This piece of the tax-exempt bond market is a -2-

So far this year, the Class A shares of the First Eagle High Yield Municipal Fund FEHAX have returned 12.3%. About 21% of this fund's portfolio was made up of investment-grade bonds as of June 30, when it had $1.8 billion in assets under management. As of Aug. 31, First Eagle quoted a 30-day SEC yield of 3.91% for this fund, with a distribution yield of 5.24%. The 30-day yield is a mandated calculation that is useful when making comparisons among various funds. Miller said the distribution yield was closer to the actual distribution yield investors could expect.

The Class A shares of the First Eagle Short Duration High Yield Municipal Fund FDUAX have returned 6.5% since that fund's inception on Jan. 2. This fund's 30-day yield was 4.02% as of Aug. 31, and its distribution yield was 4.42%.

These returns exclude sales charges, which are waived when shares are purchased through several large brokerage platforms, including Charles Schwab, J.P. Morgan Securities and Morgan Stanley, including its E-Trade subsidiary.

Returns for longer periods aren't listed here because the First Eagle High Yield Municipal Fund changed into a municipal fund late last year.

The returns are net of expenses, which after current fee waivers come to 85% of assets under management annually for both funds' Class A shares, at least until the end of February. Both funds also have Class I shares with lower expenses; these have higher minimum balances and are mainly distributed through investment advisers.

Mutual funds and interest-rate risk

During the period of rising interest rates, when the Federal Open Market Committee raised the federal-funds rate and the Federal Reserve allowed its bond portfolio to run off, bonds' market values declined. When rates rise in the economy, bond prices must decline enough so that their yields to purchasers would match those of newly issued bonds of similar quality.

Mutual funds have fluctuating share prices calculated daily after the market closes. A fund's share price - known as its net asset value, or NAV - is that day's value of the fund's holdings divided by its number of shares. So the NAVs were declining along with bond prices. Some investors are content to ride out this type of price fluctuation in return for a steady stream of dividend income. But others might sell their fund shares and if enough of them do, a bond-fund portfolio manager will be forced to sell securities into a declining market and book capital losses. And that action puts more pressure on bond prices.

When asked about this aspect of a mutual fund's structure, Miller said: "The redemptions that push bond values to irrationally cheap levels also create an opportunity to buy in."

"When you buy in during a redemption cycle, you do very well and it doesn't take that long to see a sharp snapback," he said. He added that the past 10 down cycles for the bond market were followed by more rapid snapbacks.

Miller's long experience managing large municipal bond portfolios during outflow cycles has shown a tendency, that "prior to losing 8% of assets under management, the cycle tends to exhaust itself and buyers come in to pick up compelling values."

"If you consistently carry a combination of cash and highly liquid securities, and maybe a cushion above it, you are in reasonably good preparation for that next downcycle and to cover outflows," he said. On a portfolio basis, the two First Eagle municipal funds had a combination of highly liquid investment-grade bonds and cash well above 8%, Miller said.

Credit risk for high-yield municipals

The high-yield part of the bond market calls for active management because of how complicated the bond covenants can be. With a higher risk of default comes the possibility of recoveries. There can also be measures taken by bond issuers - such as purchasing insurance for some of a bond issue - that can provide some protection or comfort to investors.

Miller said: "A pooled vehicle [such as a mutual fund] is highly advantageous for managing high-yield municipals. The reasons are diversification, research, trade execution and being a qualified institutional buyer."

For the high-yield municipal bond market, Miller described a small group of institutional investors who can take advantage of income streams that are exempt from federal taxes. He described these buyers as "essentially part of the network of people who are invited to look at certain special situations." These investors have solid relationships with the underwriting investment banks.

The investment banks "have to develop a targeted list of specific customers, with specific language and covenants," he said. In other words, most individual investors can only get exposure to this part of the bond market through a fund.

Spotlight on Florida Brightline

For example, the $925 million Brightline Issue 2024 bonds, which have a 12% coupon and made their first interest payment on July 15, were issued in denominations of at least $250,000.

The First Eagle High Yield Municipal Fund was more than 8% concentrated in Florida Brightline securities as of June 30. According to the First Eagle Short Duration High Yield Municipal Fund's fact sheet, its concentration in Brightline Bonds as of June 30 (when the new fund had only about $30.8 million in assets under management) was more than 7%.

Miller said that the concentration in Florida Brightline bonds cited in the Wall Street Journal article was "near peak exposure," as of June 30, because both funds were growing rapidly. The First Eagle High Yield Municipal Fund's assets increased to $3.19 billion as of Aug. 31 from $1.8 billion at the end of the second quarter. Miller said that with limited availability for Brightline paper, both funds' concentrations to this issuer were declining.

For Brightline specifically, he said that the bond covenants were such that there were actually three different sources of payments, as if there were three obligors.

The senior Florida Brightline bonds include those with 5.5% and 5.25% coupons, totaling $2.2 billion, with insurance coverage for $1.1 billion from Assured Guarantee. Once Brightline was able to provide six months of ridership data for the Miami to Orlando line, half of the $2.2 billion was assigned an AA rating by S&P, with the other half BBB-, Miller said. Both are considered to be investment-grade ratings.Next is the 12% bond issue, which is subordinated, "but is secured by a different asset than the senior-lien" bonds, Miller said. These bonds have a scheduled mandatory tender date (effectively a maturity date) of July 15, 2028, at 109. And Miller paid 98 for the bonds when they were issued at a discount. He added that "all of the bonds we are referring to have prefunded interest through the next four years, which [the railroad operator considers to be] a ramp-up period," for the passenger service. He expects the 12% bonds to be called before they mature. This year they can be called at 103. If they are called in 2025, the redemption price will be 106. So this issue has the potential to provide the First Eagle funds with significant capital gains, on top of the high interest payments. Last is the Brightline issue with an 8.25% coupon, which Miller described as a commuter rail project that Brightline is negotiating with Palm Beach, Miami-Dade and Broward counties, "to take the edge off connections in Miami, Fort Lauderdale and West Palm Beach." He said the counties would pay Brightline for the use of its tracks and that the bonds were "secured by tentative but soon-to-be-executed agreements with those counties."

Miller added that even though the 12% issue is subordinated when it comes to liens on hard assets, "it is the first recipient of operating cash flow, to pay down principal."

A broader look

Miller cited data compiled by Moody's from 1970 through 2022, covering rolling 10-year periods. Moody's said that bonds with Ba ratings (the highest non-investment-grade rating, analogous to S&P's BB) had an average 10-year default rate of 3.31%. Miller believes this is a fair comparison to the credit risk levels of the funds he oversees.

"A 3.3% default rate for a 10-year period might be 33 basis points for a one-year period," he said.

-Philip van Doorn

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09-24-24 1013ET

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