Municipal bonds associated with high yield corporate issuers are being traded and quoted at prices substantially higher than bonds of similar maturity issued directly by the same corporations. The price differences, which became evident during the second half of last year, have persisted into 2016 as market participants' risk appetites wane.
Federally tax exempt corporate backed municipal bonds include, for example, economic/industrial development bonds and pollution control bonds. A local government entity is the named issuer of the bonds, whose payments are backed by a corporation. Such issues typically carry the same credit rating as the corporation's directly issued debt.
Tables 1 and 2 summarize price differences we observed between senior unsecured municipal and corporate bonds of similar maturity and identical credit ratings. The corporate entities fall within commodity-related sectors whose products experienced steep declines in demand and price over the past 18 months, along with volatility in the companies' operating results and stock and bond prices. (Prices reflect trades reported on TRACE® and MSRB. Except where otherwise noted, trades cited in the tables and text of this article involve lots of $1 million or greater and credit ratings are as of Dec. 31, 2015.)
An Indiana State Financing Authority revenue bond issued on behalf of U.S. Steel (B2/BB-) that matures in 2042 traded at $90.50 on Sept. 30, 2015. One week earlier, on Sept. 23, a U.S. Steel corporate bond maturing in 2037 traded at $72.25 for a $500,000 lot. (By late January, amid a broad decline in asset prices, a U.S. Steel-related municipal bond with similar characteristics traded at $60 and $61.75.)
A Rockport, Ind., revenue bond maturing in 2028, issued on behalf of AK Steel Corp. (rated Caa1/CCC-) traded at $88.23 last September 24. An AK Steel corporate bond maturing in 2021 traded at $54.25 just four days earlier. A Maryland State Economic Development Corp. bond maturing in 2025 issued on behalf of Consol Energy (B3/BB-) traded at $86.00 on December 3. A Consol Energy corporate bond maturing in 2022 traded at $63 one month later, on January 5, 2016.
Interactive Data evaluated prices likewise reflect divergence between corporate-backed municipal bonds and comparable direct issues of the corporation. An Illinois Finance Authority revenue bond issued on behalf of Navistar (Caa1/CCC-) that matures in 2040 was evaluated at $93.222 on Dec. 31, after a trade at $93 on Dec. 11. Meanwhile, a corporate bond issued by Navistar that matures in 2021 had a year-end evaluation of $66.50 after trading at $67 on Dec. 29. A Pennsylvania Economic Development bond issued on behalf of Talen Energy (Ba3/B+) that matures in 2038 was evaluated at $99.747 on Dec.31, nine days after trading at $99.375. A corporate bond issued by PPL Energy Supply (affiliated with Talen) that matures in 2036 had a year-end evaluation of $45.00 and traded in a $300,000 lot at $47.875 on December 23. As of Jan. 15, 2016, Interactive Data evaluated a St. John the Baptist Parish, La., bond issued on behalf of Marathon Oil (Baa1/BBB) that matures in 2037 at $98.00, based on $60 million of trades; while a Marathon Oil corporate bond that also matures in 2037 was evaluated at $81.
When assessing market indications for these and other corporate-backed municipal bonds, Interactive Data municipal evaluators regularly consult our corporate evaluations desk for relevant information from that market. Because of the breadth of asset types we evaluate, we have the ability to consider inputs from both municipal and corporate market sources plus related news media headlines.
Differences between the bonds' risk characteristics or after-tax cash flows are too narrow to account for the magnitude of observed price differences. High yield corporate-backed municipal bonds are exposed to similar default risks as their directly-issued counterparts. For example, in various bankruptcy proceedings since 2000, the holders of the parent entities of Delta Air Lines, Northwest Airlines, United Airlines and US Airways municipal debt received the same treatment as their corporate bond holders.
Price discrepancies between bonds issued directly by low-rated corporations and related municipal bonds appear to primarily reflect fragmented markets and shifts in investor demand across market sectors. Investors fled from corporate high yield bond funds throughout 2015; this market flight accelerated late in the year and has continued into 2016 amid sliding equity markets and concerns sparked by the failure of the Third Avenue Focused Credit mutual fund in early December. Meanwhile, municipal bond funds, including high yield funds, have experienced steady inflows. For the first three weeks of January, high yield muni funds attracted net inflows of $937 million, according to Lipper data. Separate data from the Investment Company Institute show that municipal bond funds overall attracted $3.7 billion net new cash flow for the first three weeks of January and $12.08 billion since November 2015, while taxable bond funds experienced outflows throughout that period. Supported by mutual fund purchases together with scant new issuance, spreads for high yield municipal bonds tightened versus benchmark Aaa yield curves.
High-yield muni bonds have benefited from a search for yield among investors in tax-exempt bonds. Even after the Federal Reserve raised short-term U.S. interest rates in December for the first time in more than nine years, long-term market interest rates – including yields for municipal bonds – remain near historic lows. To earn more yield, muni bond investors have been taking on greater credit risk. Industrial development bonds of high yield corporate issuers provide a relatively scarce alternative to bonds issued by Puerto Rico or backed by tobacco settlements, which comprise a large share of the municipal high yield market, but are widely viewed as particularly vulnerable to default.
