Non-Rated Munis: “Big Boy & Girl Bonds”
Unlike the corporate junk bond market, the high yield municipal bond market has never broadly adopted the use of ratings. The lack of independent ratings presents a real risk for retail investors who attempt to reach for yield in the riskier municipal credits.
With over 1.5million different bonds outstanding representing over 50,000 issuers the municipal bond market is diverse in types of issuers, types of bonds, term structure and credit quality. Some issuers are very large and fairly frequent borrowers in the market, others are very small and infrequent borrowers.
There are two primary reasons for bonds to not have a rating by a Nationally Recognized Statistical Ratings Organization (NRSRO).
- Due to the cost of paying for a rating, or multiple ratings, a smaller issuer may forego obtaining a rating and the bonds come to market as non-rated bonds.
- Bond ratings below investment grade for new issues are just not as widely accepted as they are in the corporate bond market. Nor is there an incremental yield benefit for obtaining such a rating.
Many of these non-rated bonds are actually good credits that are simply bringing deals to market that are too small to benefit from the cost of the ratings themselves.
Many are also weaker, higher risk credits (high yield bonds) such as single source revenue bonds (senior housing, healthcare, multi-family housing, land development.) These risks these types of bond pose to investors can be difficult to understand and track. I call these bonds “big boy & girl bonds”. While they can be sold to individual investors they really are bonds that should be left to the institutional investor and the mutual fund community that have teams of analysts that specialize in following each individual segment of the market whether they be acute care facilities, assisted living facilities, nursing homes, resource recovery, development (dirt) or any other of a myriad of unique high risk issuers in the municipal bond market.
Recent trends in the bond markets, not just the municipal bond market, have reduced or even eliminated bondholder protections and covenants along with the reward of holding these bonds. These trends make these bonds even more risky. First, the ability of bondholders to intervene early in potential financial stress situations and take actions appropriate to protect the loan of money the bonds represent is severely hampered by these reduced or eliminated protections. Secondly, the risk v. return of these bonds has been elevated due to a severe supply / demand imbalance. Yields simply are not rewarding investors for the long-term risk.
My view is clear. If a bond is a single source revenue bond and it doesn’t have an investment grade rating, I am avoiding that bond at all costs. I would struggle to diversify my portfolio enough to offset the potential default risk and the inherent liquidity risk that distress can bring to that bond. I also would have difficulty tracking the underlying credit quality of that bond as its credit condition changed. If I want high yield exposure to the municipal bond market there are mutual fund and exchange traded fund options that offer a diversified exposure coupled with the value of having the bonds surveilled by analysts who specialize in doing so and are experienced in handling financially distressed situations they can create.
If tactical opportunities arise in this segment of the bond market, my view is to use exchange traded funds (ETFs) for that exposure. These ETFS have several benefits including low cost, diversification and liquidity. Liquidity to me is the ability to sell ETF shares when I want. When things turn bad, I want out and out quickly. Some passive ETFs to consider for tactical exposure include: SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB) and VanEck Vectors High-Yield Municipal Bond ETF (HYD) along with its short-term counterpart symbol SHYD. Why passive for tactical exposure? These are broad and well diversified ETFs and while distress and defaults happen the diversified exposure has inherent value to keep their impacts mitigated.
