Avoid Puerto Rico In A High Yield Muni ETF

July 07, 2015

For investors who believe there’s value in high-yield municipal bonds as the U.S. economic recovery continues, but are unsure whether to see opportunity or danger in debt issued by Puerto Rico, the ETF market’s three high-yield municipal bond ETFs offer some clear choices.

Richard Bernstein, founder and chief investment officer of New York-based Richard Bernstein Advisors, is one who sees value in high-yield munis, but is keen on minimizing exposure to the U.S. protectorate, where years of heavy borrowing and sluggish growth has raised the possibility of default.

“High-yield munis are yielding more than government bonds in Iraq and government bonds in Lebanon,” Bernstein said recently at the ETF.com Global Macro Conference in New York. “That’s pretty amazing because Lebanon doesn’t even have a real government.” He argued that such a dislocation suggests U.S. high-yield munis are seriously oversold and constitute a clear opportunity.

The muni market in general has been dented by bankruptcies all over the country, notably Detroit’s. But Bernstein isn’t alone in seeing value. Cumberland Advisors, the firm headed by David Kotok, is one such firm, though Kotok’s firm has historically built muni portfolios out of individual bonds rather than ETFs.

Different Funds, Different Returns

Advisors like Bernstein that use muni ETFs must choose the right fund to avoid pitfalls like Puerto Rico.

The year-to-date chart below shows the choices Bernstein has been making. The SPDR Nuveen S&P High Yield Municipal Bond (HYMB | D-63), down by almost 1.5 percent, reflects concern about the fund’s relatively heavy Puerto Rico holdings. The Market Vectors High-Yield Municipal ETF (HYD | C-59), shown in blue, is barely lower—a reflection that it has a fifth as much invested in Puerto Rico as does HYMB.

Chart courtesy of StockCharts.com

U.S. law currently precludes Puerto Rico from declaring bankruptcy, adding a layer of complexity to holding credits issues by the U.S. island territory in the Caribbean. However, Congress is currently debating a statutory fix that could allow for the U.S. territory to declare bankruptcy.

Puerto Rico and island-related institutions did make a $1.9 billion bond payment last week, but have signaled they want to restructure the territory’s $73 billion in debts in ways that could affect current bondholders for years.

“We like high-yield munis as an asset class because we think the fundamentals of municipal finance are getting stronger. But you have this outlier in Puerto Rico, so why don’t we limit our exposure to Puerto Rico and play the fundamental story? And that’s what we ended up doing,” Bernstein said.

The firm has held positions in two of the ETF market’s biggest muni bond ETFs, the SPDR Nuveen S&P High Yield Municipal Bond (HYMB | D-63) and the Market Vectors High-Yield Municipal ETF (HYD | C-59), but it sold its holding of HYMB because the portfolio was building holdings of Puerto Rican debt.

Holding On To HYD

“HYD is the one that we own. HYMB is the one everybody has been talking about. HYD has about 3 percent in Puerto Rico, versus about 15 percent for HYMB,” Bernstein said in a recent interview. “We sold HYMB about four months ago because it was actually increasing its weight to Puerto Rico.”

The chart above also shows a short-dated version of HYD, the Market Vectors Short High-Yield Municipal Index ETF (SHYD | C), which is in red. SHYD has about 4.5 percent of its holdings in Puerto Rico. The portfolio has an average maturity of 7.2 years, compared with 19.59 years for HYMB and 21 years for HYD, according to data compiled by ETF.com.

“We’re not muni-bond experts, but we like the asset class. The fact that Puerto Rico was becoming such a large part of the of the high-yield muni universe and the fact that people seemed relatively sanguine about that made us feel very uncomfortable,” Bernstein said.



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