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Fixed-Income Insights

First in a new series of weekly commentaries on the tax-exempt sector from our Director of Municipal Bonds

Read Time: 3 minutes

During the week ended May 1, the municipal bond market moved lower, underperforming equity and most taxable fixed income markets. We believe the major reasons for the underperformance were the negative tone set by Senator Mitch McConnell’s comments on the possibility of bankruptcies among U.S. states, outflows from municipal bond mutual funds, and negative media reports on the credit outlook for high yield muni issuers. As the week ended, the market turned slightly more positive, likely reflecting investors’ recognition of the attractive relative value of municipal bonds.

[Register now for a May 13 webinar with Dan Solender on opportunities and risks in the municipal bond market.]

McConnell’s comments created some misguided concerns about municipal bonds, in our view. First, Congress cannot decide whether states can declare bankruptcy because there are constitutional issues restricting it from having this power. Second, most state governors were clear that they do not want this option. Indeed, the senator has since backed off his earlier statements about bankruptcy. We anticipate that there will be divisive discussions about financial assistance to state and local governments, but we believe that Congress will ultimately provide support.

Reviewing the Performance of Municipal Bonds
Since the pandemic crisis started, muni market performance has largely been driven by the pace of flows into or out of related mutual funds, in our view. Early on, municipals outperformed other markets as investors held steady. Then, in early March, funds started having large outflows—more than $30 billion for the full month—which drove yields higher and prices down. (All fund-flow data mentioned herein are from Lipper.) During late March, the market performed well and remained stable into April as the flows turned positive for a couple of weeks. For the reporting week ending April 29, muni funds saw negative flows of $1.3 billion.  It appears to us that this was partially driven by McConnell’s comments.

All along, much of the money moving out of the market has been from high yield muni funds.  As of April 30, the year-to-date return of the Bloomberg Barclays Municipal Bond Index was -1.88%, while the Bloomberg Barclays High Yield Municipal Bond Index was down -10.02%. In our view, the forced selling of lower quality munis has led to significant costs necessary to find buyers for the bonds for sale, which has helped push these prices down to a greater degree; investors’ uncertainty about the credit outlook likely has been a contributing factor. Our credit analysis suggests that these concerns are overblown, but some investors may need to see more evidence about how credits will respond to virus-led economic disruptions before re-entering the market.

Media reports on muni credit quality may have also dampened sentiment. For example, one article suggested that default rates were increasing for high yield munis. But the supporting examples cited—a recycling plant, a continuing care retirement community, a local YMCA, a hotel in Illinois—were already weak before the economic slowdown, and thus not representative of actual credit trends, in our view. There have been other articles echoing this negative view, but the sources quoted in them appear to be investors who don’t normally participate in the high yield muni market.

The Big Picture for Municipal Bond Investors
Concerns about muni market credit quality should be placed into context. An annual Moody’s study released in 2019 showed that the historical default rate for investment grade municipal bonds has been virtually 0%. We do not believe that is going to change now, especially with supportive policies from Congress and the U.S. Federal Reserve. High yield municipal bonds also have had much lower historical default rates than comparably rated corporate bonds, and we believe things will remain that way. Yes, there have been some minor ratings downgrades and additional negative outlooks from the rating agencies, with more likely to come, but we believe investors have largely factored in such developments.

We believe it is important to reflect upon what entities are supporting municipal bond credits. Americans will always need electric utilities, water and sewer systems, secondary schools, colleges, healthcare facilities, toll roads, public transportation, marine ports, and airports—all sectors which derive significant funding from the sale of municipal bonds. Most of these credits are expected to be able to support their muni-bond obligations through this environment based upon prevailing projections of how long it will last.   

Amid the current challenges for the municipal bond market, it is important to recognize that yields at all maturities were recently higher than U.S. Treasuries of comparable maturities--even though municipals are tax-exempt. In many cases, muni yields are similar to corporate bonds and sometimes cheaper--even though municipals are tax-exempt. The municipal bond market has gone through other trying times over the past few decades.  Although this episode is clearly different, we believe there is no reason that the credit quality of the market should not maintain the high levels it has achieved since the first municipal bond was issued in 1812.

 

Charts of the Week

Municipal Bond/U.S. Treasury Yield Ratios Are Significantly Higher Than the One-Year Average
Data as of May 1, 2020


Source: Bloomberg.
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.

SPOTLIGHT:

This chart shows the yield ratio of tax-exempt issues versus taxable issues directly backed by Goldman Sachs as of May 1. This is not a comment on the investment merits of securities in either category, but rather an observation about investor preferences in the current market: While the implicit credit standing of the bonds (both backed by Goldman) is exactly the same, yields on tax-exempt bonds are extremely close to their taxable counterparts before any calculation of tax-equivalent yield

Tax-Exempt vs. Taxable Yield Ratio on Goldman-Sachs Backed Bonds—May 1, 2020


Source: Bloomberg. Data as of May 1, 2020.
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, do not reflect the deduction of fees and expenses, and are not available for investment.

Muni-Bond Yields Are Higher than Treasures at All Points on the Yield Curve
One-month to 30-year yield curve for the indicated categories as of May 1, 2020’


Source: Bloomberg and U.S. Treasury Dept. Data as of May 1, 2020. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
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, do not reflect the deduction of fees and expenses, and are not available for investment.

 

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