Seeking Alpha: Why Municipal Junk Bonds Are A Favorite Among Top Mutual Fund Managers

By Robert Kane, CEO Bondview

Dec. 16, 2015 12:03 PM ET|11 comments | Includes: CMU, CXE, HYD, HYMB, MAV, MHF, MHI, NMZ, SHYD, VBMFX
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)
Summary

Municipal fund data show the so-called smart money currently have a strong appetite for junk-rated bonds despite the troubles surrounding Puerto Rico and pension shortfalls across the country.

Compared with like-rated corporate bonds, many “junk”-rated munis are diamonds in the rough. Thehistorical default rate in the municipal bond market is less than 1/3 of 1%.

Default does not mean bankruptcy in the municipal bond marketplace. Municipal bankruptcies are very rare.

The municipal bond market is a bazaar of nearly two million bond issues — totaling some $3.7 trillion. There are about 80,000 different types of bonds to chose from. Municipal fund data show the so-called smart money currently have a strong appetite for junk-rated bonds despite the troubles surrounding Puerto Rico and pension shortfalls across the country. It suggests fears over pension costs are probably overblown.

Municipal bond funds employ an army of managers and analysts to research each holding. Bearing in mind that funds have different investment objectives, from conservative to high yield, a vote of confidence from a broad swath of funds should carry a lot of weight with individual investors.

With that investment angel in mind, here’s a short list of the most widely held municipal bonds in mutual funds, based on both the number of funds owning these bonds and the total value of the bond holdings.

Most of these top 10 names are fine but curiously some are high yielding, the polite term for junk-rated and are in technical default. One Ohio Tobacco bond sports a yield as high as 6.3%. After tax this is almost a 10% yield. Yet a group of 67 different professional fund managers believe this bond is a good enough bet to have invested $631 million.

(Source: BondView.com)

The No. 1 Buy for Muni Bond Funds

Sometimes bonds may be mistakenly thrown into the junk pile just because they are not rated, such as the New York Liberty Development Corp. 3 World Trade Center Project Bonds with nearly a 5% yield. The 3 World Trade Center bonds are unique in that they were the municipal bond market’s largest unrated deal, Bloomberg reported. That means portfolio managers and analysts hopefully studied the nearly 2,700-page bond document without the help of the three major ratings agencies. While unrated bonds sometimes are equated with junk, that’s probably not the case here. The issuer may have assumed the marketplace appetite was solid enough that unnecessary ratings and the associated extra fees were not warranted.

The 3 World Trade Center bond is the most widely held muni bond among mutual funds. A total of 123 mutual funds own $889 million , as of early October 2015. Some of the biggest mutual funds invested in this bond as the table below shows.

(Source: BondView.com)

The 3 World Trade Center bonds, approved in Oct. 2014, were issued as part of the federal Liberty Bond program. The program was created to support the revival of Lower Manhattan with $8 billion of tax-exempt financing. The 3 World Trade Center are unique in that most commercial office developments are financed by bank loans — not tax-exempt bonds. It’s scheduled to be completed in 2018.

The bonds are secured by a mortgage on the 80-story building, tenant rents and leases. Anyone who has been to Manhattan in the last few years can tell you the real estate market is booming with low vacancy rates, high prices and record international tourism. The popularity of the 3 World Trade Center bonds suggests the smart-money has taken into consideration and is fairly comfortable with the risk of the developer failing to finish the project, among many others.

Muni Bond Fund Performance

(Source: Morningstar)

Of course, it all comes down to performance. As this table shows, high-yield muni funds have outperformed the rest of the bond market, as tracked by the Vanguard Total Bond Market Index Fund (MUTF:VBMFX), over the past one and five years. Some outperformed the index over the past 15 years while carrying a lower risk profile.

Bond Defaults Often Are Worked Out

Compared with like-rated corporate bonds, many “junk”-rated munis are diamonds in the rough. The historical default rate in the municipal bond market is less than 1/3 of 1%, compared to a corporate default rate that exceeds 10%, the Council of State Governments notes citing Fitch research.

Cities and states historically have raised taxes to make up for budget shortfalls. That said, Chicago is set to raise property taxes next year after Moody’s rated it below investment grade with a negative outlook because of pension issues. But public pension plans are not facing a crisis that the news headlines would lead you to believe, says the CSG. Writes the The CSG in a report:

Most state and local employee retirement systems have substantial assets to weather the economic crisis. There is currently $2.7 trillion already set aside in pension trusts for current and future retirees. Public pensions are funded and paid out over decades; state / local government retirees do not draw down their pensions all at once.

The CSG added:

More state and local governments enacted significant modifications to improve the long-term sustainability of their retirement plans in 2010 than in any other year in recent history.

Municipal bankruptcies are very rare. Only 0.06% of some 90,000 municipalities filed for bankruptcy between 1937 and 2008. That includes municipalities of all credit qualities including junk. The odds of a muni bankruptcy are “nearly in line with the odds of being struck by lightning,” writes Frank Holmes, CEO of U.S. Funds in San Antonio.

Default does not mean bankruptcy in the municipal bond marketplace. In many municipalities the jurisdictions have not successfully filed for bankruptcy on their debt / municipal bonds and have protected investors, including one of the largest in history – Orange County, Calif. in 1994,” according to the CSG.