Muni `Greed Factor' Helps Lower-Rated Debt Outperform Amid Yield Decline

Municipal debt rated two levels above high-risk junk outperformed top-rated bonds in August as investors sought higher returns amid record low yields.

The extra yield investors demanded for buying debt rated BBB, the second-lowest investment grade, fell from 165 basis points in mid-August to 150 basis points on Sept. 1, the lowest in almost three months, according to data compiled by Bloomberg. A basis point is 0.01 percentage point.

“It’s an outright search for yield,” Gary Pollack, who helps oversee $12 billion as managing director of fixed income for Deutsche Bank AG’s Private Wealth Management unit in New York. “Investors dipped down in credit quality to capture some yield.”

Yields on top-rated tax-exempt municipal bonds due in 10 years were unchanged yesterday after falling 1 basis point Sept. 3, or 0.01 percentage point, to 2.62 percent, according to data from Concord, Massachusetts-based Municipal Market Advisors. The yields, which move inversely to prices, reached 2.58 percent on Aug. 25, the lowest since MMA began compiling the data in January 2001.

The move from more creditworthy obligations to pursue higher returns may not be the safest strategy amid mixed reports on the strength of the economic recovery, according to a Sept. 2 report from John Dillon, fixed-income strategist for Morgan Stanley Smith Barney.

“This is not the time to over-reach for yield by dipping too low in credit quality,” Dillon wrote.

Colorado Borrowings

Colorado’s Regional Transportation District, whose $398 million Aug. 4 issue carried the lowest investment-grade rankings from Moody’s Investors Service and Fitch Ratings, Baa3 and BBB-, sold 20-year bonds at a premium of 104 cents on the dollar. That compares with a $635 million issue from Minnesota, rated AAA by Fitch and Standard & Poor’s, which had 20-year bonds sell at par.

The trend is likely to continue as municipal yields are depressed by investor demand amid weakened supply, Pollack said.

Money has flowed into long-term bond mutual funds, the largest institutional holders of municipal debt, for at least five consecutive weeks through Aug. 25, according to the Investment Company Institute, a Washington-based trade group. Fund investors added a net $1.12 billion to municipal securities in the week ended Aug. 25. The 30-day visible supply averaged $6.5 billion in August, almost $4 billion below the daily average for the last year.

Muni yields have room to continue falling, which may prompt investors to extend their search for yield among riskier debt, according to Pollack.

‘Greed Factor’

“It’s a greed factor rather than a fundamental good idea,” Pollack said. “It’s dangerous for an investor to assume the safety of munis.”

Harrisburg, Pennsylvania’s capital, revealed last month it would not be making $2.2 million in Sept. 1 bond payments it had guaranteed on behalf of the Harrisburg Authority. The city has considered seeking bankruptcy protection to cope with the $68 million in debt service it is responsible for in 2010.

“The credit picture for state and local governments remains open to debate and clearly difficult,” Dillon wrote. “Credit headwinds will likely persist into fiscal 2012 for many issuers.”

Following are descriptions of pending sales of municipal debt in the U.S.:

NEW YORK CITY MUNICIPAL WATER FINANCE AUTHORITY, which finances the capital needs of the water and sewer system in the most populous U.S. city, plans to sell $600 million of Build America Bonds on Sept. 16. The securities are rated second- highest by S&P and Fitch, at AA+, and third-highest by Moody’s, at Aa2, and will be marketed by a group led by Barclays Plc. (Added Sept. 8)

FLORIDA STATE BOARD OF EDUCATION is set to issue $223.4 million of bonds backed by a portion of the state’s lottery income as soon as this week. The offering, which will be used to refund earlier issues, was rated A1 by Moody’s, fifth-highest. S&P, which has not rated the current issue, in July gave the previous issue its AAA rating. After selling the bonds, the state will have about $3.1 billion of lottery bonds outstanding. (Added Sept. 8)

NORTH CAROLINA EASTERN MUNICIPAL POWER AGENCY, a wholesale power supplier to 32 cities and towns, plans to sell about $182 million in tax-exempt and taxable bonds today to refinance existing debt. The offering, rated by A- by S&P and Fitch, the fourth-lowest investment grade, will be marketed by underwriters led by Citigroup Inc. (Updated Sept. 8)

To contact the reporter on this story: Brendan A. McGrail in New York at bmcgrail@bloomberg.net;

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