Investment Perspectives

Municipal Matters: When It May Be Virtually Free to Be Tax Free

Tue, 7 May 2013 01:00 EDT

Before the financial crisis of 2008–09, it would have been significant news if yields on municipal bonds had exceeded those on Treasury securities at any maturity, and that occurrence likely would have attracted a variety of investors seeking to take advantage of the relative-value opportunity.

Following the financial crisis, however, the ratio of 10-year municipal bond yields to comparable 10-year Treasury yields has frequently hovered above 100% and even moved more than 200% during the most strained moments. After the crisis, this ratio attempted to revert to its historical relationship as the ratio on 10-year municipal bonds fell to about 82% as of May 2011. But even then, the upward slope of the trend remained intact and the ratio again reached more than 100% of Treasuries in late April 2013.¹ (See Chart 1.) This recent increase also has taken the ratio back above its post-credit crisis average of 93.7% since 2009, according to the Municipal Market Monitor. Previously, the 10-year municipal/Treasury ratio was typically in the 80-85% range.

Chart 1. The Increase in the Ratio of Muni Yields to Treasury Yields Has Headed Back Toward Its Upward-Sloping Trend Line

Based on the 10-year 'AAA' segment of the municipal bond market and the Treasury market, July 1, 2009–April 19, 2013

Source: Based on data from the Municipal Market Monitor.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment.
The income derived from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. 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.

Many investors have become accustomed to higher municipal/Treasury ratios, so the historical yield ratios may have less influence on their investment decisions. However, in an environment where investors' search for income has compressed the yields in most asset classes below their historical spread levels, investors should consider the rarity of a credit-spread relationship that remains above its long-term average.

Investors seeking relative-value opportunities might also want to consider what needs to occur for the yield ratio between municipal and Treasury yields to revert to its historical average. In that scenario, municipal bonds will need to outperform Treasuries. For this to happen, either Treasury yields would need to rise—which is one of the prominent concerns for fixed-income investors—while municipal yields would need to remain stable or rise to a much lesser extent. Another way the ratio could revert to its historical average is that Treasury yields could remain stable, while municipal yields decline.

When taking a broader look at the current yield environment, the higher yields on municipal bonds compared to Treasury securities reflect two major considerations. The first one has been investors' flight to the perceived safety of Treasuries given the recent bout of weaker than expected economic reports. The second one has been the Federal Reserve's monthly purchases of $85 billion in securities, including Treasuries, under its open-ended quantitative easing initiative.

The combination of these factors have pushed Treasury yields lower, while municipal bond yields have been held back by the presence of some incremental credit risk, despite being regarded as an asset class with traditionally strong credit quality, and the uncertainty regarding federal budget initiatives. In addition, municipal securities have encountered some seasonal selling pressure from investors who tend to sell bonds for tax-related reasons.

With municipal/Treasury yield ratios remaining above their historical levels, the Fed's pervasive influence on the Treasury market may have convinced some investors that higher municipal yields may not necessarily reflect relative-value opportunities. Instead, these investors may believe that these yields represent a new paradigm that persists even when the Fed starts to adjust monetary policy.

These investors should also consider that the financial advantages provided by municipal securities have not only remained in place but also have potentially improved. Therefore, investors should question whether such a new paradigm outweighs municipal bonds' exemption from federal income taxes and, in some cases, state and local income taxes. This characteristic may be of particular interest, considering the recent increase in the top marginal income tax bracket to 39.6% and the implementation of the 3.8% Medicare surcharge.

For those in the top marginal income tax bracket, these recent tax changes indicate that municipal securities with 'A' credit ratings provided a tax-equivalent yield of 4.61% as of March 31, 2013, compared to 2.46% from corporate bonds with similar credit ratings.² Although municipal securities generally have longer maturities than corporate bonds, the difference of 215 basis points may reflect much more than the impact of slightly longer maturities.

These tax-equivalent yields reflect the value that investors may obtain from the tax benefit on municipal securities. Prior to 2008, this benefit typically would cost investors a notable amount of yield relative to taxable securities. Yet, that cost has steadily declined in recent years, to the point where investors could receive the tax benefit without giving up yield when compared to buying Treasury bonds. And in an environment where investors have scoured the fixed-income markets for every incremental-income opportunity and yields continue to compress toward Treasury rates, the minimal cost of the tax benefit on municipal securities may be an opportunity that remains available to many investors. It also may allow municipal bonds to outperform other fixed-income markets as the interest-rate environment continues to evolve.

Five Muni Considerations for 2013

Wed, 17 Apr 2013 00:00 EDT

After a rewarding year for many municipal bond investors in 2012, there is some uncertainty about what 2013 may have in store. Some perspective on relative value trends, recent market developments, and particular issues that might affect the asset class could help investors identify this year’s potential investment opportunities.

1) Proper Perspective for Relative Value
The capital markets have been in an unprecedented environment during the economic recovery, and investors evaluating the market in the context of only the past five years could overlook further opportunities. For example, one of the most visible signs of the Federal Reserve’s policy accommodation has been the steepness of the yield curve—that is, the yields on bonds with similar quality ratings but different maturities—relative to its historical levels. That suggests that investors still can find potential value in longer maturities.

Despite last year’s significant outperformance of the longer-term portion of the market, the municipal yield curve still stood at about 280 basis points (bps) to start 2013. That’s 10 bps steeper than the long-term average,¹ but it appears even steeper when considering that it was less than 50 bps in early 2007, before the Fed started its aggressive policy accommodation. The portion of the curve consisting of 10- to 30-year maturities is even steeper compared with historical averages.

Similarly, the extreme market dislocation of 2008 left credit spreads between high-rated and lower-grade bonds extraordinarily wide. That creates opportunity for investors who are willing to assume a little more credit risk potentially to find yields well above average at the lower end of the rating spectrum.

Even after tightening last year, the yield spread of ‘BBB’ rated muni bonds to the yields on ‘AAA’ rated muni bonds was 220 bps at the end of 2012, 96 bps wider than the long term average.² Also, the spread of high-yield (below-investment grade) muni bonds over investment-grade munis was 350 bps at the end of last year, 73 bps wider than the long-term average.³

2) Watch for Headlines
The outcome of Washington’s ongoing fiscal drama has broad implications, and the municipal bond market continues to be directly affected. While the recent tax package could be considered largely positive for the municipal bond market, there are other fiscal issues that will require negotiation and may not have a similar outcome.

Indeed, if one now views the “fiscal cliff” as consisting of two parts—the first regarding revenues and the other regarding spending—then it was very positive that the recent tax package did not include a previously suggested 28% cap on the exemption for municipal bond income. Given the unpredictability of Washington, however, this is an issue that could resurface, and new headlines about an exemption cap could negatively affect the municipal market.

Investors also should expect additional headlines about underfunded pensions and municipal bankruptcies. While both issues are serious, they deserve some context. To start, most states are considered to be sufficiently funded, but the news reports will often focus on the handful that are not. Also, the worst pension issues, such as those in Illinois, are not current issues for the market. In most cases, it will be years before the liabilities will need to be paid out. Delays in dealing with pension issues, however, could contribute to credit-rating downgrades.

Another municipal bankruptcy would generate headlines, but it is important to recognize the rarity of Chapter 9 filings. Professional credit research could assist investors in avoiding not only those municipalities that are bankruptcy risks but also those that are facing consistent economic deterioration.

3) Tangential Factors in Play
The Fed is expected to continue its quantitative-easing initiatives through the first half of 2013, at the very least, keeping both short and long-term rates near their historically low levels.

But if the pace of growth were to accelerate, this could prompt the Fed to curtail some of its asset purchases, and, consequently, long-term rates could move higher. This scenario could potentially benefit the more credit-sensitive segments of the municipal market because a strengthening economy should improve overall credit quality and, consequently, tighten credit spreads.

Another issue that could affect certain segments of the municipal bond market is the implementation of the Patient Protection and Affordable Care Act, which is scheduled to be in place by January 2014. There are some widespread uncertainties about how the various components of the act will be implemented, which could affect the healthcare/hospital portion of the municipal bond market. Still, hospitals have been given a lot of lead time to prepare for these changes, so most of them should be well positioned for the act’s eventual implementation.

4) Reading the Tea Leaves
The combined prospects for headline events that are specific to the muni market and the broader factors that can affect all the capital markets support some expectations we have for the muni market in 2013, including:

• Assuming that the Fed’s policy efforts to keep interest rates range-bound are successful, total returns on municipal bond investments should approximate their current yields, and could be slightly higher, since there are opportunities for positive price performance from relative-value opportunities.

• The large volume of refinancing-related issuance in 2012 underscores the risk that individual investors are facing when their bonds are being called away, thus leaving them with the challenging task of reinvesting the returned principal in the current low-rate environment. This issuance trend is likely to continue, therefore leading to negative or limited changes in the net supply of outstanding municipal bonds.⁴

• As long as interest-rate volatility remains subdued, which is likely given the Fed’s policy initiatives, municipal bond demand should be strongly positive. More than $50 billion flowed into the asset class in 2012.⁵

• If economic growth continues at its current pace or better, credit quality across the country should remain consistent with its historical stability. This would continue the trend from 2012, when the municipal bond market saw its fewest number of defaults in three years.⁶

5) Areas of Potential Opportunity in 2013
Municipal bond opportunities in 2013 could begin with the overall asset class itself for tax-sensitive investors. After all, the recently passed tax package (the American Taxpayer Relief Act of 2012) phases out some exemptions and limits deductions. For many investors, these adjustments may underscore municipal securities as one of the remaining viable tax havens. Some specific areas of opportunity within the market in 2013 could include:

• Investment-grade bonds with credit ratings below ‘AA.’ Credit spreads are still wide compared with historical averages, and credit quality appears to be improving with the economy. The long-term portion of the market, particularly bonds with maturities of 21–25 years, could continue to outperform, but with potentially more volatility. [There is no guarantee, however, that the market will perform in the same manner under similar conditions in the future.]

• Bonds with 10-year maturities are an attractive segment of the curve, especially when considering the potential for total return versus interest-rate risk.

• If home sales continue to accelerate, some municipal bond sectors that are backed by revenues from increasing real-estate values, or that benefit from a housing market recovery, could appreciate. This includes tax-revenue bonds where the taxes come directly from real estate, or other projects that benefit from the increased ability of consumers to sell their homes.

Principles of Portfolio Construction—Lord Abbett Short Duration Income Strategy

Mon, 15 Apr 2013 05:00 EDT

Andrew O'Brien, Lord Abbett Partner and lead Portfolio Manager for Taxable Fixed Income, discusses how his team seeks a high level of current income investing in short-duration investment-grade mortgage, corporate, government, and asset-backed securities with select exposure to high-yield corporate bonds and bank loans.

Q. How would you describe this Strategy's investment philosophy?
A. Our goal is to consistently provide our clients with a high level of income consistent with preservation of capital and limited duration.¹ This dual purpose—high relative returns and management of risk—is actively pursued via a research-intensive investment approach. We construct a diversified portfolio with undervalued securities from fundamentally attractive sectors.

Q. How does that translate into practice?
A. We typically invest at least 65% of the portfolio's assets in investment-grade debt securities, including U.S. government and other government-related issues, U.S. and foreign companies, and mortgage-backed and other asset-backed securities. We may invest up to 35% of its net assets in high-yield (below-investment-grade) debt securities; non-U.S. debt denominated in foreign currencies; senior loans and loan participations; and convertible securities.

Q. Please elaborate.
A. The investment process can be described as value oriented and thematically driven. Value comes from bottom-up security selection in concert with the identification of salient investment themes. We have three formal meetings each week to discuss the issues affecting business, political, and regulatory conditions and capital markets valuations and determine appropriate sector weightings. Sector specialists are then charged with the search for those issues or issuers that best reflect our investment thesis and offer the best risk-adjusted return opportunities. We continually assess the market environment in an effort to maintain a dynamic understanding of the drivers of valuation across all sectors.

Q. What's your universe?
A. We select from a broad universe of securities that includes CMBS, ABS, high-grade corporates, and other fixed-income sectors, although we focus primarily on securities whose average life² falls within the range of one to three years. We will also opportunistically have limited exposure to high-yield bonds, non-U.S. debt securities, and bank loans.

Q. Please describe your purchase criteria.
A. Sector teams are responsible for purchases and make them based on an assessment of expected risk-adjusted return in the context of our strategic opinion. Once we identify investment themes and attractive sectors, our sector specialists are responsible for individual security selection. The security selection process is sector specific. In the corporate bond market, a proprietary spread model is used to determine valuations based on ratings and maturity, which are then compared with market pricing to produce a rich/cheap metric. This analytical model, the Relative Valuation of Credit Spreads (RVACS), interpolates a security's fair value on a maturity- and quality-adjusted basis. The RVACS screen identifies dislocations by sector, subsector, industry, and issuer. Once excess spread is identified (spread in excess of fair value as determined by us), we employ bottom-up, fundamental analysis. Our fundamental research on corporate credits includes: a) an understanding of the metrics of a given industry; b) the state of an issuer’s balance sheet; c) the quality of the assets on that company's balance sheet; d) the quality and trustworthiness of management and their insightfulness in responding to change in their industry; and e) financing needs relative to the liquidity of the investment market. For mortgages, we employ a proprietary prepayment model to identify mortgage-backed securities with what we believe is the most attractive valuation. For asset-backed securities, we survey the market for opportunities to purchase the highest-yielding securities without sacrificing creditworthiness.

Q. What about econometric models?
A. Econometric models range from adjustable-rate mortgage prepayments to forecasting payroll employment to disentangling interest-rate and term structure risks.

Q. What factors dictate the sell discipline?
A. Sale candidates are typically those with the least attractive risk-adjusted return profile or those whose inclusion results in suboptimal portfolio characteristics. Sales based on deteriorating credit fundamentals occur as appropriate and tend to be done incrementally unless dramatic events unfold. In order of frequency, sales occur for the following reasons: 1) bonds attain the spread target we established when we opened the position; 2) we change our strategic outlook; 3) more attractive alternatives are identified; 4) our risk management discipline prompts us to reconsider an exposure; and 5) an issuer’s credit fundamentals evidence deterioration. We constantly monitor portfolio summary statistics to ensure consistent risk profiles.

Q. To what extent do you work with other parts of the firm?
A. Our short-duration team is fortunate to be able to draw on the extensive analysis of our colleagues in equity investments, who have ready access to senior management of companies they follow and invest in. Such cooperation can be quite valuable.

Q. How do you approach risk management?
A. We invest a great deal of effort identifying and measuring risk. Our quantitative team, led by Walter H. Prahl, Ph.D., Partner & Director of Quantitative Research, has built proprietary risk management systems to quantify relative exposures to sector, subsector, and issuer, as well as interest rates, volatility, prepayments, and term structure. For corporate bonds, on an industry level and on an issuer-specific level, we utilize a value at risk methodology that calibrates exposure to a variety of risks, taking into account credit rating, maturity, and sensitivity to changes in financial market credit conditions. Position limits are set to certain tolerances to minimize the risk that any individual credit would penalize portfolio performance beyond a specified amount.

Q. What about position limits?
A. There is no limit on the weighting of an individual Treasury or agency security. However, for other securities, we would generally not hold more than benchmark plus or minus 3% per issuer in the highest-rated securities [i.e., 'AAA'] and no more than benchmark plus or minus 0.25% per issuer in below-investment-grade securities.

Q. To what extent do you use derivatives?
A. We use Treasury futures to manage the overall duration and term structure of the Strategy. This is often the most efficient and effective way of managing such exposures. Eligible derivatives may include options, futures contracts, forward contracts, or swap agreements.

Q. How would you sum up the competitive advantage of the Strategy?
A. The strategy's sector rotation emphasis has been a significant source of value added over time. The anomalies we have exploited emanate from insights based on a value approach. Another source of value added has been our internal research, both qualitative and fundamental, and inherent investment flexibility. We have material quantitative expertise, enabling us to utilize a diverse set of strategies. Team members with doctoral degrees in finance and economics have designed a suite of quantitative models that provide insight into financial markets. Strategy diversification has provided access to multiple sources of excess return while reducing systematic risk. [Of course, there is no guarantee that the strategy will perform in the same manner in the future.]

Market Insights: A Taxing Matter

Mon, 15 Apr 2013 00:00 EDT

Because some states have plans to substitute sales taxes for income taxes, talk about a similar move at the federal level has emerged, including perhaps the introduction of a European-style value-added tax (VAT). When similar proposals have surfaced in the past, they came to nothing. This time, too, Washington will reject the move, though some states may make the unilateral switch.

One big issue is the question of equity. Though consumption-based taxes are easier to administer than income taxes, and much less intrusive, they favor the rich at the expense of the poor. Poorer people, who are forced to spend every penny, wind up paying taxes on their entire income. But because wealthier people tend to save a greater part of their income, they are able to avoid some tax. This consideration alone likely will generate considerable opposition, particularly among representatives and senators from poorer districts and states. There are ways to make sales taxes less inequitable, with rebates to lower-income people, for example, or exclusions for certain staple products, but still, questions of equity remain, and, meanwhile, such solutions reintroduce administrative difficulties and intrusiveness.

Questions of intergenerational equity add to these objections. Because retired people have amassed their nest eggs under an income tax regime, and so have paid taxes on much of the income they have saved, they certainly would object to paying taxes now as they spend the money. Further, because retirees constitute a large and politically potent group, their objections alone could stop such a tax change. Homeowners would swell the ranks of the resistance, because a switch away from income taxes would take away real estate tax deductibility and so lower house values.

Still more powerful resistance would likely emerge from the states. For one, federal sales taxes would raise their costs. Right now, states make no contribution to the federal government, but a federal consumption tax or VAT would impose on everything states buy—from police cruisers to paper clips. For another, those states that rely on income taxes would lose the administrative and enforcement help they currently get from the federal code. Third, states that do rely on sales taxes would feel a tremendous and unwelcome pressure to conform to whatever system the federal authorities adopted. Fourth, questions would arise about which tax is applied first and whether the second tax would compound an already-administered tax—effectively a tax on tax. Finally, additional administrative difficulties would extend to all the cities and localities that rely on sales taxes of their own.

Those who take their cue from Europe argue that a federal VAT is inevitable, that all these other countries have one. That may be true, but it is a more difficult path to travel for the United States than for European nations because U.S. retirees are a more powerful voting and lobbying bloc than in Europe, but still more because the federal nature of this country introduces 50 powerful state political actors that are unknown in European government.

Fund Insights Q&A: Intermediate Municipal Bonds May Be in the Sweet Spot

Mon, 15 Apr 2013 00:00 EDT

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.