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In the past several years, the municipal bond market looked appealing because of the general downdraft in interest rates and the historical stability of the asset class. Now, investors may be placing more emphasis on the tax benefits of municipal securities, given the change to the top income tax bracket (39.6%), the new 3.8% Medicare surcharge tax, and the elimination of certain tax deductions. Investors weighing the opportunities in the asset class might focus on the intermediate part of the market, as Daniel Solender, Lord Abbett Partner & Director of Municipal Bonds, explains.
Q. What is appealing about the intermediate part of the municipal bond market?
A. The intermediate portion of the municipal bond market has, historically, provided a large percentage of the income available in the longer portions of the market, but with considerably less interest-rate risk. The 10-year range is also the steepest segment of the yield curve, which indicates the possibility for price appreciation as a bond’s maturity shortens each year. The combination of this potential income and price appreciation may provide attractive total return opportunities.
Q. Which sectors have been attractive additions to the Lord Abbett Intermediate Tax Free Fund portfolio?
A. We prefer revenue bonds over general obligation bonds due to the dedicated sources of support and more attractive valuations. Among revenue bonds, we see opportunities in the healthcare and education sectors. Within health care, we favor issuers that have strong market positions, healthy financials, and have taken initiative to prepare for the new federal healthcare environment. Within education, we favor issuers that have strong demand, well-managed endowments, and solid financials.
Q. Why should investors who usually hold individual bonds consider investing in a mutual fund?
A. Investing in the municipal market has become more challenging over the past few years, as bond insurance has virtually disappeared, dealer inventories have been shrinking, liquidity has been inconsistent, and headline risk has increased. Individuals, even those who rely on financial advisors, have relatively limited access to the broad market, which constrains their ability to diversify.
Individuals may also have fewer resources to conduct ongoing credit analysis of their holdings. In addition, individuals need to sell bonds into a market with high liquidity costs for retail-sized holdings while depending upon a specific dealer to provide bids.
Within a mutual fund, very few holdings reach even 1% of the entire fund, and investors can sell on any day at a price determined by the fund’s net asset value. Since we participate in the market every day, we trade with more than 100 dealers per year, and these relationships provide us with wider access to bonds that are available to purchase and liquidity when we want to sell. Finally, with dedicated research analysts who are experts in their sectors, we are able to keep track of the credit quality of our investments in an in-depth, timely manner.
Q. Is credit quality a concern in the municipal bond market?
A. In recent years, there have been some headlines expressing concern about how the municipal bond market was going to perform in a slow-growth economy. And now that we are a few years into this environment, there are indications that the historically higher-quality dynamics of the market have not changed. Most headlines about the market have focused upon general obligation bonds, even though they represent less than one-third of all issuance. Indeed, the majority of bonds are backed by specific revenues, and the range of sources provides a good range of diversification. Therefore, investing in municipal bonds provides exposure to a diverse set of issuers in the investment-grade portion of the market.
Q. What should investors know about the credit quality of investment-grade municipal bonds?
A. Investment-grade municipal bonds historically have demonstrated strong credit quality, compared with similarly rated bonds in other markets, and considerably less default risk.1 At the same time, credit-rating agencies have produced analyses showing that the default rate of investment-grade municipal bonds is lower than similarly rated bonds in other markets.
Q. What are the potential risks?
A. If the economy continues to recover, there is potential that rates will rise from their historical lows, which would negatively affect the fixed- income market.
The value of investments in debt securities will fluctuate in response to market movements. When interest rates risk, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Investments in high-yield securities sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Lower-rated investments may be subject to greater price volatility than higher-rated investments. Income from municipal securities may be subject to the alternative minimum tax. Federal, state and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. While municipal bonds are backed by municipalities, U.S. government securities such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. Government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Corporate bond are considered higher risk than government bonds.
Diversification does not protect an investor from market risk and does not ensure a profit.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest) Bonds rated 'BBB' or above are considered investment-grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.