Illinois’ financial woes present risk — and opportunity — to muni bond investors

Illinois’ financial woes, coming in the immediate wake of Puerto Rico’s bankruptcy filing, is shining more light on the risks and opportunities in the municipal bond market, and stands out as a reminder that financial advisers should pay extra attention to underlying holdings in muni bond funds.

The state’s legislative tug-o-war, which has caused the government to go nearly two years without an approved budget, is pushing some of Illinois’ debt toward junk status.

That is a clear warning flag to advisers like Ronald Bernardi, president of Chicago-based Bernardi Securities.

“We manage our clients’ mattress money, where safety and value of principal is important, so this is not a buying opportunity for us,” he said, reacting to the 4.45% yields currently available on Illinois’ 10-year bonds. That’s more than double the rates paid by top-rated muni bonds.

A report last week by Citigroup described the state’s high-yielding debt as a potential buying opportunity, during the ongoing standoff between Illinois’ Republican governor and the Democratic-led legislature.

Citing Illinois’ $14.3 billion backlog of unpaid bills, the report suggested “the state has strong fundamentals and possesses the ability to tax-and-grow its way out of fiscal and operational troubles. But it hasn’t been able to do so due to the lack of collective political will.”

Unlike some higher-tax states like New York and California, there are no mutual funds dedicated specifically to Illinois municipal bonds.

But for those investors eager to take the leap of faith that Illinois’ lawmakers can cooperate enough to navigate a way out of the current political impasse, there are several mutual funds offering significant exposure to the state’s municipal debt.

Two funds with just over 20% allocated to Illinois muni bonds include the $21 million Hartford Municipal Income Fund (HMKIX), and the $580 million Wells Fargo CoreBuilder Share Series (WFCMX).

Of those two funds, the Hartford fund has the best performance so far this year, with a gain of 4.1%, compared to a 3.8% gain by the Bloomberg Barclays Municipal Index, and a 3.2% average gain by the Morningstar muni bond fund category.

The Wells Fargo fund is up 3.8% so far this year.

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, said muni-fund investing can be tricky because of the flexible portfolio mandates that allow managers of investment-grade funds to take on high-yield risk, and vice versa.

“It’s quite common to find a high-yield muni bond fund investing in investment-grade bonds,” he said.

For example, the $11.1 billion Vanguard High-Yield Tax Exempt Fund (VWAHX) has just a 14.3% weighting in a combination of high-yield and un-rated muni bonds.

Likewise, the $580 million SPDR Nuveen S&P High Yield Muni Bond ETF (HYMB) has a 41% weighting in investment grade debt.

“In the (corporate bond) index fund world, when a credit is downgraded to junk there typically is some selling that takes place because of the rules of the index,” Mr. Rosenbluth said. “But that isn’t the case in the muni bond world, which means both active and passive funds will have exposure to both investment-grade and junk-rated bonds.”

Tim McGrath, managing partner at Riverpoint Wealth Management in Chicago, feels close enough to the challenges facing Illinois to want to avoid the risk the comes with chasing the higher yields of the local muni bonds.

“This has been an ongoing issue, and where there’s smoke, we want to look for higher-quality bonds,” he said. “If we’re deciding between two bond funds, I’d rather have the one with higher-quality bonds, because we’re later in the cycle now and I don’t think this is the time to take on more risk to try and inch out a little more yield.”