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In previous Market Views, we noted municipal bond investors' concerns about 1) the rise in interest rates as the Federal Reserve mulls "tapering" its $85 billion in monthly purchases of Treasuries and mortgage-backed securities and 2) potential market spillover from the July 18, 2013, bankruptcy filing by Detroit. Since then, fears in the municipal bond market have been exacerbated by a third factor: worries over Puerto Rico's fiscal viability and the potential negative impact of the commonwealth's bonds on municipal bond funds.1
Heightened investor fears became evident as the market began to sell off in May, with muni yields moving upward along with Treasury yields. The slump appeared to be prolonged by the Detroit bankruptcy, and was given an extra boost by the situation in Puerto Rico. Volatility in the muni market has continued, as evidenced by 14 straight weeks of outflows in municipal bond funds through early September, according to Reuters.2
In the broad market, the sell-off has caused muni yields to rise significantly higher relative to corporate yields. As Chart 1 shows, 'A' rated muni and 'A' rated corporate yields had been trending similarly over the last year, based on the 'A' rated components of the Barclays Municipal Bond and Barclays U.S. Corporate Bond indexes. While the 'A' rated muni and corporate indexes have slightly different maturities (munis at 14.9 years and corporates at 9.9 years), the relationship between the two indexes has remained close over the last two years, based on data from Barclays.
Source: Barclays index data.
Past performance is no guarantee of future results.
The value of investments in fixed-income securities will change as interest rates fluctuate in response to market movements. As interest rates fall, the prices of debt securities tend to rise, and as rates rise, prices tend to fall. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Index descriptions are located in the "Important Information" section.
However, the severe correction in the muni market has placed them out of sync. Muni yields have shot up relative to corporate bond yields, causing an opportunity not seen since December 2010, when the market was whipsawed by banking analyst Meredith Whitney's now-infamous forecast of "hundreds of billions of dollars" of muni defaults.3 In the following year, 2011, muni bonds proceeded to return 10.7%, as represented by the Barclays Municipal Bond Index, based on data from Barclays.
The current relatively high yields in municipal bonds appear to be at odds with the fundamentals of the broad market (with Puerto Rico and Detroit as notable exceptions). The overall long-term default rate of 'A' rated municipal bonds was 0.05% over the last 42 years, versus a long-term default rate of 2.48% in similarly rated corporate bonds, based on average 10-year cumulative default rates, according to a May 2013 study by Moody's.4
More important, fundamentals of muni issuers have continued to improve over the last three years. In fact, as Chart 2 indicates, state and local governments saw increasing tax revenues for 12 straight quarters through the first quarter of 2013 (latest available data).
Source: Census Bureau Quarterly Summary of State and Local Tax Revenue.
Note: Data indicate trailing 12-month revenue, calculated quarterly. Data are the most recent available, released on June 25, 2013. The historical data shown in the chart are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment.
While attention has been focused on the troubled finances of Detroit and Puerto Rico, the outlook for another high-profile issuer has improved. For a long time, California, the largest issuer of municipal bonds, had the lowest credit rating of any U.S. state, and was a concern in the marketplace. But its credit rating was raised by Fitch to 'A' from 'A-' in August 2013, following a similar upgrade by Standard & Poor's in January 2013.5 Increasing tax revenues and lower rates on new debt have caused the state to project a current fiscal year surplus by the end of the year.
Given these developments, what should muni investors make of the current environment? Dan Solender, Lord Abbett Partner & Director of Municipal Bonds, pointed to munis' appealing value relative to other fixed-income categories. He noted that muni "credit quality has held up." According to Solender, recent muni market action has been "more an issue of interest rates rising" than any significant change in issuer fundamentals, leaving muni yields "looking attractive now versus other markets."
1 Tim McLaughlin, "Puerto Rico Debt Roils U.S. Municipal Bond Mutual Funds," Reuters, September 3, 2013.
3 Christopher Palmieri, "Whitney Defends Her Prediction of 'Hundreds of Billions' in Muni Defaults," Bloomberg, May 4, 2011.
4 "U.S. Municipal Bond Defaults and Recoveries, 1970-2012," Moody's Investors Service, May 7, 2013.
5 Kelly Nolan, "California Sells $764 Million in Debt," The Wall Street Journal, August 27, 2013.
A Note about Risk:
The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. 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. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and are secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The Barclays U.S. Corporate Bond Index includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt. The index is composed of both U.S. and Brady bonds.
The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, Standard & Poor's, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. Bonds must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
The credit quality ratings of the securities in a portfolio are 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.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.