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Fixed-Income Insights

Attractive yields are currently found on issues that are longer dated or lower rated.

Detroit's $18 billion bankruptcy, combined with Puerto Rico's fiscal problems and the prospect of a reduction in the Federal Reserve's bond-buying program, have resulted in eight straight months of outflows from municipal bond mutual funds in 2013, according to the Investment Company Institute. And after peaking on May 2, the market (as represented by the Bank of America Merrill Lynch Municipal Bond Index) lost 7.6% over the following four months.1

But outflows have diminished in recent weeks, and after months of turmoil, the market has begun to rebound. As of November 7, the index had risen 3.6% from the low hit on September 5.2 Yields, however, remain attractive, and improving credit fundamentals suggest that investors should consider a range of muni bond opportunities.

Although yields have come down a little since the market began to rally in September, they remain relatively elevated, especially at the long end of the curve, according to Dan Solender, Lord Abbett Partner & Director of Municipal Bond Management. "The yield curve was pretty steep earlier in the year, but since the pullback this summer, the short end of the market has performed better than the long end. So the steepening of the curve provides some opportunity at the long end."

Historically, yields on municipal bonds have run at a discount to Treasury yields because of a muni's tax-exempt status, and over the past decade, the yield on a 'AAA' rated 10-year muni averaged 91.6% of the yield on a 10-year Treasury note, according to Thomson Reuters.3

But these 10-year munis are now offering a yield that is more than 94% of that on the 10-year Treasury, according to Thomson Reuters. Yields on 30-year munis are currently even more appealing.4 In fact, the yield was recently 109% of that available on comparable Treasuries. This relatively high ratio may provide a cushion to investors if interest rates begin to rise. [Of course, there is no guarantee the municipal market will perform in a similar manner in the future.]


 

Chart 1. Yields on 'AAA' Rated Municipal Bonds Are Relatively Attractive

Source: Analysis of Thomson Reuters Municipal Market Data (10/01/2003 - 11/05/2013). Pre-2008 figures are for 10/01/2003-12/31/2007.
For illustrative purposes only and does not represent any specific Lord Abbett account or any particular investment.
Past performance is no guarantee of future results.
Please refer to "Important Information" regarding the economic indicator data in this table and index information. The historical data are for illustrative purposes only and do not represent any specific Lord Abbett account or any particular investment and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Performance during other time periods may be different or negative.
The income derived 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-free income. In addition, bonds may be subject to other types of risk such as call, credit, liquidity, interest-rate, and general market risks. 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.


As Chart 2 shows, opportunities may also be available below the 'AAA' rated tier. On a tax-equivalent basis, muni yields appear particularly attractive, especially relative to comparably rated corporate bonds. High-yield munis,5 for example, are paying a tax-equivalent yield of 11.59%, nearly 500 basis points more than the corporate equivalent,6 according to index data from Barclays and Bank of America Merrill Lynch.


 

Chart 2. Tax-Equivalent Yields Currently Look Particularly Attractive
Tax-equivalent yields* for selected municipal bond indexes, as of 10/31/2013

Source: BofA Merrill Lynch and Barclays Capital Index data. Investment-grade municipal data represented by ratings-specific subsets of the BofA Municipal Bond Index and Investment grade corporate data represented by ratings-specific subsets of the BofA U.S. Corporates Index.
*At the 28% tax bracket, the tax-equivalent yield would be 1.89%, 2.19%, 2.98%, and 4.45% for the AA Rated, A Rated, BBB Rated, and High-Yield Municipal indexes, respectively. Tax-equivalent yield calculation for the municipal indexes above assumes the top marginal tax bracket of 43.4% on investment income, which includes the 39.6% income tax rate and the 3.8% in Medicare tax. This tax rate does not factor in the effect of AMT (alternative minimum tax) or taxes in your individual state. Tax-equivalent yield will vary based on an investor's tax bracket.
**Represents a data subset of the Barclays Municipal Bond Index. †Represents BofA/ML High Yield Master II Constrained Index.

Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in this chart and index information. The historical data are for illustrative purposes only and do not represent any specific Lord Abbett account or any particular investment and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Performance during other time periods may be different or negative.
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. Lower-rated bonds carry greater risks than higher rated bonds. 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. The income derived 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-free income. In addition, bonds may be subject to other types of risk such as call, credit, liquidity, interest-rate, and general market risks. 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.


Higher yields often indicate that risks are higher as well, but recent data suggest that the muni credit picture is improving. State and local tax revenues have been growing year over year for 15 straight quarters, according to the U.S. Census Bureau. And in August, after five straight years of "negative" outlooks, Moody's Investors Service revised its outlook for the states to "stable." Moody's attributed improvements among the states not only to surging housing and stock markets but also to the prospect that federal budget cutbacks would be less detrimental to state finances.7

At the local level, fiscal conditions are a mixed bag, with some cities facing long-term challenges related to pension and healthcare benefit obligations. Still, according to a recent survey by the National League of Cities, 72% of city financial officers said their municipalities were better able to meet their financial needs in 2013, up from 57% in 2012.8

Moreover, first-time muni defaults have become less common in recent years, according to the research firm MMA. Through three quarters this year, only 39 unique issuers had defaulted versus 68, 80, and 97 during the same period in 2012, 2011, and 2010, respectively. Morgan Stanley notes that this is impressive, given that the broad market, including high-yield and non-rated munis, consists of 60,000 unique issuers.9


1 Lord Abbett research.
2 Ibid.
3 Municipal bond and Treasury bond yields based on composite data from Thomson Reuters Municipal Market Data.
4 Ibid.
5 As represented by the Barclays Municipal High-Yield Bond Index.
6 As represented by the Bank of America Merrill Lynch High Yield Master Constrained Index.
7 Morgan Stanley Municipal Bond Monthly, October 10, 2013.
8 National League of Cities, City Fiscal Conditions in 2013, October 2013.
9 Morgan Stanley, op cit.

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The Fund seeks to deliver a high level of income exempt from federal income tax by investing primarily in lower-rated municipal bonds.
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