Smart Money Wants Mediocre BBB Instead of Top Grade: Muni Credit

Investors are pouring the most money since September into the riskiest U.S. local debt, a boon to lower-rated issuers such as Puerto Rico that plan to borrow in the $3.7 trillion municipal market in coming weeks.

The cash infusion is leading speculative grade munis to a 2 percent gain to start the year, beating the broader tax-free market and drawing a buy recommendation from Citigroup Inc.

Puerto Rico debt is ranked BBB-, one step above junk, by Standard & Poor’s. It is earning more this month than all 27 states tracked by S&P, staging the longest rally since November. Puerto Rico officials want to sell bonds this month or in February, after they said soaring yields last quarter derailed a deal of as much as $1.2 billion of sales-tax debt.

“People are looking to maximize their income opportunities and that’s why they’re migrating down to some lower-rated credits,” said Peter Hayes, head of munis at New York-based BlackRock Inc, which oversees about $108 billion in local debt.

This month’s advance in high-yield munis is beating 1.5 percent gain for the entire municipal market. Tax-exempt securities are rebounding after the steepest annual decline in five years.

Flowing In

Last week, investors added money to muni mutual funds for the first time since May. High-yield managers received $276 million, the most since September, Lipper US Fund Flows data show.

The extra yield on lower-rated debt offers a buffer as bets mount that a growing economy will push up interest rates, Hayes said.

Bonds in S&P’s speculative-grade muni index yield about 6.7 percent on average, equivalent to 11.1 percent on a taxable basis for top earners. In comparison, the S&P index tracking the entire tax-free market yields about 3.7 percent.

Interest rates on 30-year Treasuries will climb by about 0.5 percentage point to 4.25 percent in the fourth quarter, according to the median forecast of 50 analysts in a Bloomberg survey. Bond prices move in the opposite direction of yields.

“More income will give you a better cushion against any potential move down in price,” said Hayes. “But I think the move down in price will be somewhat muted.”

Investors are returning to high-yield munis after the securities cheapened last year, said Daniel Solender, who helps manage $15 billion of local debt at Lord Abbett & Co. in Jersey City, New Jersey.

‘Knocked Down’

“It was knocked down the most last year given that a lot of redemptions were coming out of the high-yield range” or longer maturities, he said. “So they really underperformed.”

Debt of junk-grade localities lost 4 percent in 2013, compared with a 2.6 percent decline for the entire market.

New York-based Citigroup is directing the maximum allowed proportion, 20 percent, to high-yield local debt in its $1 billion muni model portfolio, analysts led by Mikhail Foux said in a Jan. 16 report.

Puerto Rico is proving to be one of the biggest beneficiaries of heightened demand for riskier local obligations. Its bonds have climbed 2.8 percent this month.

Commonwealth borrowings have rallied even as Moody’s Investors Service threatened last month to cut the island to junk within 90 days and as the island struggles to grow its economy. Yields on Puerto Rico securities set record highs following Moody’s warning, Bloomberg data show.

Payment Plan

The island of 3.6 million people wants to sell bonds to repay debt used to balance budgets for last year and this year. If the territory is unable to borrow through capital markets, that could put its investment-grade rating at risk, Moody’s and S&P have said.

In the municipal market this week, the Port Authority of New York and New Jersey leads states and cities selling close to $5 billion of long-term debt, Bloomberg data show.

The governments are borrowing with benchmark 10-year munis yielding 2.7 percent, close to a two-month low and compared with 2.82 percent for similar-maturity Treasuries.

The ratio of the interest rates, a measure of relative value, is about 96 percent, close to the lowest since May. The lower the figure, the more expensive munis are relative to federal securities.

Port Authority plans to sell $1 billion of taxable revenue debt as soon as this week, Bloomberg data show. Proceeds will finance redevelopment of the World Trade Center, according to bond documents.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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