Terry Goode, senior portfolio manager for the Allspring Municipal Fixed Income team, speaks with David Farace, portfolio specialist for the team, about Allspring’s view on today’s themes in the high yield municipal market and how to navigate the risks and opportunities in this space.
Terry Goode: This is a key differentiator for our team, having our credit analysts on the trading desk with us. So, the relative value component is something that really makes our team different.
David Farace: That’s Terry Goode, senior portfolio manager for the Allspring Municipal Fixed Income team. I’m David Farace, portfolio specialist for the Allspring Municipal Fixed Income team, and you’re listening to On the Trading Desk®. We are discussing Allspring’s view on today’s themes in the high yield municipal market. Thanks for being here, Terry.
Terry: Happy to be here. Thank you.
David: Now, can you describe the high yield municipal market and what makes it unique when comparing it to investment grade muni bonds?
Terry: The high yield market is about $350 billion, so it’s much smaller than the general muni market. Last year, we had record outflows out of high yield municipals of about $20.5 billion. This year, we’ve actually seen inflows. We’ve seen $2 billion into high yielding municipals. Supply in the high yield market has also been very, very light, with only $1 billion in issuance so far in 2023. Last year, we had $23 billion in high yield supply. Most market participants are calling for $15 to $20 billion in high yield supply for 2023. So, we’re already behind schedule in terms of supply. This technical backdrop was extremely supportive of bond prices in January and paired with the rally in municipal and Treasury rates, January was a very strong month for higher municipals. In February, we have given almost all of the returns back with the backup in Treasury and municipal rates. Major sectors in the high yield municipal market include senior living, special tax, health care, student housing, charter school, project finance, Puerto Rico and tobacco settlement bonds. Some of the most liquid and most volatile sectors include Puerto Rico and tobacco settlement bonds. Senior living has typically been the sector with the most defaults and impairments. Project finance deals tend to be more speculative and are characterized by new and unproven processes and operations. Many are equity-like investments in their operations and business functions. They also tend to have much less liquidity.
David: I’d like to focus quickly on your comments around the size of the municipal high yield market. Can you help us understand the composition of this market, specifically when looking at publicly available mutual funds and perhaps address any risks that an investor may want to be aware of there?
Terry: Sure. It’s something that’s very unique in the high yield muni market. High yield muni funds have about $124 billion in assets under management. The top three funds represent about 29% of total high yield assets under management and the top five funds represent 35%. The top fund actually represents a sizable 16% of assets under management. The large size of the funds compels them to almost buy every high yield bond deal and to be less selective. In many cases, these larger funds will be the sole owner or a sizable majority holder of a single high yield issue. This leads to much less liquidity, especially when credit challenges arise with the holdings. And a restructuring of a deal that has gone to default can often end up with the resulting credit that is much less like a municipal credit and more like an equity holding. This can lead to a situation in which you are left taking equity risk but receiving municipal type returns or yields, which isn’t the best outcome.
David: So, Terry, to dovetail on those comments a little bit, how does Allspring’s standing in the municipal marketplace lend itself to successfully managing investments in the municipal high yield category?
Terry: We typically have run our high yield product being a little shorter in duration. We have no exposure to Puerto Rico, which has been a challenging credit that really could be weakened even more based on the outcome in court. We’ve also been underweight positions in tobacco settlement bonds. Tobacco settlement bonds can be very volatile in times of stress since it’s typically the most liquid sector in high yield and gets hit hard when the sector has redemptions. We can use our credit research to sift through the market and buy the credits we like and those that will perform in a slowing economic scenario, which may be happening. We are also a major player in the municipal market and are recognized by the sell side for our ability to navigate the lower investment grade and high yield sectors. We see almost all high yield deals up front and can help to negotiate better security provisions for high yield deals up front so we have better credit outcomes.
David: You mentioned earlier that in the month of February, we started to see some additional outflows from the municipal high yield category. And my question is if client concerns continue to develop into increased level of fund outflows, do you feel this may negatively impact the high yield asset class or does it provide additional opportunities and advantages for a manager like Allspring?
Terry: Yeah, we’d like to take advantage of a situation like that. We try to position ourselves as a provider of liquidity in times of stress and never to be a forced seller. As the supply calendar builds, we expect pricing of primary deals to be more attractive. Yields also continue to be attractive with the yield to worse for BBB-rated bonds and high yield bonds in excess of 5-year and 10-year averages. We also like AMT (alternative minimum tax) bonds, which are available up to 50 basis points wider than non-AMT bonds. We do monitor the amount of AMT in the products and we definitely feel like we are being paid more for the risk. We like the A and BBB rating category for current opportunities and selectively participate in the non-rated sector, realizing that credit spreads could widen in a recession. We are also favorable to taking structure risk for some higher investment grade names by buying deeply discounted 4% coupons that provide better convexity. Historically, we have been more defensive in our duration positioning and we would like to extend duration in a high yield outflow situation, which could provide more attractive yield opportunities in the lower investment grade rating category. So, we really do look forward to taking advantage of opportunities like this.
David: So, one final question. What makes your team different, Terry?
Terry: Well, our team has a long tenure in the credit markets. We have experienced portfolio managers, experienced credit analysts that have had backgrounds at rating agencies, insurance companies, as well as the buy side. Our credit analysts assign internal ratings to every issue we purchase and are responsible for surveillance of their various sectors. Our analysts also sit on the trading desk with the portfolio managers and traders and opine on relative value and make purchase or sale recommendations. However, portfolio managers make the final buy or sell decision. This is a key differentiator for our team, having our credit analysts on the trading desk with us and making purchase or sell recommendations and not only assigning internal credit ratings. So, the relative value component that our credit analysts offer is something that really makes our team different.
David: Well, thank you, Terry, for being with us today and sharing your insights.
Terry: Thank you.
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Disclosure:
100 basis points equals 1.00%. The ratings indicated are from Standard and Poor’s, Moody’s Investors Service, and/or Fitch Ratings, Limited. Credit quality ratings: Credit quality ratings apply to underlying holdings of the fund and not the fund itself. Standard and Poor’s rates the credit worthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus or minus sign to show relative standing within the rating categories. Moody’s rates the credit worthiness of bonds from AAA (highest) to C (lowest). Ratings AA to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the credit worthiness of bonds from AAA (highest) to D (lowest).
