Bloomberg News

High-Yield Munis ‘Alive and Well’ Despite Their Underperformance

September 14, 2011

Sept. 14 (Bloomberg) -- Timothy Pynchon, who specializes in high-yield municipal bonds, manages $3 billion for Pioneer Investment Management Inc. in Boston. Pynchon exchanged e-mails for an interview in today’s issue of the Bloomberg Brief: Municipal Markets newsletter.

The high-yield muni sector had a total return of 7.58 percent for the year through yesterday, underperforming investment-grade bonds by about 0.54 percentage point, according to Standard & Poor’s/Investortools index data.

Q. Is the high-yield muni market less fun than it used to be? It seemed that in the 1990s there were more speculative transactions.

A. I try not to confuse fun with good credit. Whenever that happens it seems bad things, like defaults, occur. There are fewer of the speculative transactions that you mention, primarily because many of them simply did not work. But the market is not devoid of them, as we have seen from the ethanol plants, the fuel- cell plants and the cow manure-to-energy plants of recent history. The nice thing is that each deal (like the cow manure-to-energy plant) leads to an entire crop of new jokes to accompany it. That said, I have fun on most days because the market offers such a variety of deals, continues to have enormous inefficiencies and has enough suspect transactions that require effective due diligence in order to be successful. No one can accuse our asset class of being boring -- ever.

Q. What counts as “high yield” these days? There don’t seem to be many theme-park/tourist attraction bonds any more.

A. Be assured that high yield is alive and well, albeit in a slightly different form today. The theme park/tourist attraction deals are far and few between largely because so many of them failed. Early in my career it was Space Center Houston and the Retama Race Track in San Antonio. Great concepts, very poor results stemming largely from overly optimistic traffic flows. We have learned that making a deal work at 50% of projected cash flows is very difficult, indeed. Hopefully we learn from our mistakes. That said, there is plenty of yield available -- CCRCs, tobacco bonds and privatized prisons all provide attractive yields for those who know what to look for. As always, however, buyer beware the deals that look too good to be true.

Q. Are site visits a part of the job? How many do you go on a year, do you think?

A. My professional opinion is that site visits are all important, and they constitute a very important part of my due diligence. As a general rule I want to see as many of our “bricks and mortar” facilities as possible. Site visits capture what documents cannot. The old joke is that “the project looked great in the documents, if only I had known about the Superfund site next door.” Over the past 12 months, I have seen about 20 facilities.

Q. How much of the hysteria that surrounded the muni market for a couple of years was the result of people thinking of munis in terms of equities?

A. I have thought for some time that the muni market -- and particularly the high-yield muni market -- is not well understood at all. Investors are fascinated with wanting to compare the muni market to the corporate market, the global high-yield market, and the equity markets. My belief is that munis offer a set of attributes that may be less sexy than their counterparts, but are nonetheless very fitting for a wide variety of investor portfolios. I would include tax exemption, low default rates, low correlation to other asset classes, and a very attractive risk/reward ratio as being very significant attributes in selecting this asset class. In high-yield munis, I would add that the inefficiencies in the market add an intriguing and potentially rewarding element. Where else can one find 7% plus tax-exempt yields (10.75% taxable equivalent yield) without assuming enormous levels of risk? I think the answer is nowhere. When investors start looking at munis in terms of equities, caution has to be exercised -- two very different animals that have very different behavioral characteristics in different markets. The two can peacefully co-exist; just don’t confuse the two.

Q. Does the muni market adequately price risk?

A. Risk is a funny thing, and is in some sense in the eye of the beholder. What are tobacco bonds worth? That’s a great debate currently. What is a broken deal worth? That can vary by tens of points. As a whole, however, I think that the muni market prices risk quite well. This starts with the fact that there is a long track record of very low default rates -- less than 1 percent -- in the investment-grade arena, and very manageable default rates in the high-yield arena. 2011 has been a great test case for risk, with Meredith Whitney sounding a loud and long alarm for impending doom (a prophecy that I strongly disagree with) and a very weak underlying economy. However, munis have held in very well, defaults total only about $1 billion year to date, and the returns have been very attractive year-to-date, at about 8%. I make the case that under these circumstances, the market has priced in excessive risk and a higher-than-reality default rate, which make munis look cheap. I will happily clip this current coupon all day long. But, as I stated, risk is in the eye of the beholder.

--Editors: William Glasgall, Mark Schoifet.

To contact the reporter on this story: Joe Mysak in New York atjmysakjr@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net.


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