March 19 (Bloomberg) -- The riskiest part of the municipal-bond market is off to its best annual start in five years as Puerto Rico’s record $3.5 billion junk deal leaves demand for higher-yielding securities unslaked.
Tax-exempt local debt ranked below investment grade or lacking a rating has gained 6.2 percent this year through March 17, beating the broader market’s 3.6 percent advance, according to S&P Dow Jones Indices. Similarly rated company bonds have earned 2.7 percent, Bank of America Merrill Lynch data show.
With municipalities defaulting at a third of the pace of the past two years as the U.S. economy expands, investors are gaining confidence in lower-rated munis. The improving backdrop is reviving demand after Detroit’s historic bankruptcy filing in July and as Puerto Rico’s sale this month bought the struggling U.S. territory at least 15 months of breathing room.
“After a good six to 12 months of negative headlines, people are beginning to understand the risks and rewards and have voted with their money,” said Gary Pollack, who oversees $6 billion of munis as managing director in Deutsche Bank AG’s private-wealth unit in New York.
Investors in the $3.7 trillion market have added cash to U.S. high-yield muni mutual funds for the past 10 weeks, the longest stretch since September 2012, Lipper US Fund Flows data show. The purchases are a reversal after withdrawals in every week but two from October through December.
The demand is fueling a flip-flip from last year, when junk-rated munis lost 4 percent, more than the 2.6 percent decline for the rest of the local-debt universe, S&P data show. Junk issuers are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
Borrowers such as Pace University stand to benefit from the junk rally. The school is set to sell as much as $110 million of debt this week to build dormitories and other facilities on its campus north of New York City. S&P cut it to BB+ in January, its top speculative grade, partly because of the increase in debt.
Puerto Rico’s March 11 sale of general-obligation debt was the biggest junk offer ever for a state or locality, according to data compiled by Bloomberg. The deal priced to yield 8.73 percent, or 93 cents on the dollar, after speculation a few weeks earlier that the borrowing would need to carry an interest rate of at least 10 percent.
The self-governing territory’s economy has shrunk 14 percent since 2006, spurring speculation the island would struggle to repay $72 billion of commonwealth and agency debt.
Investors who typically buy other types of distressed assets participated in the Puerto Rico sale, with hedge funds accounting for the majority of buyers, according to David Chafey, chairman of the Government Development Bank, which handles the island’s debt transactions.
Puerto Rico’s finances affect the broader muni market because about 70 percent of U.S. muni mutual funds hold the securities, which are tax-exempt nationwide, according to Morningstar Inc.
While non-traditional muni buyers buoyed demand for the sale, the borrowing gave investors confidence that there would be enough appetite for last week’s $12.8 billion of long-term issuance. It was the biggest wave since 2010.
The sale “contributed to a very positive sentiment and outlook,” said Jim Colby, who helps manage $1.8 billion of munis as a senior strategist at Van Eck Global in New York.
Puerto Rico has led the junk muni gains, earning about 8.8 percent in 2014, the best annual start since at least 1999, S&P data show. The island’s new general-obligation bonds traded yesterday with an average yield of 8.56 percent, or 0.17 percentage point less than where they priced.
For junk munis, the 2014 start is the best since they earned about 6.5 percent at the same point of 2009, en route to a 35 percent gain that year.
The $819 million Market Vectors High Yield Municipal Index ETF, the biggest exchange-traded fund for high-yield munis, traded at $29.53 per share yesterday, close to the highest since August, Bloomberg data show.
There are signs that high-yield can keep rallying.
The extra yield that riskier munis offer compared with the broader market still exceeds the historical average, Colby said. The yield on an index of high-yield munis was 6.81 percent March 17, or 4.15 percentage points above the broader muni market, Barclays Plc data show. Over the past decade, that spread has averaged 3.11 percentage points.
“That tells me that high-yield has got a ways to go,” Colby said.
The waning number of defaults almost five years after the 18-month recession is also bolstering confidence.
Five issuers have missed payments for the first time this year, less than a third of the tally at the same point in the past two years, according to Concord, Massachusetts-based Municipal Market Advisors.
“Impairments in one form or another and big headlines throw a scare into the investment community,” Van Eck’s Colby said. “But soon they come to realize that it doesn’t infect the entire municipal marketplace with bad performance or erosion of value.”
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