Income hunters are taking on more municipal bonds and exchange traded funds to compensate their fixed-income yields as Treasuries remain near historic lows. However, potential investors should be wary of the higher yields as there are no free lunches.
Issuers are lowering the safeguards in the tax-free municipal bond market, taking advantage of increasingly high demand for munis in a low yield environment.
Debt service reserve funds provide a safety net for retail and institutional investors when a project does not provide enough cash to repay a bondholder, reports Joan Gralla for Reuters. However, negative net issuances, or supply dropping below the amount of those redeemed or refunded, along with record demand has allowed issuers to sell muni bonds, despite the diminishing safeguards.
The reserve funds were more common during periods of low demand for high-yield muni bonds. Looking ahead, investors may be particularly vulnerable in July and August as a net negative supply accrues.
“We’re getting into the place where it’s an issuer’s market, the covenants, the types of reserves, the collateral provided, do not make the structures as attractive,” as they previously were, Michael Walls, a portfolio manager with the Ivy Funds, said in the report.
“The change that I have seen in the transactions, generally, as of late, especially in the Central Plains and Black Belt deals, is that a lot of risk is now being backstopped by the gas supplier or the investment bank, in a secondary capacity through structures like a receivable purchase agreement or a custodial agreement,” Bhala Mehendale, a director at Fitch Ratings, said.