Discussing high yield and risk in bonds and current climates (2024)

As the economy slows and possiblymoves into recession or soft landing in2024, we expect occasional headlineshighlighting the fiscal stress onmunicipalities. Investors are concernedabout the impact of higher inflationand slower revenue collections ongovernment budgets. While these topicsare important for the high-qualityinvestment space, high yield municipalbonds typically fund essential servicesentirely separate from governmentaloperations that are financed by generalobligation bonds (GOs). Therefore,high yield investors are paying closerattention to issues such as a project’seconomics and competitive position.

High yield municipal bonds are primarily project bonds

High yield municipal bonds are not GOs, forthe most part. They are primarily project bondsthat provide an element of essential service thatis financially independent from the city, countyor state they serve. These revenue bonds tendto offer higher yields to compensate investorsfor the risk and uncertainty associated with aproject, such as construction risk, political/governance risk and third-party risk.

That means that the high yield municipal bondmarket is generally not concerned with issuestypically associated with GOs — managingpublic services, balancing budgets and fundingpension costs. Rather, high yield investorspay close attention to a project’s economicsand competitive position, as well as securityfeatures such as:

• A revenue pledge, which provides a security interest in the revenues generated by the project.

• A limited tax revenue pledge, where only those tax revenues pledged to debt service support the bonds.

• Any debt service or project-based covenants which, if violated, could accelerate rights of the bondholders.

• A first mortgage lien on property or other assets.

• Other forms of security interests in the real estate or project.

These features, along with higher yields, helpcompensate investors for the added risk.

These forms of security are not provided forhigh-quality GO bonds, as the revenue pledgebacking GOs allows for unlimited taxingauthority to cover debt service. Substantial creditmonitoring is still required, but these creditstrengths put high quality GOs and associatedrevenue bonds solidly in the investment graderated category. Since high yield municipal bondsoften have security features such as liens on land,tax liens on the project and/or security interestin the revenue stream, more potential remediesexist in the event of distress or default. Theseremedies potentially provide more protectionthan those found in similarly rated corporatehigh yield bonds, which are often subordinatedin the capital structure of a high yield issuer.

Lastly, high yield municipal bonds often relateto an element of essential service that provides astrong level of credit support.

High yield municipals cross many sectors

High yield municipal credit sectors can becharacterized in numerous ways. Some creditfactors cut across sectors, such as whether abond holder is secured by a first mortgage lienon the land or an annual appropriation pledge(a taxing entity’s promise to appropriate funds).However, the major credit sectors can be brokeninto various profiles:

Tax backed.A tax associated with land orinfrastructure development generates revenuesfor repayment. Subtypes include specialassessment districts, community developmentdistricts, redevelopment districts, infrastructuredevelopment and public improvement districts.Some projects in this sector are referred toas “mud” districts or “dirt” deals, indicatingvarious stages of above-ground development.Many of these projects also include a lien onthe above-ground project. These credits canrange from very risky projects with limitedinitial development to fully developed projectswith diversified sources of tax payments froman array of landowners and residents who havesubsequently moved into the district.

Health care.These projects range fromhospitals or hospital systems to nursing homesand congregate care facilities. These credits aretypically rated anywhere from AA+ to B- andbelow. Although size is not the determiningfactor, some larger, diversified health careprojects fall into the mid-investment gradespace, while smaller, less financially flexiblestand-alone facilities tend to be higher yieldingand lower-rated credits. Health care is beingimpacted by many factors, including an agingpopulation, increasing expenditures frommuch higher wages, and the federal regulatoryenvironment. As a result, these bonds requireintense and ongoing credit analysis. Many healthcare credits can be evaluated like corporatecredits, with balance sheets, income statements,endowments, real estate and other assets.

Education and charter schools.Similar tohealth care, credits in the education sector spanthe ratings spectrum from AAA-rated HarvardUniversity to high yield credits such as small,private colleges or charter schools. Evaluatingthese credits requires knowledge of enrollmenttrends and intense focus on operating andbalance sheet metrics (debt service coverage,operating leverage and liquidity cushion).Bondholder security is another key part of theanalysis, with attention to legal protections,such as a mortgage or revenue pledge, andfinancial covenants.

Transportation and toll roads.Theserevenue bonds are repaid by tolls or facilityrental fees from a public transportation system(e.g., toll roads, airport gates). Debt servicerepayment depends on facility usage andproject management.

Tobacco. Tobacco settlement bonds arerepaid by revenues from the Master SettlementAgreement between various states andparticipating tobacco manufacturers. Thepayments by the tobacco companies to the states are determined by a multi-variableformula heavily based on cigarette consumption.Therefore, one risk is that domestic sales ofcigarettes may decline further than declinesassumed in the various bond documents.Some of these bonds carry investment graderatings, but the market generally trades these ashigh yield bonds.

Industrial development and pollution control.Many of these projects depend onrepayment from large industrial firms, with thebond proceeds meeting the public purpose tocreate jobs and/or reduce pollution. This sectoris very similar in credit profile to the taxable highyield space, and sometimes a company will havebonds issued in both marketplaces.

Other sectors.High yield municipal bonds canalso include financings for convention centers,Native American Tribal gaming facilities, utilities(including water and sewer facilities), multifamily housing and other smaller credit sectors.

Liquidity remains a risk

Liquidity is a risk in the high yield municipalmarketplace. Headline risk can affect liquidityand may be triggered by events that have nothingto do with actual credit factors. For example,high yield municipal prices fell dramaticallyin 2008 even though the vast majority of highyield municipal bonds continued to pay interestand principal when due. In late 2010, an analystforecasted a rapid increase in municipal bonddefaults within cities and counties, causinga selloff in high yield municipals. In reality,defaults had actually begun declining fromtheir post-crisis peak. During the coronaviruspandemic in 2020, limited defaults in the highyield market mainly affected nursing homes andcongregate care centers. However, even thesedefaults were spread out over time and space andcontained mostly to this single sector. Becausethese credit issues can be misunderstood andthe bonds are often thinly traded, headlines andother factors can impact liquidity – an inherentrisk in the high yield municipal bond market.

Portfolios were eventually compensated for patience

In times of elevated market volatility ornegative press, investors may decide to sell andwait for conditions or valuations to improvebefore reallocating funds. But most cannottime the market perfectly, which can meanlost opportunity.

Prior to the selloff induced by the U.S. FederalReserve beginning in 2022, there had been fiveperiods where municipal yields increased byat least 100 basis points in less than one year.We examined the total return of a hypotheticalinvestment of $100,000 held for 3-, 6- and12-month periods following each spike. Inholding periods of 12 months or longer, stayingthe course benefited investors. We are nowmonitoring how the high yield market willrecover from the inflation-based/Fed tighteningselloff of 2022, giving us a sixth period totest the market’s ability to bounce back frominvestor outflows.

Misunderstanding may create value

Municipal credit has continued to prove resilientduring periods of market disruptions, with themost recent example being the coronaviruspandemic. Municipalities have not onlyrecovered from this crisis, but metrics areeven stronger.

Media attention on high profile credit situationsleaves many investors concerned about theoverall state of municipal GO credit quality.However, in this cycle, high quality municipalbonds are well prepared for a fiscal slowdown.Reserves stand at all-time highs, and tax receiptsremain robust despite some declines. Therefore,the media is less focused on high qualitymunicipal credit than in the past.

High yield municipals may benefit from thesepositive perceptions, even though these GObonds are not typically owned in high yieldbond funds. Investors may read about financialproblems in cities and hesitate to invest inhigh yield munis, even though high yieldcredit exposure is not related to municipalbudgets. In this cycle, a stronger bid for highyield may continue, even if the economyweakens somewhat.

This misunderstanding may create investmentopportunities. The current ratio of high yieldmunicipal yields to high yield corporate yields is73%, slightly less than the historical average.

Furthermore, high yield municipals have a lowhistorical correlation to other asset classes,making them an appropriate complement toan overall portfolio. The correlation to equities,Treasuries and corporate high yield is generallynear or below 50%.

Fundamental research identifies opportunities

Evaluating high yield municipal bonds typicallyrequires understanding issues relating to land orinfrastructure development, potential impact onbalance sheets and income statements and issuesspecific to healthcare policy and education. Webelieve that in-depth fundamental researchcan help an investor understand risks, identifyopportunities and capitalize on the inefficienciesin this misunderstood asset class.