Why Top Mutual Fund Managers Love Municipal Junk Bonds

January 13, 2016, by Robert Kane of BondView

The municipal bond market is a morass of nearly two million bond issues worth about $3.7 trillion in total. Investors have about 80,000 different issues to chose from. Data for municipal bond funds show the so-called smart money investors have big bets on junk-rated bonds despite the worries over Puerto Rico and pension deficits across the U.S. Perhaps fears over pension costs are overblown.

Municipal bond funds have an army of analysts and managers to perform due diligence on each holding. Although funds have different investment goals, from conservative to high yield, a vote of confidence from a wide array of funds should carry considerable weight with individual investors.

Given that investment angle, below is a list of the most widely owned municipal bonds in mutual funds. This table is based on both the number of funds with stakes in the bonds as well as the total value of the funds’ bond holdings.

Most of the top 10 municipal bonds in this list are fine. But curiously some are high yielding — the euphemism for junk-rated — and are in default technically. One Ohio Tobacco bond shows a yield as high as 6.3%. This is nearly a 10% yield after tax. Data show 67 different mutual fund managers must believe this bond is a sound investment given they have poured $631 million into it.

(Source: BondView.com)

The No. 1 Purchase for Muni Bond Funds

Municipal bonds sometimes may be thrown into the junk pile by mistake simply because they are not rated. For example: the New York Liberty Development Corp. 3 World Trade Center Project Bonds with nearly a 5% yield. The 3 World Trade Center bonds are very different because they were the municipal bond market’s largest unrated deal, Bloomberg reported.

Portfolio managers and analysts had to study the nearly 2,700-page bond document without the assistance of the three major credit ratings agencies. Unrated bonds sometimes are equated with junk. But that’s unlikely to be the case here. The issuer may have thought the bond market’s appetite was strong enough that getting rated and paying the associated fees were not necessary.

The 3 World Trade Center bond is the most widely-owned municipal bond among mutual funds. In total, 123 mutual funds own $889 million worth of the bond, as of early October 2015. Some of the largest mutual funds holding this bond are listed in the table below.

(Source: BondView.com)

Approved in Oct. 2014, the 3 World Trade Center bonds were issued as part of the federal Liberty Bond program. It was created to support Lower Manhattan’s resurgence with tax-exempt financing to the tune of $8 billion. Given that most commercial office developments are financed by bank loans — not tax-exempt bonds, the 3 World Trade Center’s financing makes it unique. The project is set for completion in 2018.

A mortgage on the 80-story building, tenant rents and leases secure the bonds. If you have been to Manhattan in the past few years, you saw thatl the real estate market is on fire with very low vacancy rates, sky-high prices and record international tourism. The mass appeal of the 3 World Trade Center bonds indicates the smart-money has considered and is fairly comfortable with the risks such as the developer failing to complete the project, among many other risks.

Muni Bond Fund Performance

(Source: Morningstar)

It all comes down to performance of course. High-yield muni funds have outpaced the rest of the bond market, as tracked by Vanguard Total Bond Market Index Fund (VMBFX), over the past one and five years, as the table shows. Some even beat the index over the past 15 years and had a lower risk profile.

Bond Defaults Are Worked Out Frequently

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

States and cities have historically increased taxes to make up for budget deficiencies. Chicago is raising property taxes next year after Moody’s gave it a below investment grade rating with a negative outlook owing to its pension issues. However, public pension plans do not have a crisis despite all of the news headlines, says the CSG.

“Most state and local employee retirement systems have substantial assets to weather the economic crisis,” The CSG stated in a report. “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.”

“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,” the CSG added.

Municipal bankruptcies seldom occur. Only 0.06% of about 90,000 municipalities filed for bankruptcy from 1937 to 2008. This includes municipalities of all credit ratings including junk. The likelihood of a muni bankruptcy are “nearly in line with the odds of being struck by lightning,” says Frank Holmes, CEO of U.S. Funds in San Antonio.

In the municipal bond marketplace, default does not mean bankruptcy. In many cases bankrupted municipalities protected investors, including one of the largest in U.S. history – Orange County, Calif. in 1994, according to the CSG.

Robert Kane is the CEO of BondView, a provider of municipal bond data and analytics, in Roslyn Heights, N.Y.

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