Like most of the fixed income market, municipal bond have been crushed. Volatility in Emerging Market bonds surprises no one, but municipal bond investors are often attracted to their reputation for safety. Unfortunately, these investors have learned first hand about overvaluation and duration risk.
Back in May 2016 I mentiond that high yield munis were overvalued relative to their risk. The correction started in October. While the equity market has rallied, the munis have sold off, especially high yield munis.
Back in May, I shared a chart of high yield munis vs. investment grade muni yield ratios as evidence of high yield overvaluation. At that time the yield ratio was trading near historical lows of 1.15x. Below is an update, as you can see, the correction has improved valuations, but they are not yet in line with the historical fair value of about 1.25x.
For clarity, here is a YTD version of that chart. You can see how much this metric has moved since May. I believe high yield municipal bonds are a great asset class for taxable investors, provided valuations make sense. The best book I've ever read on the topic is Investing in the High Yield Municipal Market: How to Profit from the Current Municipal Credit Crisis and Earn Attractive Tax-Exempt Interest Income by Triet Nguyen.
The caveats I've previously shared on TTM yields still apply here.
Another metric I find interesting is historical drawdown. As you can see below drawdowns of 5% to 8% are fairly common. This includes prior rate hike cycles. We are currently at about 5.5%
It seems that during each market correction, investors wake up to the risks of liquidity mismatches. Recent examples include the Third Avenue Funds during the corportate high yield correction of 2015, and UK property funds post-Brexit. While high yield munis ETF funds have not had the same level of issues, the disconnect from NAV illustrated below should concern investors.
So why the melt down in muni bonds? Here is my punch list, most of which are related to the new Trump administration:
If you'd like to get notified when I have new posts like this, sign up below.
This is the personal blog of Emory Redd.
This blog is not investment advice. This is not a solicitation to invest. Don't take candy from strangers.
BEST OF HEDGEROLL
ACHILLION AND RA CAPITAL: MY FAVORITE TRADE
SALIX INVESTORS LOOKING FOR A BUYOUT SHOULD BE CAUTIOUS; MORE ACCOUNTING PROBLEMS AHEAD
BIOTECH AS BUFFETT'S WONDERFUL BUSINESS