Investors seeking higher yields as the economy grows are making a winner of the biggest exchange-traded fund that tracks the municipal market’s riskiest securities.
The $868 million Market Vectors High Yield Municipal Index ETF, called HYD, has added about $100 million this year, according to data compiled by Bloomberg. That’s the most among 42 ETFs focusing on state and local debt.
Investors are boosting bets on junk-grade munis as local finances strengthen with the economy while defaults ebb. With benchmark yields close to 10-month lows, buyers have an extra incentive to add lower-rated munis and ETFs that track the securities, said Bart Mosley, co-president at Trident Municipal Research in New York. HYD’s inflows picked up in April, when it added $59 million.
“High yield is leading the pack because people are reaching for the marginal increase in yield,” Mosley said. “Every extra basis point counts for a lot when there are so few basis points to go around.”
The fund’s performance echoes climbing demand for riskier securities across the $3.7 trillion municipal market as local balance sheets rebound from the 18-month recession that ended almost five years ago. Puerto Rico sold $3.5 billion of general obligations last month, the largest junk-rated muni deal ever.
Localities across the credit spectrum have more revenue to repay obligations. Property-tax collections nationally rose to $182.8 billion during the last quarter of 2013, eclipsing the previous peak four years earlier, according to U.S. Census data.
High-yield munis earned 6 percent in 2014 through April 22, exceeding the 4.4 percent gain for the entire market, Barclays Plc data show. High-yield includes unrated debt, as well as securities ranked below Baa3 by Moody’s Investors Service or lower than BBB- by Standard & Poor’s and Fitch Ratings.
ETFs are similar to mutual funds that track indexes of equities, bonds or commodities. Yet they can be bought and sold during the trading day and their prices may rise or fall more than the value of the assets they hold.
The funds held $11.4 billion of munis at year-end, almost double the amount four years earlier, according to the Federal Reserve.
The HYD fund, created in February 2009, reached $29.75 cents per share yesterday, the highest since August. In a sign of swelling demand, the fund sold at about 0.33 percent above the value of its holdings April 11, the largest premium since November 2012. The fund’s 6.7 percent gain this year is beating the 1.5 percent advance for the S&P 500 index.
Investors have added cash to U.S. high-yield muni mutual funds for 15 straight weeks, the longest stretch since September 2012, Lipper US Fund Flows data show.
“We’ve seen inflows pick up across the spectrum of fixed-income investments,” Mosley said. “HYD gets the benefit of being at the front of the pack when flows are coming in.”
The appetite for riskier munis is a reversal from last year, when investors rejected the debt after Detroit’s record bankruptcy in July and as Puerto Rico’s struggling economy cast doubt on the commonwealth’s ability to repay its obligations.
High-yield munis lost 5.5 percent in 2013, the worst performance since 2008, Barclays data show. HYD’s price fell in September to the lowest in about two years.
This year, investors are more comfortable with riskier debt. Some who typically purchase taxable high-yield corporate securities, called cross-over buyers, are turning to munis, said Jim Colby, who helps manage HYD as senior municipal strategist at Van Eck Global in New York. Hedge funds accounted for the majority of buyers in Puerto Rico’s March sale.
Yields on junk-grade munis have exceeded interest rates on company debt since October, contrary to historical trends.
The interest rate on an index of high-yield munis maturing in seven years was 7.23 percent April 22, or 2.17 percentage points above speculative-grade U.S. corporates with a similar maturity, Barclays data show. Over the past five years, yields on the corporate index have been 1.63 percentage points above those on high-yield munis on average.
“We’ve had some crossover investing that has brought some assets into our space,” Colby said. “With an ETF, you have that aspect of liquidity on demand.”
Even as riskier city and state debt yields more than corporate securities, localities default less frequently than companies, according to a Moody’s assessment of issuers it rates. From 1970 to 2012, an average of 5.7 percent of munis sold a decade or more earlier and carrying a junk rating defaulted, compared with 33.9 percent for company debt.
Nine municipal issuers have missed their payments for the first time this year, down from 25 at the same point last year, according to Concord, Massachusetts-based Municipal Market Advisors.
“There’s definitely a sense of growing comfortability with the broader municipal-credit story and broader awareness of the differentiation between the broad market and some of the headline-driven stories like Puerto Rico and Detroit,” Mosley said.
Increasing the appeal of junk munis, the extra yield on the obligations relative to the broader municipal market also exceeds the historical average.
The yield on an index of high-yield munis maturing in 10 years was 6.51 percent April 22, or 4.19 percentage points above 10-year munis, Barclays data show. Over the past five years, that spread has averaged 3.3 percentage points.
“Those yield relationships make a very strong argument for muni high yield,” Colby said.