High yield municipal bonds have experienced a period of strong performance over the last several years. Robust U.S. tax-adjusted performance relative to other asset classes, coupled with U.S. investors’ growing appreciation of federal tax-exempt income in a low-rate world, drove a steady stream of inflows that pushed high yield muni fund assets to record levels. At this juncture, however, lofty valuations are beginning to give some investors pause.
We believe there is still a strong case to be made for high yield municipals in U.S. taxable portfolios. The global macro backdrop remains supportive of the asset class. The combination of continued U.S. GDP growth and muted global inflation expectations leaves municipals in what we believe to be a macro sweet spot. Credit fundamentals continue to improve, without a lot of upward pressure on long-term U.S. interest rates. Low municipal bond default rates compared to similarly rated corporate bonds and relative stability amid global volatility – even in the wake of post-Brexit uncertainty – add to municipals’ value as a portfolio diversifier.
The municipal federal tax exemption remains extremely valuable for U.S. tax-conscious investors. On a tax-adjusted basis over the past decade, high yield munis have delivered equity-like returns with about half the volatility.
However, some pockets of the high yield municipal market have become less attractive on a risk-adjusted basis. In particular, we see many long-duration, less-liquid sub-investment-grade valuations as stretched. Caution is warranted in portfolio construction and credit selection.
Municipals – a “safe-haven” asset?
Beginning in the second half of 2015 and into 2016, global markets saw a marked increase in volatility. Shifts in China’s foreign exchange policy and concerns about slowing global economic growth sparked anxieties over waning commodity demand and falling asset prices. As U.S. investors fled taxable high yield corporate funds throughout 2015 and early 2016, high yield municipal funds continued to attract inflows (see chart).
Consistent investor demand helped high yield munis avoid much of the volatility that hit the U.S. taxable high yield market. Spreads between sub-investment-grade municipals – excluding Puerto Rico and high yield tobacco bonds – and investment grade municipals were driven to the tightest levels seen in years.
Over the secular horizon, PIMCO sees growing left tail risks for the global economy. Investors should be compensated for taking additional risks as uncertainty increases. The municipal market is no exception.
We believe high yield munis are now best viewed through a late-cycle lens. We prefer more liquid BBB- and BB+ rated debt from larger issuers, more moderate duration positioning and higher allocations to cash. While this may mean sacrificing some near-term distribution yield, we believe it is the more prudent way to go for long-term investors.
Read more: PIMCO Insights on Municipal Bonds
David Hammer is head of PIMCO’s municipal bond portfolio management.