BlackRock Inc., the world’s largest asset manager, suggests scaling back on lower-rated municipal debt even as the bonds rally the most in almost five years.
Investors in the $3.7 trillion municipal market are buying riskier issues for their higher yields as interest rates on 20-year bonds remain below their five-decade average. The extra yield investors demand to buy 10-year tax-exempt munis rated BBB, or eight steps below top-grade debt, has shrunk to 0.97 percentage point, close to the least since September 2008, data compiled by Bloomberg show.
The rising demand presents an opportunity to reduce holdings as signs of a strengthening economy raise the prospect that interest rates will rise this year, said Peter Hayes, BlackRock’s head of munis. The New York-based firm oversees about $109 billion in local securities.
“If you’ve taken too much risk in high-yield, it’s a good time to take some risk off the table there because you have to take advantage of liquidity while it’s good,” Hayes said at a media briefing at the firm’s Manhattan office. “And liquidity is still very good in that market.”
The securities are delivering earnings that are more than double the broader muni market. High-yield munis earned 14.6 percent in the past 12 months, compared with about 6 percent for all munis, according to Barclays Plc data.
Higher interest rates will erode those gains, Hayes said.
He anticipates 10-year Treasury yields will increase to about 2.2 percent by year-end from 1.75 percent today.
Yields on 20-year general obligations were 3.96 percent last week, below the 5.86 percent average since January 1961, according to a Bond Buyer index.
Hayes suggests buying munis with a higher credit grade, from four to six levels below top-rated securities, which still carry loftier yields yet have lower default risk than munis rated junk.
From 1970 to 2011, an average of 7.9 percent of munis that were sold a decade or more earlier and had a junk rating from Moody’s Investors Service defaulted, compared with 0.08 percent for investment grade.
When interest rates climb, investors will move back to higher-rated securities and away from speculative-grade munis, Hayes said. Yields on junk debt would then need to increase to bring in other investors, Hayes said.
“Once rates go up, high-yield rates will have to adjust to attract hedge funds and other type of non-traditional muni buyers,” he said.