Muni Bonds: We Address Some of Our Investors’ Top Questions | Lord Abbett
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Fixed-Income Insights

A Lord Abbett expert offers perspective on the municipal bond market. 

Amid the ongoing market volatility, Lord Abbett investment professionals have stayed in close contact with advisors and investors to provide timely perspective on recent events and their impact on portfolios. On March 19, Lord Abbett held a phone call for professional investors on developments in the municipal bond space. (Register to hear a replay of the call.) Here, Partner and Portfolio Manager for Municipal Bonds, Dan Solender, tackles a few of the most frequently asked questions from our clients.

How does this market downturn compare with others in history?

I started in the investment industry in the late 1980s and began managing municipal bond funds in 1992, so over the 28 years I've been managing funds, we've clearly experienced a lot of downturns. In each case, whether we’re talking about the downturns of 1994, 2008, 2011 or 2013, the challenge of the markets has always been to find liquidity.

With each downturn, we’ve also observed that prices don't move down in a straight line or at a similar pace even for bonds with comparable characteristics. Some bonds just get marked to market faster than others.  In my experience, the pace of price changes is typically not affected by concerns over the credit risk of a particular bond. Some are simply more liquid than others, so the transaction costs for their liquidity may get priced into their valuations faster. We believe there's been a lot of selling that is about accessing liquidity and not about a shift in the fundamental credit outlook.

The primary difference between this downturn and most others we’ve experienced is that this one started in the context of a very low interest rate environment. It became clear very quickly that the low rates were no longer compensating for the unknown risk that lay ahead in terms of the COVID-19 virus and its impact on the U.S. economy. Rates would have to adjust, and they did, fairly rapidly.   

Fund outflows started to put a lot of pressure on the muni bond market, as did market participants engaging in heavy selling. With every downturn, there are differences and similarities to the previous one, and we deal with them in a very similar way as we interact with market participants to source liquidity.  But this time, the rapid pace and the sharp volatility made a difference in terms of how the market is functioning right now.

Is the muni market frozen?

I’ve heard people say that the muni market is frozen, but I think that’s a misrepresentation of what’s going on.  In my opinion, we're not even close to a frozen market. Trading volumes have been extremely high each day. It's not that we can't trade, it's just that the cost of liquidity, the costs of trading are very high. We typically want to work for a quarter of a point or an eighth of a point in transaction cost, but in this market we have found it is typically multiple points off the price of a bond to consummate a trade and much higher than that for odd lot, separately managed account trades. As I mentioned earlier, I think rates had to rise to find the liquidity that was necessary given the outflows the market has experienced.

Where do you find liquidity in this market?

In this type of environment, for us it doesn't come from selling to the other fund families. It doesn't come from selling to other separately managed accounts. We believe the following. It comes from selling to buyers in other bond markets. The dealers no longer take risks the way they used to. So rates have to rise to the point where they're competitive enough to attract buyers in the taxable markets. Recently, we’ve observed that banks and insurance companies have become big buyers. In our view, they had lost interest after the corporate tax rate went from 35% to 21% in 2017. But now they’re back in a big way, which has been very helpful. Other active players we’ve noticed are hedge funds and total return funds.

We're not anywhere near the market leaders in terms of outflows.  But we do have to raise our liquidity every day and we're having no trouble finding bonds to sell.  We have plenty of cash built up, but each day we keep building it more and more. The difficulty we run into in the muni market is a function of its relatively small size. As participants, we're all dependent on each other. So if a competitor falls behind on keeping up its liquidity, and they start selling bonds at fire sale prices, we all feel the impact in terms of valuations. Market performance is impacted by how investors participate and that includes individual investors selling their fund shares and the pace portfolio managers follow to meet those redemptions.  This has always been the case in our experience.

How does the liquidity of your portfolios affect performance in this market?

From a competitive performance standpoint, we believe if you hold a more liquid portfolio, with more liquid bonds, you're underperforming in a lot of cases because those bonds are being marked to market for their costs of liquidity faster. That doesn't mean that over the long term a portfolio is going to be an under performer necessarily. It also doesn't necessarily mean that the other parts of the market won't catch up.  But that’s one of the things we're facing because we did focus, particularly in our high yield strategy, on having a lot of large liquid issuers in our portfolio. We are more liquid than some other competitors, but that is making us get marked down a little bit faster even though the credit quality of our investments is holding up well.

What is the outlook for credit?

Clearly, COVID-19 is having a significant impact on the U.S. economy with businesses shutting down and many people losing jobs. Convention centers and stadiums likely aren't going to be used for a while. Airlines are cutting back on flights. We can't deny the fact that sales revenues are going to be down.  The real severity of this will depend on how long the economy will basically be shut down.

What we do expect to see on the credit side is an increase in credit rating downgrades or negative outlooks.  Not defaults, but rather downgrades. The airlines provide a perfect example of that possibility. And that’s something we’re preparing for. As of March 16, 2020, airlines comprise under 1% of our high yield portfolio.  We were light on that sector going into this downturn because their bonds were trading so rich but the negative outlook for that sector has impacted our holdings.   

But there are a lot of sectors that we believe will hold up well during the crisis. New York City, for example, is a high grade credit because they have reserve funds, financial controls and diverse sources of revenues, including income and real estate taxes. We believe a few months without tourism is likely to have little impact on the city’s credit rating.

The key point is that we expect downgrades, not defaults and the market has already traded down in price considerably due to the costs of liquidity. When considering the impact of future downgrades on price valuations, in our opinion it is extremely likely that the negative market performance we have already had due to the liquidity costs of trading has already been greater than the potential impact would be from downgrades in the future.

What about the outlook for markets as a whole?

It's important to remember that going into this crisis, we had a very strong economy, and the fundamentals driving that economy were sound. We would be in a much worse position today if that were not the case.  We also believe that in the long term, municipal bond investments generally provide good investment opportunities, despite frequent short-term volatility.

Furthermore, we feel strongly about what we think will end this downturn. The pharmaceutical companies and innovative bio-engineering firms and our government are very focused on defeating COVID-19.  And many of these are global efforts. We didn’t have that level of reassurance so soon after the terror attacks of September 11, 2001 or, for that matter, after the financial crisis of 2008-09, when we couldn’t be sure so quickly about what had happened to toss us into that level of chaos and what it might take to solve the problems. In our view, this will end, and life, business, and markets will eventually return to normal.

To end on a positive note: Right now the market is functioning, and we see that there are opportunities there. Municipal bonds are available at yields that look attractive to us and that we feel typically provide good relative value compared to other investment alternatives such as Treasuries.

 

A Note about Risk: 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. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. 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. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

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.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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.

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