First and foremost, we hope that you and your families are safe and healthy during the COVID-19 crisis. Undoubtedly, we find ourselves in uncharted waters on both the social front and in the financial markets. With this letter we hope to allay many of your recent concerns regarding your investment in Principal Street High Income Municipal Fund (“GSTAX” or the “Fund”).
Perhaps the most important point to emphasize is that while the Fund may be in turbulent waters, they are not unchartered waters for this management team, which managed successfully through the 2008 Financial Crisis, the 2010 Meredith Whitney sell-off, the 2013 Puerto Rico debacle, the 2013 ‘taper tantrum’, and the 2016 ‘demise’ of the bond market following the Trump presidential election. In each example, an important lesson followed, but none more so than in 2008: remaining invested proved to be the single best strategy. There is compelling evidence to support the notion of staying invested, which we outline below. We also outline the plan to stay on offense as we move forward to take advantage of this market dislocation.
A rare investment opportunity is now presenting itself that seemingly occurs once every ten years or so. We believe investors in this market and new capital allocated to this market will have the potential to reap substantial rewards moving forward.
In this letter we will walk you through what we are seeing in the market, some of the very important differences between GSTAX and other funds in our peer group, and how we plan to exploit the irrational disconnection that we are seeing in the pricing of the bonds versus the reality of the projects in the portfolio.
Backdrop to This Market
In the past two weeks the high yield municipal market and the Fund have experienced a swift and dramatic sell-off of 16%, following +9% year in 2019, reminiscent of the 2008 Financial Crisis. Like 2008, fear of the unknown is driving irrational investor behavior. In 2008, fear centered around the potential failure of our entire financial system. In 2020, fear is centering on the unknown and concern surrounding Covid-19. This is scary stuff, but it does not have a lot to do with your high yield investment, and to the degree that you can separate the two – investment versus virus and the value versus fear – we believe that we arrive back at a rational investing plan and the recognition that a tremendous buying opportunity exists. We take comfort that we have managed through periods like this before and have a definite plan to take advantage of the opportunity:
- This is a liquidity event, not a credit event;
- There is a disconnect playing out between the value of the underlying collateral and the current pricing;
- Redemptions at the larger funds are driving selling and lower prices;
- Forced selling to unwind leverage is exacerbating the selling pressure;
- The lack of liquidity is notable more pronounced now than in 2008 due to banking regulations adopted in 2009 which created additional and more pronounced volatility; and
- Fear over Covid-19 is acting as an irrational overlay to this asset class and virtually every other market.
We believe that separating fact from fear is critically important in coming to the correct investment decision:
A. Portfolio Composition and Construction of GSTAX Makes a Difference
The portfolio construction of GSTAX is intentionally different than many of its peers, and we believe that its design will ultimately allow the Fund to outperform over the long-term. The Fund is fundamentally sound, constructed with bonds that are typically:
- Senior-secured positions;
- Bricks-and-mortar physical assets that have underlying collateral value; and
- Essential needs and services.
A substantial contributor to this liquidity event is the forced unwinding of the leveraged open-end and closed-end fund structures that invest in high yield municipal bonds. These funds have statutory leverage limits that are measured monthly. We estimate that some $4 billion of high yield municipal bonds from closed-end funds have been sold by these funds to meet targeted leverage limits. Additionally, the very large multi-billion-dollar open-end funds are experiencing redemptions that are putting additional pressure on the liquidity in this market.
The intended design of our Fund has been to be more institutional-like, comprised of rather sophisticated, long-term investors with a thorough understanding of the asset class. In periods of disruption, this profile allows us to be in direct contact with many of these investors to offer both market color and investment advice, which we have and are continuing todo. To-date, the level of redemptions has been held to about 3%, and we believe that this is the first step towards achieving a robust rebound.
B. High Yield Municipal Bond Funds Are Very Different Than High Yield Corporate Bond Funds
Investors often make the mistake of comparing high-yield municipal bond funds to high yield corporate funds, which can then lead to incorrect conclusions. In fact, we believe that many important differences favor high yield municipal bonds over high yield corporate bonds.
A few significant differences between high yield municipal bonds versus high yield corporate bonds, respectively:
- Senior-secured versus senior-unsecured;
- Physical bricks-and-mortar projects with strong underlying collateral value versus a general unsecured corporate pledge;
- Many essential need projects versus a variety of corporate credits that may suffer and/or fail in a down-economy;
- Stronger bondholder protections versus the prevalent ‘covenant light’ transactions;
- Default rates of approximately 3% – 5% versus default rates ranings from 3% – 10%;
- Recovery values in the event of default in the 75 cents/$ range versus amounts that are highly unpredictable for corporate bonds;
- Low correlation to equities and earnings versus a high correlation to equities and earnings; and
- Little to no energy/commodity exposure versus potentially high exposure to energy/commodities.
In our opinion, these differences translate to greater security and the continuing value in the projects in which we invest.
C. The Fund’s Income Will Continue / The Difference Between Income and Price
A very important concept to understand in this market environment is that the income generated by the Fund will continue. Prior to the market disruption, the Fund was distributing 5.60% of tax-free income or about 9% taxable equivalent yield assuming a 37% Federal income tax bracket. This was very attractive at the time. Today, due to the decline in the net asset value, the tax-free yield is now about 6.30%, or about a 10% taxable-equivalent yield using the same assumptions above, which is a very attractive entry point for our market. This is also reminiscent of 2008, which, as we explain below, was a tremendous buying opportunity.
To be clear, the income will continue to be generated and distributed. Our projects continue to operate, to generate income, and to pay their debt service through current and accumulated cash flow, which in turn generates the tax-free income. The volatility in pricing that the Fund is currently experiencing does not have anything to do with the underlying viability of the projects. This same volatile pricing is creating an enormous disconnect between the actual underlying value of the bonds and the pricing. This is a technical condition in the market that we believe is temporary and that the prices will revert back to some semblance of where they were prior to this dislocation.
Applying Lessons of 2008 to 2020
In 2008 and 2009, while managing the same strategy, I made the decision to stay in a high yield and with a longer duration. This was a contrarian position to the rest of the market at the time, and in many ways an unpopular decision. But I did so with the very strong conviction regarding the value of the underlying projects and the idea that the market was not behaving rationally. At the time, I invested in airports, master settlement tobacco bonds, and continuing care retirement communities. These bonds, as a rule, were trading with 11% to 13% book yields and at general price discounts in the $70s. Prior to the disruption, these bonds had been trading in the 7% range at/or around par. The plan at the time was to put these into place, collect the income, and wait for the rebound. This came in August of 2009, and the upward trajectory was stunning. Following the 2008 market performance of -27%, the market performance for 2009 and 2001 was, 33% and 8%, respectively. The strategy employed during that time was contrarian, bold, opportunistic, and successful. Importantly, it was always based on rational, factual, and value-based investing, rather than fear.
Although the causation may be different, the market today has eerie overtones of 2008, particularly regarding the fear and irrationality in the market, the rapid price deterioration, the disconnect between price and credit, and yes, the tremendous buying opportunity. We have identified nearly 25 names that we believe represent very good value in this market, focused on high grade and moving to pure high yield. Interestingly, similar to 2008, we are focused on airports, certain master settlement tobacco bonds, and assisted living and continuing care retirement communities. As a general rule, these bonds are good credits that have sold off by between 20 and 50 points simply because of the lack of liquidity in the market. Three example:
- 5% Buckeye Tobacco. New issue that four weeks ago was over-subscribed by 5x. It came at 5% to yield a 3.80% ($112) and traded to about $119. On Friday the bonds traded at $73.50, or about a 7% yield. This is large and broadly held issue that we believe will snap back once the market settles.
- 5.25% New Jersey/Newark Airport Terminal. These are bonds that rarely trade. Solid credit relating to terminal lease. Three weeks ago these bonds were priced at a premium, and we bought a small amount last week $88, or about 7% book yield.
- Palm Coast Assisted Living. Existing Florida assisted living facility that has done everything correctly, from construction through lease-up. Solid management and attractive facility. Three weeks ago the bonds were priced at about $100. They fell to the mid-$50s. We were able to buy bonds last week at $75 or a 9.50% book yield. We believe that this is a solid credit.
Importantly, these are just three examples of bonds that are emerging as this market feels more pressure, and we believe that the opportunity is tremendous.
We have a very specific plan moving forward that we believe will benefit all of our investors:
- Continue to perform and update our rigorous bottom-up credit analysis on each bond in our portfolio.
- Move to offense. In the past two weeks we have been primarily in a defensive position, including assessing the market, the trends, and the trading. However, we have also been talking to institutional investors who have cash on the sidelines and who we feel will make additional allocations in light of the opportunity in front of us.
- Begin to invest, legging slowly into what may continue to be a volatile market. Our intended approach will be to selectively buy higher quality, “low hanging fruit”, assess the market, and continue to leg in over the next several weeks as we see value emerge. We are patient, rational investors.
- To the degree we are successful in adding these new investments, we believe that we will be adding both high levels of income and the potential for capital appreciation over time, given the dramatic price declines that we are seeing.
- Overall, the plan is to invest as much new capital as possible to take advantage of this disruption. We believe that the strategic deployment of this capital may serve the Fund well for month and potentially years to come.
We believe that our market is approaching a bottom due to the deadline for leverage limits by leveraged closed end funds coming up at month end. This should take out most of the forced sellers. Realistically, we cannot predict exactly when this will happen, but the daily market moves have been swift and dramatic to the downside, which we view as positive in terms of getting to the bottom. The market may continue to decline or bound around for a period of time. However, we believe in this asset class and the projects that we invest in, and in the value that we are seeing emerge. Our plan is to exploit dislocation and value to the greatest degree possible.