public finance rating upgrades exceeded downgrades (by 33 to 20), marking the fourth consecutive quarter for net upgrades. As further evidence, during the first quarter of 2015, Fitch’s U.S. With spreads being compressed in most fixed income sectors, and the credit cycle nearing the latter stages, where does high yield municipal stand then? Historically, municipalities lag the corporate credit cycle, primarily due to the lagged effect of tax receipts in an improving economic environment.Īccording to Morgan Stanley research, 7 when the economic cycle is in a late expansion, municipalities tend to be in an early expansion phase. In this case, spreads are slightly wider than average. Given that the Morningstar average credit quality of high yield municipal funds 5 is BBB (which is technically Investment Grade), and many invest in a combination of high yield and investment grade securities, we think looking at the BBB municipal spread to the AAA municipal spread is a relevant alternative value indicator. A major driver of spreads today is the index concentration of Puerto Rico and Tobacco securities 3, two higher yielding sectors that comprise 45% of the Bloomberg Municipal High Yield Index. 2 With that said, we think it would be imprudent to consider spreads alone. The spread of high yield municipal to investment grade municipal is 1.2 standard deviations wide. The image below would suggest that the municipal high yield sector is very attractive today relative to history. Additionally, it is important to combine this with an analysis of the municipal credit cycle. To make a reasonable assessment, investors need to know what is driving spreads in the market. We think it is important to present both cases. Today, valuations can be presented as being very attractive, or they can be considered average. High Yield Index, DJIA: Dow Jones Industrial Average Index, NASDAQ Index, S&P 500 ® Index, Russell 2000 ® Index. Credit Index, Global Treasury: Bloomberg Global Treasury Index, Muni HY: Bloomberg Municipal High Yield Index, US HY: Bloomberg U.S. Agency Index, MBS: Bloomberg Mortgage Backed Securities Index, Aggregate: Bloomberg Aggregate Bond Index, Euro Dollar: Bloomberg Eurodollar Bond Index, Muni: Bloomberg Municipal Bond Index, US Credit: Bloomberg U.S. Indexes referenced: Agency: Bloomberg U.S. ** Based on an equally weighted national average federal and state (top bracket) income tax rate local taxes have not been considered. Note:* US Treasury income is exempt from state income taxes and is adjusted using a national state average (top bracket), net of federal income tax. However, for a sector that has historically produced tax equivalent returns similar to equities at half of the volatility but with increased risk, we think tax-sensitive investors should consider taking another look. Whether it be the size of the sector (only $94 billion in size) 1, or the amount of due diligence required to access the sector as compared to the investment grade municipal sector, many clients invested in tax-managed solutions may be under exposed. Municipal High Yield sector can often be overlooked in a tax-managed portfolio.
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