May 29 (Bloomberg) -- Borrowing costs for municipalities rated BBB are approaching the cheapest levels since 2008 as cash floods into the riskiest investment-grade local-government debt.
The yield penalty over top-grade bonds on local debt rated BBB fell to 1.28 percentage points this month, the smallest since 2009, data compiled by Bloomberg show. The gap is set to shrink another 0.5 percentage point, said Mark Paris at Invesco Ltd. and Duane McAllister at BMO Asset Management U.S. That would drive it to levels last seen in July 2008, two months before Lehman Brothers Holdings Inc. filed for bankruptcy as the financial crisis deepened.
Investor appetite for BBB debt from issuers such as Pittsburgh and Puerto Rico has been whetted as localities are defaulting at half the pace of the past two years while demand is rising for high-yield municipal bonds. Muni yields close to four-decade lows are enticing investors to take more risk.
“The default pace is down, and there’s a tremendous bid for high-yield right now because there’s less fear of taking on risk,” John Hallacy, head of municipal research at Bank of America Merrill Lynch in New York, said in an interview.
Buoyed in part by a rebounding U.S. economy, localities’ fiscal health is improving. Twenty-eight issuers have defaulted this year, compared with an average of 62 for the same period the past two years, according to Municipal Market Advisors. That’s helped high-yield muni funds add about $1 billion in the past five weeks, the most since July, Lipper US Fund Flows data show.
Lower-rated municipals are benefiting from a flight to Treasuries and other fixed-income assets amid concern that Europe’s sovereign debt crisis is widening. The buying is helping keep state and city interest rates close to the lowest since the 1960s, even after yields rose the past two weeks.
Twenty-year general obligations yield 3.81 percent, compared with an average of 5.87 percent since 1961, according to a Bond Buyer index.
Investors looking to boost returns with high-yield munis, those with speculative ratings, are also finding less available. Issuers rated below investment grade have sold about $190 million this year, about a 10th of the five-year average, data compiled by Bloomberg show.
As a result, investors such as Invesco’s Paris, who oversees $6.6 billion in high-yield munis in New York, are moving up to BBB. Yield spreads on the debt may compress by a half-percentage point in the next three months, he said.
‘Pretty Wide’ Spread
“We’ve been aggressively buying BBBs in the last year-and-a-half because the spread has been pretty wide,” he said. “Spreads have come in significantly this year, but we’re still adding BBB paper because of where supply and demand are.”
Investors have pushed down yields on issuers such as Pittsburgh, with a BBB Standard & Poor’s rating. The extra yield on 10-year Pittsburgh bonds relative to top-grade debt fell to about 0.98 percentage point last week, the lowest since it was issued in January, according to Bloomberg data.
Puerto Rico Public Buildings Authority, with a grade in the BBB tier, may get a boost as it plans to sell $500 million of refunding debt as soon as next week, Bloomberg data show.
“High-yield players have money and normally would want to buy a BB credit, but they just aren’t out there,” said McAllister, who helps manage about $3 billion of munis in Milwaukee. At the same time, “high-grade people are stepping down in credit quality, which creates this convergence in BBB,” setting the debt up to rally 0.50 percentage point, he said.
The yield spread on BBBs remains wider than its historical average, giving it room to narrow, Paris said. The gap over AAAs has averaged 0.75 percentage point since 1992, Bloomberg data show. It peaked at 3.57 percentage points in February 2009, four months before the end of the recession.
Municipal debt rated BBB has returned 6.3 percent this year, beating the 2.4 percent gain for AAAs and the 3.9 percent increase for the entire $3.7 trillion municipal market, according to Bank of America data.
Following are pending sales:
The TRIBOROUGH BRIDGE & TUNNEL AUTHORITY plans to sell $225 million in revenue bonds as soon as tomorrow, according to an offering document. The proceeds will finance capital projects. Moody’s Investors Service on May 23 downgraded the agency one level to Aa3, fourth-highest. The debt will be sold competitively. (Added May 29)
LOS ANGELES COUNTY is set to issue $1.1 billion of tax- and revenue-anticipation notes that will mature in one year, according to sale documents. Proceeds will help pay expenditures in the fiscal year that begins July 1. (Updated May 29)
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