Muni Bonds: Red Flags to Navigate
Risks are rising in the muni bond market.
True or False?
(Read to the end of the blog to find out the answer.)
- Nebraska, California and Arkansas have the highest number of municipal bankruptcy filings of any state since 2007.
- AMG Vanadium LLC’s recent $307 million state agency bond issue to finance turning waste into products used to make steel didn’t provide secured collateral, yet the sale was oversubscribed.
- In August, SoutheastHealth, a health-care network, issued about $92 million of bonds without a debt-service reserve and was oversubscribed about 10 times.
- The municipal market historically has had low default rates, with only 0.16% of those rated by Moody‘s Investors Service defaulting between 2009 and 2018, compared with 6% of the global corporate bond universe.1
Sharp demand for yield has led to froth in the bond markets. Nowhere is this more evident than in the muni bond market, where some issuers are playing fast and loose with investor protections. Other issuers are seeking financing for eccentric business propositions through the municipal market. Consequently, some muni bond funds may carry higher risk than investors think, and advisors need to be alert.
Tax law changes, as well as the anticipation of Fed rate cuts, have brought investors to the muni market looking for higher yields than they can find in money market funds. New issuance of muni bonds hit a three-year record of $271 billion2 by the end of August year to date. The muni bond mutual funds have seen net inflows every week and a record $63 billion3 of new inflows from the beginning of January through August of 2019.
Looking for Yield in All the Wrong Places
High demand is allowing some hospitals, schools and other issuers in the $3.8 trillion municipal bond market to use a devil-may-care approach with investor protections such as mortgage pledges, sinking funds and rate covenants. Coupons may not reflect the risk, with yields on some of the riskiest tax-exempt securities down to about 4%, the lowest since 2003.4
Defaults are rising and include offerings that may not belong in the traditional muni sector. Through August of this year, about 59 municipal bond issues defaulted versus 47 for the same period in 2018.5
Keep an Eye Out
We believe advisors need to look under the hood of muni bond funds to avoid rising risks. Here are some suggestions:
- Be cautious about areas most prone to default, such as rural districts or small urban centers with little to no taxing authority or base.
The smaller the area that the project serves, the more often the project reflects the interest of one party, meaning there may be no recourse should the project fail.
- Be wary of offerings passing themselves off as “municipal” that are financing economic speculation, especially in what many deem to be the waning days of a business cycle.
Potentially speculative projects have included schemes such as novel health-care treatment centers, factories that turn trash into fuel and fertilizer plants for marijuana cultivation.
- Entities that are recurring issuers are less likely to default.
Perhaps it is counter-intuitive, but counties with higher impairment rates tend to have less municipal debt outstanding than those with lower or no impairment rates.
Time to Review Risk Exposure and Consider a Tune-up
Even though increased risks have emerged in the muni market, there is always an important role that muni bonds can play in a portfolio, due partly to their tax benefits. Investors seeking tax-free income and stability would be wise to choose muni funds with highly active management and disciplined fund construction. A balanced approach to risk and yield and bottom-up credit research can help identify issues with “lite” covenants. At the same time, active laddering can offer stabilization, liquidity and upside potential.
Financial advisors: Click here to watch “Muni Demand Keeps Climbing,” a short video with Nicholos Venditti, CFA, Managing Director and Portfolio Manager, Tax-Exempt Fixed Income.
Answer: All are true.
2. (EMMA Jan-Aug 31, 2019 Muni Issuance), https://emma.msrb.org/MarketActivity/ViewStatistics.aspx
3. Investment Company Institute, 2019 mutual funds flow data
4. Bloomberg data