“For most investors, the mere mention of high yield recalls the high-risk, speculative “junk bonds” of the Michael Milken era and its well-documented excesses. In the municipal arena, high yield also means higher risk, but the term encompasses a much broader class of securities with an astonishing variety of security structures and risk characteristics.” – excerpted from Chapter 1: The Basics of High Yield Municipal Bonds
Triet Nguyen wrote Investing in the High Yield Municipal Market in an attempt to “lift the veil of mystery from this arcane industry and shed some light into its inner workings.”
In the book, and in the interview that follows, Mr. Nguyen explains how high yield municipal bonds can be an attractive asset class based on the potential for high returns on investment. At the same time, investment in high yield bonds requires a lot of discipline, as well as an understanding of their inherent risks.
MuniNet: Is that Michael Milken era “junk bond” perception an accurate one today?
Nguyen: The perception of the high yield market as a highly speculative one is still out there, primarily because it is a very specialized segment of the market. Historically, most muni investors seek capital preservation, not wealth creation, and only the most aggressive among them would consider this asset class. Mutual funds often perpetuate this perception, primarily to support their own business, by arguing that they are best equipped to analyze high yield investments. While there is a fair amount of retail demand for high yield municipal bonds, trading in this type of security should be reserved for well-educated investors. Valuation of high yield municipal bonds is often difficult due to the lack of comparable benchmarks for pricing, therefore the potential for mispricing and abuse is greater. Keeping in mind all the above, I do think it’s time to give high yield municipals their due as a legitimate fixed-income asset class, with clearly documented historical risk/return characteristics. After all, the corporate high yield market has also evolved from its Milken days and has now become a legitimate component of any broad fixed-income strategy.
MuniNet: How do you define a high yield municipal investment?
Nguyen: The broadest definition of a high-yield municipal opportunity is any issue whose investment performance is driven primarily by the underlying credit, and not as much by general moves in interest rates. By their nature, high yield municipal bonds are generally perceived to carry a higher credit risk and are, therefore, usually priced with an enhanced yield premium to compensate investors.
High yield bonds are issued by a state or local government or conduit agency which is either nonrated or rated below investment grade. High yield bonds are often issued to finance private-purpose projects, including, for example, hospitals, multi-family housing developments, retirement centers, waste recovery projects, etc. Some high yield investments are actually backed by private corporations who happen to have access to tax-exempt financing, ostensibly for economic or pollution control purposes.
MuniNet: What differentiates the high yield municipal bond market from the investment grade municipal bond market?
Nguyen: Besides the obvious difference in credit risk, liquidity and transparency are also two factors that differentiate the two markets. Because fewer broker/deals maintain a market in high yield municipal securities, there is less liquidity in the high yield market than its investment grade counterpart. Less trading activity also leads to a lower degree of pricing transparency.
Historically, we haven’t seen much overlap between the two markets, particularly due to the preponderance of bond insurance until recent years. But the economic downturn has brought the solvency of many state and local government issuers into question, and the line between the investment grade and high yield markets is beginning to blur.
MuniNet: What types of risks are associated with high yield municipal bond investments?
Nguyen: Most people tend to think of default risk when they hear the word, but it is important to understand the distinction between spread risk and actual default risk inherent in investing in high yield municipal bonds. Spread risk refers to a credit’s relative performance versus an index or other benchmark. Money managers often seek bonds that trade at spreads deemed too wide in the hopes that future credit improvements will lead to tighter spreads, which would allow the credit to outperform an index or universe of credits. The risk, of course, is that the spread will widen, rather than tighten. For active investors, spread risk is just as important a factor as default risk because it can impact the overall relative performance of a portfolio.
Default risk matters most to buy-and-hold investors. By definition, default risk is the risk that the borrower will be unable to repay interest and principal as scheduled. For most investors, default risk means “monetary default”. But there is also what we call “technical default”, which can encompass many events, from a short-term covenant violation to a more serious invasion of reserve funds. A technical default is usually a precursor to an actual monetary default, unless the obligor takes steps to cure it.
A high yield municipal bond is still a fixed income instrument, and is, therefore, still affected by changes in interest rate levels, so there is some interest rate risk
On certain types of private activity bonds, there is also potential taxability risk if the issuer, for some reason, uses bond proceeds for purposes that are not allowed by tax laws.
MuniNet: Are defaults and bankruptcies more prevalent among high yield municipal bond issuers?
Nguyen: Default risk is in fact significantly higher in the high yield municipal market. However, much of the default history has been concentrated in only a handful of sectors: taxing districts, housing, health care/congregate care and retirement housing. Moreover, while high yield issuers may default at a higher rate, the average size of default in dollar terms has been relatively small. This suggests to me that you can significantly improve your potential risk/return profile by staying away from only a few troubled sectors and by constructing a truly diversified portfolio.
With regard to municipal bankruptcy, what may cause some confusion – particularly in light of today’s headlines – is that default and bankruptcy do not necessarily go together. A municipal entity can file for Chapter 9 bankruptcy protection, but may choose to continue to pay debt service, thereby avoiding default. Conversely, if a municipal entity enters into default, it will generally lead down a path toward bankruptcy.
Project economics, including market position, budget conservancy, start-up allowances, should all be considered when assessing a project’s risk factors. Legal covenants should never be a substitute for sound credit analysis; investors should never put themselves in a position of having to test their legal protection. As you know, all bets are off when you end up before a bankruptcy judge.
MuniNet: While the book is a product of your expertise in this area, did you learn anything new or gain any additional insights into the high yield municipal market during the writing process?
Nguyen: Yes, taking a step back to analyze the market over the last few decades revealed to me that the risk profile for high yield municipal securities has largely tracked the ebbs-and-flows of the US economy and the credit cycle. Therefore, timing does matter greatly. In addition, I also found some recurring themes: the two types of risk that seem to trip up the market time and time again are health care and real estate.
MuniNet: Do you have a favorite chapter?
Nguyen: While I really enjoyed working on the entire book, I would have to say that Chapter 3, The Investment Case for High Yield Municipals, was the most rewarding for me to write. This chapter afforded me the opportunity to put forth a unique conceptual approach to investing in high yield municipal bonds. Whether or not you agree with my approach, this chapter should provide a good basis for spirited discussion among market professionals. I devoted a sub-section of the chapter to what I call “The Six Basic Tenets of High Yield Municipal Investing.” These basic principles are designed to guide investors who choose to participate in the high yield municipal bond market. While I believe that each of the six tenets is important, the two I would identify as the most critical are:
- Invest for after-tax total return; and
- Respect the credit and interest rate cycle.
High yield municipal bonds can be a profitable investment instrument, but only if potential investors carefully choose their entry and exit points and are fully aware of interest rate fluctuations and credit market conditions.
About the Expert:
Triet Nguyen is a thirty-year veteran of the fixed income markets and a high yield municipal bond expert. He was Senior Vice President at B.C. Ziegler in charge of tax-exempt high yield and taxable municipal bond trading, and Managing Director of Saybrook Capital, LLC, managing municipal bond hedge funds. In addition, Nguyen was President of Axios Advisors, LLC, a Vice President/Portfolio Manager of the Putnam Funds.
Nguyen received a BA degree in Economics and an MBA in finance and accounting from the University of Chicago.