HY Munis Worth A Look Vs. HY Corporate Credit Right Now


High-yield credit brings to mind junk-rated corporate bonds for most investors. However, the municipal space offers bonds across the entire rating spectrum as well. In this article, we take a look at this part of the market and compare it to its corporate analogue. We find that the municipal sector’s greater resilience in fund format, attractive relative valuation, cheaper leverage and longer duration in a relatively steep curve environment are attractive features.

We also highlight a number of funds that allocate to the space:

  • Invesco Municipal Income Opportunities (OIA)
  • Nuveen Municipal Credit Income Fund (NZF)
  • Nuveen Municipal Credit Opportunities Fund (NMCO)

HY Muni or HY Corps?

To motivate the discussion, it’s worth comparing the two high-yield muni ETFs with the benchmarks of the broader municipal and high-yield corporate sectors. What we see is a fairly striking outperformance by the high-yield muni space which is a good way to kick off the discussion.

Source: Systematic Income

Apart from historical outperformance, there are a few advantages of high-yield municipal funds over high-yield corporate funds in the current environment.

First, relative value supports municipal over high-yield allocation here, in our view. Below we plot the yields-to-worst of the S&P High-Yield Municipal Bond Index against the ICE HY Corporate Bond Index. We can see that the gap between the two yields has narrowed recently.

Source: S&P, FRED

We can see this dynamic more clearly in the following chart which plots the difference in yields. The current yield differential is at the lower part of its 5-year range, favoring HY munis in relative terms. And recall that the municipal yield here is tax-exempt so the tax-adjusted municipal yield would be significantly above the high-yield corporate yield.

Source: Systematic Income

Secondly, the yield curve has steepened since its flattening in 2019 and now stands close to the steepest level in about three years. Because municipal bonds tend to be longer-duration instruments than high-yield corporate bonds, it means that they are now enjoying a sizable term premium for their longer duration.

Source: Systematic Income

Thirdly, while some investors are hesitant to hold longer-duration instruments for fear of a spike in interest rates, we should remember that a macro shock is typically accompanied by a sharp drop in long-end rates (exactly what we saw earlier this year) – this means that the risk of holding longer duration bonds should be viewed alongside their benefit of being a better hedge in a macro shock environment.

Fourthly, the drawdown of the S&P HY Corporate Bond Index was significantly above that of the HY Municipal Bond Index. This has two important implications for investors: behavioral and CEF-related. On the behavioral side, the larger the drawdown of a given position, the easier it is for investors to lose conviction and hit the sell button, locking in permanent capital losses. And on the CEF-related side, the larger the drawdown, the more likely a leveraged CEF will be forced to undergo deleveraging, likely resulting in a similar locking-in of permanent capital loss.

Fifthly, all high-yield municipal bond funds we look at here have sizable investment-grade rated buckets – the fund with the smallest IG-rated bucket has a 30% allocation as well as a sizable rated high-yield bucket. The reason why we make a distinction between a rated high-yield and unrated buckets is that high-yield rated municipal bonds have seen much lower default rates than similarly rated high-yield corporate bonds. This additional flexibility is also attractive as it gives fund managers greater freedom of action to find attractive opportunities across a larger investment space. It also enhances the credit quality of the portfolio relative to an entirely high-yield/unrated one.

Source: Moody’s

Sixthly, there are some technical tailwinds for broader munis. There has been a sizable increase in taxable issuance as a proportion of all municipal issuance which has to do with the elimination of tax-exemption for advanced refunding. That, plus the fact that much of the muni supply was pushed forward this year, suggests that supply will be relatively sparse over the coming year which should support valuations.

Finally, some municipal CEFs tend to have both more resilient and cheaper leverage structures than high-yield corporate bond CEFs. Muni CEFs that use municipal preferreds are less likely to be forced to deleverage unlike muni CEFs that use tender option bonds or taxable CEFs that use bank-facing leverage instruments such as repos, credit facilities or loans. It’s also important to remember that tax-exempt muni leverage instruments are also tax-exempt which means that they require lower interest rates. So, for example, while tax-exempt borrowing typically runs at around 0.5-0.8%, taxable borrowing runs at around 1-1.5%.

Another advantage of municipal CEFs over corporate credit CEFs is that municipal bonds tend to have stickier NAVs due to their lower liquidity. This means that CEF NAVs are likely to remain better supported during sharp drawdowns than that of corporate bond funds, all else equal. This should keep the leverage of muni CEFs from rising as much, allowing the fund to maintain its borrowings without driving a forced deleveraging.

A Yield Comparison

Before going ahead, it’s important to address some key yield issues having to do with municipal bonds in particular. Unlike investment-grade and high-yield corporate funds which have strikingly different yields, municipal funds that allocate to investment-grade and high-yield/unrated bonds do not have very different yields. So, most investors looking at whether or not to allocate to investment-grade or high-yield/unrated munis will question the point of moving down the quality spectrum if it does not obviously result in a higher fund yield.

However, just like the corporate bond space, municipal bonds with different ratings also have pretty different credit spreads and yields. For example, the S&P Investment-Grade 5+ Bond Index YTW is 1.49% while its High-Yield Bond Index YTW is 4.07%. The reason that muni funds look like they have similar yields regardless of their underlying quality has to do with the coupon-issuing convention of municipal bonds that tend to issue at 5%. For example, out of 1,100 bond positions in the popular Nuveen Quality Municipal Income Fund (NAD), about half have 5% coupons, despite yields at the time of issuance that were significantly below that. This dynamic will tend to overstate the yields of the funds themselves.

So, to get a clearer picture of the impact of yields on CEF earnings, let’s have a look at how the sector yield will flow through a typical CEF structure. We assume both CEFs have 35% leverage, 0.6% management fee and 0.7% leverage cost. Net Asset Yield is simply the YTW of the fund’s portfolio. Levrg Yield is the additional yield provided by the fund’s leveraged exposure. The other line items are self-explanatory.

Source: Systematic Income

What we get to is that for the Investment-Grade sector CEF, the CEF structure actually subtracts income from the underlying portfolio, starting with a 1.49% and ending up at 0.99% because the addition of management fees and leverage costs are higher than the what the additional leverage can provide. For the high-yield CEF, however, the CEF structure adds 0.89% of yield simply because the underlying yield is high enough so that the additional yield pick-up provided via leverage is more than enough to pay for management fees and leverage cost.

This doesn’t mean that investors shouldn’t use CEFs to hold high-quality bonds – after all, if they have a bullish view on the sector using a leveraged CEF makes sense. However, doing so from the point of view of income generation is challenging.

A Look At The Fund Space

To keep the comparative fund analysis manageable, we restrict ourselves to ETFs and CEFs that allocate to high-yield rated and unrated municipal bonds. There are about 30 mutual funds that also allocate to the space – all of which can be easily compared using our Investor Tools on the service. Suffice it to say, that the mutual fund performance is roughly between that of the CEFs and ETFs across different time horizons. The key advantage of the mutual funds is on the risk side where their drawdowns and volatility are significantly below that of either CEFs or ETFs. The disadvantage of mutual funds, in our view, is their combination of high fees, lack of leverage in most cases and inability to trade at a discount.

Despite a few dozen mutual funds focusing on the high-yield and unrated municipal bond space, it is a little surprising that so few CEFs have sizable allocations to it, particularly when they don’t have to worry about the liquidity of their holdings. As the following chart shows, there is only a handful of CEFs with below 50% Investment-Grade allocation.

Source: Systematic Income

We pick 7 CEFs with the lowest IG allocation:

  • Invesco Municipal Opportunities Trust (OIA)
  • BlackRock MuniAssets Fund (MUA)
  • Nuveen Municipal Credit Income Fund (NZF)
  • Nuveen Municipal High Income Opportunity Fund (NMZ)
  • MFS High Income Municipal Trust (CXE)
  • MFS High Yield Municipal Trust (CMU)
  • Nuveen Municipal Credit Opportunities Fund (NMCO)

We also add two ETFs that focus on the space:

  • VanEck Vectors High-Yield Municipal Index ETF (HYD)
  • SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB)

This is how the funds stack up across some of the key variables.

Source: Systematic Income

From a rating perspective, NMCO, OIA and HYD have the largest allocation to high-yield and unrated bonds.

The Prtf Ddown metric captures the NAV drawdown of the CEF or the price drawdown of the ETFs. It may be surprising that the two ETFs had among the largest drawdowns; however, this is likely due to the stale nature of municipal bond markets which tend to be illiquid. This works in the CEF favor as it allows them to maintain their leverage at lower levels. The other consequence of this dynamic is that muni CEF discounts during periods of sharp drawdowns are likely to be purely optical, particularly when muni ETF discounts open up as well. For example, the HYD discount opened up to double-digit levels with the general consensus being that the price of the ETFs was a better indication of where the bonds should be trading than their NAVs. So, if CEF discounts were measured against the prices implied by the ETFs rather than by bond marks, it would have caused the CEF discounts to be much smaller than what they were in March.

The Cap Struct metric shows the percentage of the borrowings in municipal preferreds rather than tender option bonds. As we have discussed here and here, tender option bonds are more fragile instruments as they allow lenders to call their cash back at any sign of distress. This forces municipal funds to sell down assets unless they can very quickly line up another source of leverage. Funds that use preferreds as leverage instruments would not be forced to deleverage at the first sign of trouble. There are occasional comments to the effect that funds are required maintain a certain asset coverage ratio if they use preferreds; however, this is actually not the case. It is only certain actions that are conditioned by the asset coverage ratio such as common share buybacks or distributions on common stock – there is no regulatory mechanism to force funds to deleverage immediately. This means that, all else equal, investors should prefer CEFs with a higher proportion of preferreds in their capital structure, though they do tend to be somewhat more expensive than tender option bonds.

This is how the funds have performed from the point when all the data is available. The legend is sorted according to total return with the S&P HY Muni Index included for reference as well.

Source: Systematic Income

What is interesting here is that the S&P index outperforms all the funds, despite its lower quality – the index is entirely in unrated or high-yield munis, whereas the funds are only partly in the same space. Given CEFs use leverage and both investment-grade and high-yield munis finished this period in the green, returning about the same +4-5%, purely mechanically, leveraged exposure should have allowed the funds to outperform so it’s odd that not a single fund was able to beat the index.

It is also interesting that NMCO is a clear laggard here. The fund got a bit unlucky with the timing of its invest-up period which caused it to fully allocate its exposure to lower-quality bonds just in time for the drawdown. The fund ended up deleveraging which was driven more by the need to keep its leverage from rising above its target level due to its already elevated leverage and the sharper drawdown in lower-quality bonds rather than any external forces. This means it is unlikely to close the performance gap that opened up since then with the other funds. Since the end of the drawdown, NMCO has put in strong performance; however, the same combination does make the fund vulnerable to another drawdown, though the likelihood of a similar size and speed drawdown is arguably much reduced given the Fed backstop of the market and additional financing options available to muni issuers.

Source: Systematic Income

If we take NMCO out, we can extend the data back to 2015. Here, the index outperforms the funds as well, though this is likely because high-yield munis outperformed investment-grade munis by around 14% – the CEF use of leverage closed this gap. It also explains why the two ETFs are in last place – though they are relatively competitive despite their lack of leverage.

Source: Systematic Income

What does this mean from an allocation perspective?

Our view here is that municipal CEF discounts are relatively attractive, though not as much as they were earlier in the year. Wide discounts, alongside rock-bottom leverage costs as well as historic returns that beat ETFs make CEFs reasonably attractive options for exposure to the sector.

Source: Systematic Income

Most of these CEFs have tended to trade at a tighter discount to the sector given their higher current yields.

We liked NZF earlier this year and as it bucked this trend, though it has now closed the gap and is trading at the sector average discount which is still attractive, though not as much as when it traded 2-4% wider of the average discount.

Source: Systematic Income CEF Tool

The moderate leverage and strong historical returns also make OIA fairly attractive, particularly as its discount has compressed much closer to the sector average.

Source: Systematic Income CEF Tool

The discount of NMCO has moved to trade wider of the sector average despite it having the highest covered yield in the sector. It is likely that the fund has disappointed some investors with its performance due to its earlier deleveraging. We are fairly positive on the fund given the strong Fed backstop of the broader fixed-income market as well as a number of programs for the municipal sector, in particular as well as the lower likelihood of a similar market panic and liquidity squeeze. The fund does have the lowest quality portfolio in the sector so this remains a clear risk for investors; however, as we said above, investors should place the fund in the context of their other lower-quality holdings rather than a replacement of their higher-quality muni holdings.

Source: Systematic Income CEF Tool

Takeaways

High-yield corporate debt is a mainstay of many income portfolios. Its analogue in the municipal space is typically less of a focus; however, in our view, it has additional benefits over and above the corporate debt space despite comparable credit spread levels. More resilient and cheaper leverage structures, stronger quality portfolios due to significant investment-grade buckets and attractive relative valuation argue for an allocation to the sector within the lower-quality portion of an income portfolio.

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Disclosure: I am/we are long NMCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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