May 31 (Bloomberg) -- The riskiest debt in the $3.7 trillion municipal market is on pace for the biggest rally since at least 1999 as a growing U.S. economy spurs investors to hunt for higher yields.
Powered by tobacco bonds, municipal securities ranked below investment grade or lacking a credit rating are gaining for the 18th straight month, Standard & Poor’s total-return data show. An advance in June would extend the streak to the longest in at least 14 years. The securities are joining a global high-yield rally. Bonds of Greece are the world’s best performers this quarter.
In the U.S., junk-graded munis are defying the steepest monthly loss this year in local debt. The gains in speculative munis come even as BlackRock Inc., the world’s largest asset manager, recommends that some investors scale back on the securities on the view that yields will rise. City and state bonds rated junk have earned 0.3 percent in May, compared with a 1.1 percent drop for the broader market, S&P data show.
“You have the so-called yield hogs, or just folks that want to earn more than 3 to 4 percent tax-free, who are going to migrate to the high-yield area,” said Alan Schankel, head of fixed-income research in Philadelphia at Janney Montgomery Scott. “There’s more comfort in doing that with a stronger economy underlying things.”
An expanding economy gives investors confidence to take added risk in weaker credits. State tax collections have risen 12 straight quarters, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. Property values in 20 cities rose 10.9 percent in the year through March, the most since 2006, the S&P/Case-Shiller index shows.
“Economic growth has caused the amount of municipal receipts to go up dramatically, and that makes high-yield a better bet,” said Scott Colyer, chief executive officer of Advisors Asset Management in Monument, Colorado, which oversees about $11.1 billion of assets.
High-yield munis have returned 3.4 percent this year, more than five times the rest of the tax-exempt market, S&P data show. Speculative-grade borrowings are ranked below BBB- by S&P, and lower than Baa3 by Moody’s Investors Service.
Yields on 30-year munis jumped this week to 3.3 percent, the highest in a year, part of a broader decline in fixed-income assets amid speculation the Federal Reserve will reduce its debt purchases. Yet that rate is still below the 3.93 percent average since January 2009, when Bloomberg data begin. That means demand persists for the extra yields on lower-rated munis.
The investor appetite benefited the largest-ever speculative-grade tax-exempt deal. The $1.2 billion issue from the Iowa Finance Authority, rated BB-, three steps below investment grade, has been gaining since its April 30 sale. Proceeds are slated for a nitrogen fertilizer plant.
The extra yield investors demand to buy the debt has shrunk. Bonds maturing in December 2025 traded May 30 with an average yield of 4.89 percent, about 2.8 percentage points above benchmark munis, Bloomberg data show. The gap is down from 3.3 percentage points when the bonds first sold.
In a deal this week, Delaware’s Health Facilities Authority issued $46 million of debt rated BB+, one step below investment grade, on behalf of Nanticoke Memorial Hospital.
For BlackRock, the junk rally is an opportunity to sell before interest rates jump and yield spreads widen. Muni buyers who typically favor safer debt should reduce high-yield while there’s demand, said Peter Hayes, who manages $114 billion as head of munis at New York-based BlackRock.
Yields on 10-year Treasuries will climb about 0.6 percentage point to 2.68 percent by the third quarter of 2014, according to the median forecast of 59 analysts in a Bloomberg survey.
“Look at your risk tolerance, and if you have more high-yield than you’d normally have in this market environment, then think about paring it back while liquidity is good,” Hayes said in an interview. “And the liquidity is still good because the returns have been there and demand is still there.”
Bonds repaid with tobacco revenue have helped high-yield munis outpace the market. Of the $91.8 billion value of high-yield munis in S&P’s index, tobacco obligations account for $25.8 billion. Such debt has earned 4.1 percent this year.
The bonds are backed by payments cigarette companies make to states as part of a 1998 settlement to cover the makers’ liability in health-care cost litigation. The debt is rallying after manufacturers in December said they would distribute $4 billion they had withheld because of a dispute over how their loss of market share would change their payments. Those sums are based on annual cigarette shipments.
“There’s more clarity about the non-participating manufacturers dispute,” Schankel said. “Certainty is always the friend of an asset class.”
In the broader municipal market, states and cities are poised to sell $3.8 billion in debt this week, the least since March, data compiled by Bloomberg show.
At 2.19 percent, the interest rate on benchmark munis due in 10 years is the highest since March 2012. The 0.44 percentage point jump in May is the biggest for a month since October 2009.
State and local bonds have followed Treasuries in slumping this week amid signs of an expanding economy. Federal debt maturing in 10 years yields 2.12 percent.
The yield ratio between the two asset classes rose to about 103 percent, the highest since May 2. The higher the ratio, the cheaper munis are relative to Treasuries.
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