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Fixed-Income Insights

Here, we break down the trends that defined the municipal bond market in the year’s first six months.

 

In Brief

  • What did we learn in reviewing important trends in the municipal bond market in the first half of 2018?
  • For one thing, investors have preferred shorter-dated munis, giving up extra yield in doing so.
  • Following a spike in late 2017, the supply of newly issued muni bonds has remained low.
  • Despite negative headlines about fiscally challenged muni issuers, overall credit quality remains high.
  • On a total-return basis, muni bonds have weathered rising rates better than many other fixed-income categories.
  • Most important, while the 2017 U.S. tax legislation has changed many aspects of the muni sector, the market has performed relatively well and fundamentals look promising going forward.

 

I recently participated in a roundtable discussion with other Lord Abbett investment professionals about the midyear investment outlook. Reviewing the progress of the municipal bond market in the first half of 2018 uncovered a number of interesting developments. Some of these developments were as expected, but there also were a few surprises.

Here are my observations about the first six months of 2018, and how market trends could influence munis’ performance in the year’s second half:

1. Muni investors have been playing the short game.

During the first half of 2018, municipal bond investors were quite conservative in their approach to interest-rate risk. Remember that unlike many other financial markets, the municipal bond market is dominated by individual investors. According to U.S. Federal Reserve data, approximately two-thirds of muni bonds currently outstanding are held by individuals, either in mutual funds, separately managed accounts, or brokerage accounts. While demand has been strong for municipal bond mutual funds, with approximately $7 billion of inflows year to date (through June 30), much of that money has gone into intermediate- or short-duration muni funds. When investors have selected longer-maturity funds, the flows have predominantly gone into high-yield muni funds. While the statistics for separately managed accounts aren’t reported, anecdotal evidence suggests that almost all of the flows are going to intermediate or short accounts.

This trend has had a significant impact on market valuations along the range of maturities. It is notable that municipal-bond demand from individual investors has been strong, partially due to changes in the tax code in December 2017. Why? While traditional exemptions for individuals were reduced—mainly through the cap on state and local income tax deductions, along with the decrease in the size of mortgages qualifying for full interest deductibility—the full federal tax exemption of municipal bond interest has remained unchanged.

A look at the ratios of municipal bond yields to U.S. Treasury bond yields for different maturities gives a sense of how demand for different maturities has shifted. The standard way of measuring this is to use Municipal Market Data’s yield curve for ‘AAA’ rated municipal bonds. (See Chart 1.) The lower the ratio, the wider the difference—that is, the degree to which muni yields are lower than Treasury yields. Typically, the yield ratios are lower for shorter maturities, but the recent differences are particularly wide. Right now, an ‘AAA’ rated municipal bond with a 30-year maturity has practically the same yield as a Treasury bond—even though the interest on munis is exempt from federal taxes. Meanwhile, an ‘AAA’ rated two-year municipal bond has only about two-thirds the yield as a Treasury of comparable maturity. This suggests that there is excess demand for short-maturity municipals, signaling that individual investors are sacrificing substantial yield on their muni bonds to reduce their interest-rate risk.

 

Chart 1. Yield Ratios Point to High Demand for Lower-Maturity Munis
Yield ratios (‘AAA’ rated munis/U.S. Treasury bonds) by maturity, as of June 30, 2018

Source: Thomson Reuters MMD.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.  

 

This difference could get even wider. That’s because the tax bill no longer allows issuers to advance refund outstanding bonds. This means the number of pre-refunded bonds available in the market will fall, without new ones being created. Since pre-refunded bonds have a final maturity of the original call date, they typically have maturities shorter than five years. As a result, the number of bonds available with maturities shorter than five years will shrink as currently outstanding issues mature, so there will be even fewer bonds available for investors seeking to reduce interest-rate risk. Pre-refunded bonds represent a high percentage of short-maturity muni-bond indexes, as Chart 2 shows. When these bonds mature, it likely will have a significant impact on the short end of the market.

 

Chart 2. Pre-Refunded Bonds Represent a Large Portion of Short-Term Muni Issuance
Amount issued ($ in bil.), by year, as of June 30, 2018

Source: Bloomberg Barclays data.

Past performance is not a reliable indicator or guarantee of future results. Pre-refunded index represents a structure-specific subset of the Bloomberg Barclays Municipal Bond Index (the Municipal Bond Index). For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

2. The supply of newly issued muni bonds remains low.

Overall, the volume of new issues is approximately 20% behind the amount during the first half of 2017.  The main reason for this reduction has been the effect of the 2017 tax bill.  Concerns about the outcome of the final bill pushed a good number of issuers to bring their new bonds forward into December 2017 rather than take a chance on unfavorable tax changes for 2018. Also, the elimination of advanced refunding bonds, which along with current refunding bonds (i.e., bonds that are refinanced at their call date), represented more than 30% of new issuance during each year from 2011 to 2017, but only 14% of this year’s new issues have contributed to the supply decrease. New-money bonds that were issued for new projects actually have increased 22% this year; but this has been more than offset by a greater decrease in refunding bonds.

 

Chart 3. Refunding Bonds Are in Retreat
Refunding bonds as a percentage of new issues, by year

Source: The Bond Buyer.
*Through June 30, 2018.

 

Another key trend in muni-bond issuance in the first half of 2018 was a higher-than-usual percentage of general obligation bonds coming to market. This year, only 57% of new issues were revenue bonds, versus more than 60% for every year going back to 2009. The likely cause for this reduction was a tax bill-related flood of issuance in December 2017 for one key type of revenue bond: private-activity bonds. These are used for projects such as airports, universities, and hospitals. Even though the idea in the original House bill to take away the tax exemption for these private-activity bonds was eliminated from the final bill, issuers thought they might have to pay higher yields without the tax exemption, so those who were ready to come to market did so rather than waiting for the final version of the bill.

 

Chart 4. Revenue Bond Issuance Has Slumped in 2018 After a Late-2017 Surge
Revenue bonds as a percentage of municipal-bond issuance, by year

Source: The Bond Buyer.
*Through June 30, 2018.

 

3. Muni-bond credit quality remains high.

With the headlines in recent years about fiscal issues in Puerto Rico, Chicago, and the states of Illinois and New Jersey, many investors might have thought that the whole market was facing the challenging situations of these large issuers. But that’s clearly untrue. Credit ratings agency Moody’s Investors Service actually issued more upgrades (116) than downgrades (94) of municipal-bond issuers during the first quarter of 2018 (ended March 31), a trend that has held in each quarter since mid-2016. Moody’s rates 11,344 different municipal-bond issuers, meaning that the ratings changes reflect only 1.7% of those currently outstanding—so the vast majority of issuer ratings remained stable.

In addition, and on the positive side, Illinois reached a budget agreement well before the fiscal-year deadline on June 30, 2018. This was a big accomplishment, since the budget deal reached in 2017 had been the first one in two years. New Jersey also reached a budget agreement close to its deadline. Many states have seen tax revenues come in well above their budgets; states such as California have been negotiating over how to use excess revenues rather than how to balance budgets, as their fiscal plans are finalized.

4. Overall, muni returns have weathered rising rates.

Even though interest rates have risen for most maturities, investor returns have been positive to only slightly negative thus far in 2018. According to Municipal Market Data, interest rates increased by more than 40 basis points, or 0.40%, for all maturities of 10 years and longer. While fears of rising rates have prompted investors to reallocate away from longer bonds (as mentioned earlier), the overall Bloomberg Barclays Municipal Bond Index was down only 0.25% for the year (through June 30, 2018). The long bond segment of the index (i.e., maturities 22 years and longer) declined 0.66%, while the worst-performing maturity was the 10-year segment, which was down only 0.72%. Even though the 10-year index is shorter in average maturity than its longer counterpart, it actually underperformed as rates rose more in the intermediate-maturity range.

In total, the municipal-bond yield curve from one to 30 years has steepened, while the 10- to 30-year portion has flattened. This has been somewhat caused by the change in the tax bill, which lowered the corporate tax rate, from 35% to 21%. Banks and insurance companies historically have owned about one-quarter of outstanding municipal bonds; but with lower tax rates, muni bonds are now less attractive for them. This has caused banks to reduce their portfolios by selling some bonds in the 10- to 30-year maturity range. Meanwhile, demand from property-casualty insurance companies for muni securities in this range—a traditional focus for these insurers—has fallen.

Still, the main point here is that despite rising rates and corporate investors reducing their demand, the downside in returns for municipal-bond investors was small.  The high-yield and ‘BBB’ rated Bloomberg Barclays muni indexes posted positive returns of 3.66% and 0.40%, respectively. Thus, mutual funds that can invest in a wider range of credit quality have been able to attain better returns.

In discussing all these first-half index returns, it is important to remember that they do not even incorporate the advantage of the tax exemption of municipal-bond interest because tax-equivalent yields need to be calculated. Taxable fixed-income investments of comparable credit quality and maturity would need to have had significantly positive returns to outperform municipals for investors in non-tax-deferred accounts.

5. Puerto Rico muni bonds had a strong first half.

Bonds from Puerto Rico’s municipal issuers have posted some eye-popping returns over the first half of the year, which might be a surprise given all the negative headlines emanating from the commonwealth. Other than the Aqueduct and Sewer Authority, which is still paying interest, all other unenhanced Puerto Rico bonds remain in default. But that hasn’t stopped them from performing strongly. For example, subordinate COFINA sales tax bonds started the year trading at $10 for every $100 of par value, but had appreciated to $42.75 for every $100, as of July 3, 2018. That is a return of more than 300%. (COFINA is the Corporación del Fondo de Interés Apremiante—a government-owned corporation of Puerto Rico that issues government bonds.) Senior COFINA sales tax bonds started the year at $40.15, and, as of July 3, 2018, were trading at $85.25—a return of more than 100%. The large general obligation bond, which was the last new issue from Puerto Rico, started the year at $23.75 and was trading at $39.50, as of July 3, a return of roughly 75%.  The Aqueduct and Sewer bonds, which have been paying interest, started the year at $61.63, and were recently were priced at $70.88, representing a price return of nearly 15%.

The main point here is that Puerto Rico bonds have recovered quite a bit from their losses after last year’s hurricane, though they still are trading well below par. Their equity-like returns seem surprising, until you consider that prices were unduly depressed, based upon market dynamics during the last quarter of 2017.  There are varying reasons for the strong performance this year, ranging from improving bondholder outcomes in revised fiscal plans, tax revenues coming in above forecasts, government cash balances remaining high, and limited numbers of investors selling their bonds. If we look toward the future, pending negotiations between creditors, the commonwealth, the U.S. Congress-created board and court representatives may have the potential to deliver negotiated bond price-restructuring outcomes that are much better than the worst cases that investors might have expected.

Summing Up

The municipal-bond market clearly has been changed by the U.S. tax bill of 2017. Issuance patterns are different, and changes in traditional tax exemptions have helped boost demand from individual investors.  The domestic economy is performing well, benefiting the credit quality of many issuers, and leading to stable or improved ratings. Some more fiscally challenged issuers in the headlines have been making positive progress, and that has helped their performance, while demand for lower-quality bonds has been strong. Finally, while interest rates have risen, the negative impact upon municipal-bond investors has been much smaller than many anticipated; indeed, rising rates have been less of a drag on munis than many other fixed-income markets, but investors still remain conservative in their maturity preferences.  Overall, the municipal-bond market has had a decent first half of 2018, and it appears to be well positioned for the second half of the year.

 

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.

When comparing mutual funds to separately managed accounts, one should carefully consider the fees and expenses associated with each type of investment. All investments carry a certain degree of risk, including the possible loss of principal, and there are specific risks that apply to each investment strategy.

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.

The Bloomberg Barclays Municipal Bond Index a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.  Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies.  They 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.

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.

MIDYEAR OUTLOOK

Get insights from our investment leaders on key topics for the second half of 2018.

Our Experts Give Their Macro Views
• What Is the Yield Curve Telling Us? 
• Positioning Portfolios
• Muni Matters: Five Key Takeaways

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