Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Investors have been barreling into the high-yield municipal bond category so far in 2019. Joining me to discuss what investors need to know about the category is Morningstar's senior analyst Eric Jacobson.
Eric, thank you so much for being here. It's good to have you here in person.
Eric Jacobson: Hi, Christine. It's great to be with you.
Benz: Let's talk about the tax advantages of munis generally before we get into this high-yield subset. Why have investors been especially attracted to munis of late?
Jacobson: So, as you know, some of the tax law changes have made it even harder for people to take advantage of deductions and so forth. And so, people are just in search of a way to gain income without having it be taxed or disallowed, what have you. So, that always is something that will make municipal bonds that have tax advantages more appealing to people.
Benz: So, municipal bonds are typically free of federal income tax and they may be free of state and local income tax depending on what muni you invest in?
Jacobson: Right. Depending on how you look at the geography, a lot of the high-tax states are really in such a way that investors in those states really can use and have demand for municipals even more than they already did. Because as you know, if you have states where they don't tax the interest from their own bonds, it's a big deal. And if you live in New York City, for example, things like that, where you can get triple-tax-exempt.
Benz: And this state and local tax cap, this SALT tax cap, makes it even more attractive for people residing in those states to try to get some tax-free income.
Jacobson: Exactly.
Benz: So, let's get into this subset of high-yield municipal bonds. I want to talk about flows into the category. But first, what are we talking about? Is it analogous to the taxable high-yield bond category in that these are kind of junky credits that have higher yields?
Jacobson: So, it's interesting. It's a little bit of a misnomer.
Benz: OK.
Jacobson: It's an important distinction but it's not a hom*ogenous kind of category. So, for example, in taxable high-yield, you can look at that universe and you can see a pretty clear circle around the companies and the kinds of bonds that you will find in that universe. They are generally below investment-grade, they have ratings that are either BB or lower, and most of the names in that space have ratings, okay? And the usual suspects in terms of industries, often a lot of capital-intensive things, but often things that have a lot of buyout activity and generating a lot of income. But whatever the universe is, and it is kind of broad, it's a known, pretty specific universe. It's not huge in terms of the breadth. It's a big market, but anyway…
Benz: That's the taxable…
Jacobson: The taxable side. On the muni side though, it's very, very fragmented. Now, the muni market itself is very fragmented. But once you get into the muni high-yield space that we might think of, first of all, there's not a good clear technical wall. Like as I said before, in taxable high-yield, it's below investment-grade.
Benz: Right.
Jacobson: In municipal high-yield--and this is a little bit debatable on the part of certain people--but generally speaking, in the municipal world, most people think of BBB as being part of the high-yield muni universe. So, even though BBB is technically investment-grade if you look at outside ratings, those bonds tend to be favored by high-yield muni funds. They tend to get lumped together with them. You'll hear arguments that their default occurrence is a lot lower than corporate BBB, for example, and there's some truth to that in terms of the default history. But if you're looking at the universe that high-yield muni funds are involved in, it starts there. The other issue is that there are a lot of smaller nonrated issues.
Benz: OK.
Jacobson: They do cluster in certain sectors, including for nursing homes, for example. But they're really tiny often and they don't have a third-party rating because it's usually not economical for them to pay for the rating.
Benz: OK.
Jacobson: So, there's just a lot--it's a very heterogeneous universe in that regard.
Benz: Those nonrated credits may not necessarily be junky. It's just maybe not efficacious or economical for them, as you say, to pay for the rating?
Jacobson: Right. And that's absolutely true. And I'm not calling any fund manager a liar when I say this, but sometimes it doesn't matter. And what I mean by that is, yes, the ultimate default experience can be low and in the sense of you can have these issuers that are not going to default, but the bond may be very small, and it may not be widely held. And what that means is, if we're in a financial crisis of some kind, even if it's a little mini crisis, a bad quarter or a bad half year, what have you, bonds like that could still become very illiquid. And when that happens and people are selling and the pricing agencies mark prices down, it really doesn't matter whether the quality is that high. And I'm mentioning that mainly because, if you own a fund that owns lots and lots of nonrated, not only do you not know for sure, just because the manager says it's high-quality, but it may not matter that much just in terms of day-to-day pricing.
Benz: And we saw that on display during the financial crisis, right? Munis as a group had some liquidity issues and my guess is that that nonrated subset, the higher-yielding nonrated, also had some liquidity problems.
Jacobson: Absolutely.
Benz: So, let's get into what you've been seeing in terms of flows. It's pretty interesting. They had been pretty tempered until this year when we saw the big spike. Do you think it is, as we discussed at the outset, that this tax law change has prompted some investors to really gravitate to munis in general? Or what do you think is going on there?
Jacobson: Yeah, I don't think anybody knows for sure. But I definitely think that's a very plausible reason. A lot of times there's more than one driver behind that. But that would seem to be a pretty likely situation, given the recency of the tax law change, and now that it's started to hit people and so forth. I mean, there's always going to be some demand for high-yield munis among people that are looking for extra income, especially in the kinds of environments we've had in the last several years with interest rates so low. So, I would suggest that any time you have a marginal change, like tax law change or what have you, that's probably going to spike it also.
Benz: So, assuming I'm looking at this category, and it appears that a lot of investors are, what should I know beyond some of the things that we've already discussed? I guess a key question for me would be, can I look at this as sort of core muni exposure? Is it something that I would maybe bolt on once I've got my core high-quality muni exposure?
Jacobson: I would absolutely advocate not using it as a core, but rather as a bolt-on and I would be very, very careful. And the reason I say that is, I really want to distinguish between what this is and what a high-yield taxable fund is like. You know, the sectors are different. This thing about the nonrated stakes is different. We haven't had a recent catastrophe of any kind, but over the arc of time, we've been through periods where individual funds have gotten in a lot of trouble for one reason or another. You really have to have a manager that you believe in and trust and so forth. And regardless of the case, I would be really careful looking at how much of the fund is not rated.
If you see a high-yield muni fund that advertises itself as that and you can't tell how much is in nonrated, I would either call and ask the fund company or don't mess with the fund. Because that's a really important piece of information and it's hard to suss out sometimes. And basically, what it gets down to is, the more nonrated exposure you have in a fund, the more important that the rest of the fund is to be very, very liquid. And the bigger risk it is just in general. If some exogenous factor causes, I don't want to call it a run per se, but a wave of outflows, certainly for the sector as a whole, but absolutely for your specific fund or fund complex, that could become an issue and it could drive prices down.
Benz: And how helpful is yield in this context? Should I in addition to maybe doing some of the due-diligence at the portfolio level is yield a much--say, I'm looking at a fund and it has a much higher yield than the peer group, is that a red flag that there's something cooking in that portfolio that might introduce risks at a later date?
Jacobson: Absolutely. I like to tell people, there's no truer indicator. Now, what I mean by that is, I'm not going to tell you that the highest-yielding fund in every category is automatically a red flag. I would always want to dig in and understand why that number is the way it is. Sometimes it's time period shifting, and there are quirks that can cause these things. But by and large, you can look at ratings, you can look at names. All those things are sort of second-level stuff. When you see the yield on a fund or the yield on a portfolio, that's an indicator of how much the market thinks there is risk embedded in it. In other words, when the market sees risk, it drives the price down, it drives the yield up. The highest-yielding fund in any group is almost always by definition, almost always, going to be the most aggressive. Now, you may see one and if you really like it, you want to understand why it's doing what it's doing. But definitely understand: If it's at the higher end of its category, it's doing something to get there. And sometimes, it may just be liquidity risk. It may not be absolute credit risk. It may be liquidity risk, it could be maturity, it could be taking a lot more duration, a lot longer maturities and so forth. But you really want to make sure you understand and are comfortable with what those factors are before jumping in.
Benz: Eric, always great to get your perspective. Thank you so much for being here.
Jacobson: It's great to be with you, Christine. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.
