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Through no fault of their own, individual investors accustomed to purchasing municipal bonds on their own have been facing an uphill climb that could be getting steeper. And as the market continues to evolve, these investors may need ongoing credit research, broad market access, and thorough portfolio analysis to keep pace with the changes.
Much of the transformation within the municipal bond market has been a function of the economy and monetary policy. As the Federal Reserve has responded to sluggish economic growth, one result of its pervasive influence on interest rates has been the ability for issuers to refinance their bonds in order to significantly reduce their costs of capital. In the municipal bond market, this ability has meant that nearly two-thirds of the total issuance in 2012 was related to refinancing.1 (See Chart 1.)
Source: Securities Industry and Financial Markets Association. Refunding represents a replacement of existing debt, and new capital represents an increase in borrowing for a municipality.
The value of an investment 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. As rates rise, prices tend to fall. The income from municipal securities may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.
While the ability for cities and states to refinance their debt can enhance their financial flexibility, it could create a difficult situation for investors. After all, the refinancing process may call a bond with a relatively high coupon away from investors, leaving them searching for a replacement among what are likely to be securities with significantly lower coupons. And this would be occurring in a market where more than 80% of the securities issued from 1996 through 2012 are callable by the issuer.2
In this scenario, not only will individual municipal bondholders be searching for replacement bonds but also their search may be limited to a single securities dealer. In addition, many dealers have reduced the amount of bonds in their inventories as a result of regulatory changes and in their efforts to redeploy or conserve capital. For example, in the third quarter of 2012, broker/dealers' municipal bond holdings were 25% below their levels in 2008, according to the Fed. Therefore, an individual's access to the market often consists of only one securities dealer that may have a shrinking inventory of bonds from which to choose.
Individual investors looking to purchase newly issued securities could also face obstacles in the selection process. Although individuals often have an opportunity to buy municipal bonds before institutions do, separately managed accounts could be involved in the retail order period. These potentially large accounts could purchase a significant amount of a new issue, thus leaving a reduced amount of bonds for individual investors.
Another outcome of the prior economic contraction and tepid recovery has been varying degrees of strain faced by municipalities. For the most part, municipal budgets have followed the track of the economy as the recession led to significant deficits, which many cities and states addressed with difficult decisions, such as job cuts.
As the economy recovered, these municipal budget deficits improved in most locations. Yet, certain cities that were severely affected by the recession and collapse of the housing bubble have yet to recover. And some cities, such as San Bernardino, California, have actually filed for Chapter 9 bankruptcy protection. Although these troubled locations represent a fraction of the municipal universe, the wide variation in credit quality throughout the municipal bond market is something that all tax-exempt investors are facing. Yet, individuals may not have the proper resources to evaluate credit risks in a market that included $3.7 trillion in securities as of December 31, 2012.
If individual investors are holding a bond that may be encountering credit problems, it could be difficult for them to recognize this from only observing the price of the securities. This is because in such a large and diverse market, many bonds may not trade on a given day or even in a given week. This potential lack of price transparency can be another hurdle facing individual investors.
The research task may be particularly challenging considering that individuals can no longer rely on bond insurance and the resultant 'AAA' credit ratings as a form of credit support for municipal securities. During the financial crisis, several bond insurers succumbed to their real-estate exposure, thus reducing the number of 'AAA' rated securities in the market, from 70% in 2007 to only 13% as of February 2013, according to Barclays. As a result, bonds with 'A' and 'AA' credit ratings have assumed larger proportions of the market.
The transformation in the municipal bond market over the last several years demonstrates that even a market considered as stable as the municipal bond market has not been immune to changes following the financial crisis. And in order to obtain the tax efficiency and potential stability that have made municipal bonds an attractive asset class for many, investors may need a more comprehensive approach to credit research and market access that may be better accomplished by asset managers with those resources at hand.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, fixed-income prices fall, and when interest rates fall, fixed-income prices generally rise. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the alternative minimum tax, or state or local taxes. Any capital gains realized may be subject to taxation. 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.
The credit quality of the securities in a portfolio are assigned by a national 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.
Glossary of Terms:
A Coupon is the interest rate paid on a bond at par.
A Separately Managed Account is a private investment account that uses pooled funds to purchase individual assets. The investor in a separately managed account owns the assets in the account.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.