLC, an independent municipal research and investment advisory boutique specializing in high income strategies (www.axiosadvisors.com).
Triet is the author of “Investing In The High Yield Municipal Market”, published in July 2012 by John Wiley/Bloomberg Press. He also moderates the Municipal Credit Research Forum on LinkedIn. His Twitter handle is @HighYieldPro.