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Non-Rated Issues on the Rise, and Why it Matters

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Non-Rated Issues on the Rise, and Why it Matters

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Strong start to 2019

Municipal bond funds are on pace to take in a record number of net inflows this year. Investors put nearly $41 billion into municipal bond funds through just five months, making 2019 already the third largest year of inflows since Morningstar began recording flow data in 1993 (Figure 1). The market’s received support from stabilizing and then eventually decreasing U.S. Treasury yields as well as a more dovish Federal Reserve, however the main tailwind is perhaps the recent changes to the country’s tax code. Tax-exempt municipal bonds have been a haven for investors seeking to reduce the impact of now-limited state and local tax deductions.

Figure 1 – Through May 31, 2019 YTD municipal bond fund flows have already surpassed all but two past calendar years

Calendar Year and YTD 2019 Municipal Bond Net Flows Since 1993 ($ Billions)

Source: Morningstar, as of 5/31/19.

Municipal bonds have performed well YTD with the investment grade segment (Bloomberg Barclays Municipal Bond Index) returning +4.8% and the below investment grade segment (Bloomberg Barclays High Yield Muni Index) returning +6.3% (as of June 17, 2019).

Yields have dropped in response to the strong start, most notably in the below investment grade market. The high yield index yield to worst (YTW) fell to an all-time low of 4.4%, based on monthly results, looking back to its start date in October 1995 (Figure 2). Despite the trend, on a tax-equivalent basis, high yield and investment grade municipals have offered more compelling yields than their taxable fixed income counterparts (Figure 3).

Figure 2 – High yield municipal yields recently touched an all-time low

Bloomberg Barclays High Yield Muni Index

Yield to Worst

Source: Bloomberg Barclays, as of 5/31/19

Figure 3 – Municipals still offer compelling tax-equivalent yields 

Source: Bloomberg Barclays, as of 5/31/19. Tax-equivalent yields assume the top federal tax bracket of 37%, plus the 3.8% Medicare tax, and do not include local income taxes, which may impact the outcome. An investor’s actual federal tax rate will vary depending on income, investments, and deductions. The tax information shown is current but subject to change. Investors should consult their tax advisor to understand how changes in tax legislation or state and local income taxes, where applicable, may affect their personal financial situation.

Riskier borrowers are taking notice

Borrowers with lower or no credit ratings (i.e. unrated or non-rated) have taken notice of cheaper borrowing costs. The large appetite this year for tax-exempt bonds, especially within high yield, has driven down financing costs on some of the traditionally riskier deals, such as debt financings tied to continuing care retirement facilities. While overall municipal default rates since 1970 are low at 0.17%, continuing care retirement facilities, along with the housing sector, have accounted for 39.8% of the total. (Source: Moody’s US Municipal Bond Defaults and Recoveries, 1970-2017). Unrated issuers have also stepped up issuance. In April 2019, municipal investors lent one unrated borrower approximately $2 billion to fund a corporate-backed transportation project, representing one of the largest deals for an unrated issuer in the last several years. Through June 18, 2019 non-rated issuance totaled $14.2 billion, representing a 140% increase from the same period in 2018 (Figure 4).

Figure 4 – Non-rated issuance is up 140%, or $8.3 billion, year-over-year

Non-rated Municipal Bond Issuance


Source: Bloomberg Barclays, as of 6/18/19. YTD 2019 excludes $3 billion of restructured Puerto Rico bonds.

Why should investors care?

Unrated bonds typically have higher yields but may also carry increased credit and liquidity risk. Debt in this category is routinely tied to smaller, more speculative projects, sometimes backed by corporate entities, and may have less secure sources of revenue compared to other sectors that provide essential services, like water utilities. Furthermore, not all buyers are willing to own non-rated bonds, whose issuers are often relatively unknown, so their liquidity is reduced.

In light of current market developments, we believe that when assessing municipal bond funds, investors should consider choosing managers that actively manage to capture total return while also maintaining underwriting discipline during periods of market exuberance by properly mitigating liquidity and credit risk.

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