Investors' ravenous demand for high-yield municipal bonds has created an optimal environment for lower-rated issuers, analysts say.

High-yield fund flows totaled $408.1 million for the week ending May 22, and have remained positive for all but one week this year, according to Lipper FMI data. High-yield funds reported outflows 69.2% of the time in 2013.

"It's a good time for high-yield issuers, BBB category all the way down to nonrated," Adam Buchanan, vice president of institutional sales and trading at Ziegler Capital Markets, said in an interview. "Due to this market environment, we're telling issuers bring transactions to market."

Investor's desire for high-yield bonds increased this year because of the limited amount of deals coming to market. Volume as of April 30 totaled $89.34 billion, compared to $122.72 billion for the same period in 2013, according to The Bond Buyer's and Ipreo's data.

The lack of supply has allowed underwriters to price the few bonds that do come to market at relatively low yields.

"Issuers should look at this market and say yields are being driven lower by demand," Jim Colby, chief municipal strategist at Van Eck Global, said in an interview. "There is an appetite for high-yield it's a good time to bring deals to market."

He said that Van Eck is proof of investors' appetite for high-yield to a certain extent, since it's attracted flows into its high-yield fund.

Buchanan also pointed to this year's tightening credit spreads as another example for why it's an ideal time to bring high-yield issuances to market.

"There has been a lot of chatter about recent yield transactions and how much their spreads have tighten[ed]," Buchanan said. "Higher-rated yield sector borrowers' spreads have also come in, for example spreads on AA rated healthcare bonds have tightened 20-30 basis points since December of last year."

Credit spreads between the Municipal Market Data's benchmark AAA 10-year GO and its 10-year Baa GO has tightened by 29 basis points to 122 basis points from Jan. 2, 2013, to market close on Friday.

"The spread tightening in yield is from a supply and demand imbalance," Buchanan said. "High-yield supply is down 50%-plus year-over-year, while the overall market supply is down 30%. Additionally, tax-exempt fund inflows are being driven by high yield funds. The supply/demand imbalance is geared towards the high yield sector and it's creating an excellent environment for yield sector borrowers."

Despite these favorable market conditions, analysts are not seeing a large or varied amount of high-yield issuers come to market.

"High-yield is now the domain of many Puerto Rico, many securitized tobacco, and many airports," Colby said. "It's a real opportunity for other types of issuers."

Colby said investors want to see as many different types of investors as are able to come to market.

"I think if you're building a portfolio and the mantra is diversification," Colby said. "If you're not forgetting you need to hedge your bet in some intelligent manner, you want [different high-yield] in your portfolio. What you want is broad diversification and in this kind of an asset class where you really need to pay attention to credit, a broad diversification of issuers is something to be desired."

Michael Schroeder, president and chief investment officer at Wasmer, Schroeder & Co., said in an interview that this is an environment more high-yield issuers should take advantage of.

"A lot of BBB hospitals have not been issuing much in the high-yield department, and we are not seeing that they will be anytime soon," he said. "Maybe that will change. It is a good time for issuers to be borrowing, people want high-yield."

Colby said that in addition to hospitals, charter schools and transportation issuers should be borrowing more.

For the buyside there are credit dangers associated with high-yield bonds, analysts warn. High-yield issuers often have low ratings and therefore a greater chance of defaulting than issuers with investment-grade ratings.

Buchanan acknowledged that while high-yield credit conditions have improved, it is still the risk sector of the marketplace.

"Its credit by credit when you get to the high-yield sector, there are certainly well positioned good nonrated credits out there though, there's no doubt about that," he said.

Both Buchanan and Colby said that much of the risk associated with high-yield bonds can be avoided if investors do a credit analysis.

"The dangers are always there if you don't do your credit work, you don't do your homework," Colby said. "[Many investors] just react to the apparent opportunity, which is a yield comparison. But investors, whether they are individual or ETF investors have to make sure your deals are properly protective of bondholder rights, and assert the responsibility of issuer to follow through on their commitments."

Schroeder noted the inherent risks in high-yield sector, and said investors should be careful, especially in the current rich market.

Buchanan does not see anything that will change market conditions to make them less appealing for high-yield issuers in the immediate future.

"There continue to be dovish comments from [Federal Reserve chair Janet Yellen] and uneven economic data, which has given a bid to treasuries," he said. "Couple that with low supply and fund flows, this is a unique combination."

The Federal Open Markets Committee Meeting minutes released on Wednesday re-affirmed the Federal Reserve's stance that it will not look to raise interest rates until housing data and the inflation rate are stronger.

He does acknowledge though that headline risk could disrupt the high-yield rally, and described it as the "one thing" market participants have to watch.

Hillary Flynn is a reporter for The Bond Buyer

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