The riskiest revenue debt in the $3.7 trillion municipal market has provided the best returns this year, as the quest for extra yield masks the segment’s likelihood of default.
Industrial-development revenue bonds, issued by local agencies on behalf of companies, have returned 10 percent this year, the most among 16 revenue-debt types tracked by Bank of America Merrill Lynch indexes. That compares with a 5.4 percent gain for the broader market.
About 28 percent of muni defaults from 1958 to 2011 were on the development securities, the most of any area of local debt, according to a Federal Reserve Bank of New York blog post that combined rated and unrated failures to pay. Investors are looking past the trend, pouring money into high-yield funds with interest rates near the lowest in a generation.
“Some of the purposes of industrial-development revenue bonds were nebulous,” said Peter Hayes, head of municipal bonds at New York-based BlackRock Inc., which oversees about $105 billion in local debt. “People have to understand there’s more inherent risk in that sector, and they have to understand what they own. Clearly there’s a reach for yield taking place.”
The Fed’s policy of keeping its key lending rate near zero has caused investors to flock to riskier assets. High-yield muni funds have attracted about $5.6 billion this year, Lipper US Fund Flows data show. That compares with $32.5 billion in outflows for high yield over the same period last year following Meredith Whitney’s December 2010 prediction of “hundreds of billions of dollars” of defaults within a year.
Industrial-development debt poses the most risk among revenue bonds, according to Bank of America data. The average rating is equivalent to Baa1 from Moody’s Investors Service, three levels above junk. The penalty on 10-year debt with a similar rating narrowed to about 1.2 percentage points above top-rated bonds this week, the least since December 2008, data compiled by Bloomberg show.
Investors are gaining more from industrial-revenue debt than from similarly rated company borrowings. Corporate bonds rated BBB have returned 7.5 percent this year, trailing their muni counterparts by the most since at least 2005, Bank of America data show.
U.S. corporate securities rated BBB+, Standard & Poor’s third-lowest investment grade, have an average default rate of 6.05 percent after 15 years, compared with 0.19 percent for similarly rated munis, according to the New York-based rating company.
Still, the bonds are the most-volatile revenue debt, making the returns only sixth-best on a risk-adjusted basis, according to data compiled by Bloomberg and Bank of America. When factoring in volatility, the gain this year is 3.9 percent, trailing single-family housing, tobacco, hospital, multifamily housing and health.
The New York Fed’s Aug. 15 posting, “The Untold Story of Municipal Bond Defaults,” analyzed data on rated bonds from S&P, Moody’s and Fitch Ratings, along with unrated debt tracked by Mergent Inc. and S&P Capital IQ. The researchers said municipal failures-to-pay “happen much more frequently than most casual observers are aware.”
Industrial-development defaults occur most often with projects that use new technology or that lack a track record, according to the blog post.
Buying the securities is “identical to investing in a corporate bond,” said Matt Fabian, managing director at Concord, Massachusetts-based Municipal Market Advisors. The most-frequent issuers to default are smaller ones that would finance their projects through private investments or local banks if not for economic-development agencies, he said.
Bigger corporations have also sold the development debt and come under distress. American Airlines parent AMR Corp., which filed for bankruptcy in November, sold municipal securities through airports and local authorities to pay for gates and hangars.
The average yield on an AMR bond maturing in 2029 issued by AllianceAirport Authority Inc. in Texas rose to 28.4 percent after the filing from 11.6 percent before, according to data compiled by Bloomberg. The interest rate has declined since, touching 8.86 percent in July.
“Unlike a traditional municipal bond, in many industrial- development bonds we have collateral, which helps with the recovery in the event of a problem,” said Mark DeMitry, a senior portfolio manager at OppenheimerFunds Inc. in Rochester, New York. He helps run the $6.8 billion Oppenheimer Rochester National Municipals fund, which holds speculative-grade debt.
“These entities are more suspect to the ups and downs of economic cycles,” DeMitry said. “It certainly goes to show you how strong traditional municipal credit is.”
The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. The returns aren’t annualized.
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