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Fixed-Income Insights

Here are three indicators that can offer investors key insights into the valuation of muni securities in the current market.

 

In Brief

  • Determining the relative value of municipal securities encompasses a range of disciplines, including credit analysis of individual issues, evaluation of economic trends, and broader research on market sectors.
  • It also is critical to place the yields of the securities under consideration in the proper context for a portfolio’s overall positioning. In that regard, the analysis of muni bond yields versus relevant benchmarks is very important.
  • Investors may wish to examine three critical relationships: the yields of shorter-term versus longer-term municipal securities; the yields of the highest-rated munis (‘AAA’ from Moody’s, Standard & Poor’s, and/or Fitch) compared to those of U.S. Treasury securities; and the yields of investment-grade munis versus high-yield munis.
  • The key takeaway: In order to make educated decisions within the municipal bond market, investors need to select appropriate indicators for analysis. This can be more complicated than equity market comparisons, for example, whereby indicators are constantly analyzed by the media. In addition to the broad indicators mentioned here, investors may wish to consider examining other, more specific historical relationships among municipal securities to decide whether the current opportunities represent attractive values.

 

Some of the most important work we do in evaluating whether municipal securities are attractively priced—or too expensive—involves analyzing how each muni issue under consideration stacks up against other muni bond offerings, or against other classes of fixed-income securities. You might say that we’re reading yield signs to help us uncover the best relative value available in the muni market.

To be sure, our overall approach to investing in municipal securities encompasses a range of disciplines, including credit analysis of individual issues, evaluation of economic trends, and broader research on market sectors. With municipal bonds, as with other fixed-income securities, the process of calculating a security valuation typically starts with evaluating the yield that an investor can earn when purchasing the bonds. This yield leads to a computation of the bond price, which is based upon calculating the present value of the cash flows that will be paid out over the lifetime of the bonds. The main components incorporated in the valuation are the coupon, maturity, call date, and call price of the bond. Most municipal bonds with maturities longer than 10 years are callable, so the calculation needs to factor in the value of the call. The bond’s cash flows are then discounted at the prevailing market yield for the bond.

The most important input in muni valuation, however, is a judgment regarding whether the bond is being offered at an appropriate yield to compensate for the risk of the investment. In making this decision, our opinion is based on many factors, including the credit quality of the investment compared with other bond offerings, along with the bond’s structural attributes such as its coupon, maturity, and call, also compared with other offerings. Most often with municipal bonds, the particular issue may not have traded for a while, so it must be compared with bonds with similar credit characteristics that have been trading in order to make a relative valuation. In addition, we believe it is critical to compare a muni security we are considering with historical market spreads for the bond itself when and if it previously traded along with the average historical yield spread for its sector and credit quality.

It also is critical to place the yields of the securities under consideration in the proper context for a portfolio’s overall positioning. That’s why our analysis of muni bond yields versus certain other benchmarks is so important. We often are asked about the specific valuation comparisons we consider important in the muni market—which can help investors understand where we see areas of opportunity—so we thought we’d share some important ones that we consider. In general, at a global level, we believe it’s important to evaluate three key relationships:

  • The yields of shorter-term versus longer-term municipal securities;
  • The yields of the highest-rated munis (‘AAA’ from Moody’s, Standard & Poor’s, and/or Fitch) compared to those of U.S. Treasury securities; and
  • The yields of investment-grade munis versus high-yield munis.

What can these comparisons tell us about the valuation of muni securities in the current market? Let’s take a look at each in the following charts.

Signal No. 1: The Yield Spread between Two-Year and 30-Year ‘AAA’ Rated* Munis

Source: Thomson Reuters Municipal Market Data. Municipal yield curve based on proprietary data from MMD. Data as of June 12, 2014.
*As rated by Standard & Poor’s, Moody’s, and/or Fitch.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment.
The income derived from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. 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.

 

What it tells us: The difference between two- and 30-year muni yields, based on information from financial information provider Municipal Market Data (MMD), is a critical measure of relative value. Analyzing the shape of the yield curve is important when selecting the best bonds to use when structuring a portfolio among different maturities. The slope of this curve becomes steeper when longer-maturity bonds underperform shorter-maturity bonds—that is, when interest rates rise more on longer-term bonds than shorter-term bonds, or don’t fall as much as shorter ones. A steeper yield curve potentially signals opportunity in longer-maturity bonds—as long as the investor is willing to accept additional interest-rate risk. The slope flattens when longer-maturity yields do not rise as much as shorter-maturity yields or when longer-maturity yields decrease more. Note that the two- to 30-year relationship represents the extreme ends of the yield curve, and investors may want to study the spreads between intermediate maturities too when optimizing their portfolios.

The municipal yield curve is always upward sloping—that is, short-term yields historically have remained below long-term yields—unlike the Treasury yield curve (displayed in the related chart for comparison purposes), which can invert on occasion (the last time it did so was in 2007, when the fed funds rate was much higher than it is today). A historical pattern of strong demand and low supply of short-term municipal bonds is one of the reasons for this relationship.

What it’s signaling now: The two- to 30-year muni yield curve has recently been very steep due to the ultra-low fed funds rate of 0–0.25%. It steepened in 2013 amid the sell-off in longer-maturity munis, but has flattened somewhat this year as the muni market has been recovering. The muni yield curve’s flattening mirrors a similar, but not as large, move in Treasury yields, as U.S. economic growth has not been robust enough to push rates higher. These trends also reflect recent strong demand for U.S. bonds compared with the rest of the world. Furthermore, investors are eager for more yield in the current low interest-rate environment. The relative steepness of the curve means that there are higher yields for issues with longer maturities, which can compensate investors who are comfortable taking on the associated interest rate risk.

In the months and years to come, then, the yield curve could flatten under two different scenarios: if economic growth slows, pushing yields of longer-term bonds down; or if the Federal Reserve raises short-term interest rates amid concerns over the potential for rising inflation; or overly robust economic growth. The relative steepness of intermediate maturities will likely also change under these scenarios. Sometimes a steep yield curve can suggest that the market forecast is for a stronger economy in the future, and many investors have been concerned about the potential for higher interest rates under such a scenario for a while. However, the curve has stayed relatively steep amid the Fed’s recent tapering efforts, suggesting that the market consensus for rising rates has not been correct thus far and that investors have been earning attractive yields and returns for accepting the risk.

Signal No. 2: The Ratio of the Yield on 30-Year ‘AAA’ Rated* Munis to the 30-Year Treasury Bond Yield

Source: Thomson Reuters. Ratio depicts 30-year ‘AAA’ muni yield (as represented by proprietary data from Thomson Reuters Municipal Market Data) divided by 30-year Treasury yield. Data as of June 12, 2014.
*As rated by Standard & Poor’s, Moody’s, and/or Fitch.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment.
The income derived from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. 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.

 

What it tells us: This ratio is important because it is a relative value measure comparing municipal bonds to taxable bond markets. Fixed-income buyers have a range of choices among taxable and tax-free bonds, and this yield relationship often can be a predictor of when large investors such as hedge funds or taxable bond funds will be buying or selling municipal securities.

Overall, it is difficult to find a truly representative yield benchmark for the entire municipal bond category, so Municipal Market Data’s daily yield curve is considered to be the best estimate available. With some $3.7 trillion in municipal bonds outstanding as of March 27, 2014 (the most recent data available), according to the Securities Industry and Financial Markets Association, and a wide variety of small and large issuers, there is a wide range of yields available in the market for similarly rated bonds. As such, investors should expect a wide range of variation around the estimated MMD ratio if they are actually reviewing bond offerings. Demand from crossover investors—those muni buyers who typically purchase taxable fixed income or equity securities instead— has increased in recent years. This factor has helped municipal bonds rally in up markets and provided liquidity during times of outflows from municipal-bond mutual funds, or down markets, so assessing indicators of potential demand from these buyers has become even more important.

Because municipal bond yields are tax-exempt, the yield ratio to Treasuries typically should be lower than 100%. This is because investors must focus on the tax-equivalent yield for municipal bonds in order to compare them to the higher yield that a taxable bond needs to possess for its aftertax yield to be equal to that of a tax-free municipal bond. [Tax-equivalent yield does not reflect state and local income taxes and will vary based on each investor's tax bracket at the federal and state levels along with the local tax in some locationsAlso, it could be different if an investor is subject to alternative minimum tax.]  Many investors do not fully understand the magnitude of the difference between a tax-exempt yield and a tax-equivalent yield, especially with tax rates rising in recent years. One example: For an investor in the top marginal tax bracket of 43.4% on investment income, which includes the 39.6% income tax rate and the 3.8% Medicare tax, a 4% tax-free bond yield has a tax-equivalent yield of 7.07%. (At the 28% tax bracket, the tax-equivalent yield would be 5.56%.) So, when ‘AAA’ rated municipal bond yields are the same as Treasury bond yields, the aftertax yields for most investors are not really close.

What it is signaling now: In the period before the 2008–09 credit crisis, the yield ratio of AAA-rated munis to Treasuries averaged around 90% for the 30-year maturity, almost always holding well below the 100% line. Market conditions since the start of the credit crisis have upended this historical relationship; the ratio has frequently been above 100% since then, reaching a high of approximately 210% during the height of the crisis in late 2008.

Recently, the ratio has moved back below 100%, into the 96–98% range as municipal bonds have rallied from their 2013 losses. Because tax rates have risen since 2008, tax-equivalent yields have been pushed higher, and this may suggest that the ratio could fall below this range after the Federal Reserve dials down its efforts to keep Treasury rates low. It may still take some time before the ratio reaches levels similar to those seen before the 2008–09 credit crisis, but the economy is stabilizing in that direction. If it continues, municipal bonds have the potential to outperform taxable bonds.

Signal No. 3: The Yield Spread on the Barclays High Yield Municipal Bond Index Yield to the Barclays Municipal Bond Index

Source: Barclays index data. Data as of June 12, 2014.
*Represents average spread since index inception, October 31, 1995.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.
High-yielding, non-investment-grade bonds have higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

 

What it tells us: This indicator gives information about investor demand for lower-quality bonds compared to higher-quality bonds, which represents investors’ willingness to take credit risk. This relationship, as depicted in the related chart, represents an average for all high-yield bonds, based upon the constituent bonds in both indexes. It is best viewed as an indicator of the direction of credit spread movements, rather than an exact number to use for trading. Note that this relationship can be affected by movement in bonds within the indexes or bonds transitioning between the benchmarks, such as bonds from Puerto Rico issuers moving from the investment-grade Barclays Municipal Bond Index to the Barclays High Yield Municipal Bond Index during the first quarter of 2014. The movement of the Puerto Rico bonds artificially widened the credit spread between the indexes at a time when spreads on most other high-yield bonds were tightening. Thus, a more thorough analysis requires an adjustment for that change, although the average spread of high-yield to investment-grade bonds did indeed widen when the index shift occurred.

Within the municipal bond market, it is very difficult to find comprehensive credit spread indicators because there are many variables that affect bond spreads other than credit—coupon and call protection, for example—and that makes the analysis challenging, and makes it almost always necessary to make adjustments. There also are large differences in the magnitude and dispersion of spreads between sectors, such as tobacco and healthcare bonds, so the credit spreads can vary considerably by sector, making it tough to have one indicator for overall credit spreads. Therefore, the next step after looking at the  amount of the overall credit spread to determine whether there is value in making high-yield investments is to break it down further, examining these other attributes to figure out the best values within the high-yield market.

What it’s signaling now: As with the ratio of municipal bonds to Treasury bonds, this indicator has been markedly different since 2008, because credit spreads widened so much during the crisis. So, compared with the average spread since 2008, it currently represents a good value, but when using the average of the past 15 years, spreads are far wider than the mean, indicating that the value may be even more attractive. Only analyzing the shorter time period may cause investors to miss a potential opportunity. This relationship suggests that lower-quality bonds could continue to outperform if the economy continues to stabilize and the Fed reduces its purchases of U.S. Treasuries. If interest rates rise under that scenario, lower-quality munis could present an appealing value relative to Treasuries because the ratio is still higher than the historical average and muni credit spreads are still not back to where they were before the credit crisis.

Summing Up
An understanding of the relationships among various broad categories of municipal securities, along with the yield comparisons with other fixed-income instruments, provides an excellent starting point for making valuation determinations and investment decisions. These types of analyses are very important in selecting municipal bond investments because the market is composed of many bonds that don’t trade actively and many smaller issuers with whom investors may not be familiar. Global indicators are needed to explain the opportunity in a market where consistent trading in most of the individual securities does not occur, making individual security analysis challenging in many cases. Investors also may wish to consider the benefits of the deeper approach that professional management offers, providing more detailed yield analysis on the sector, maturity, and call provision levels.

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in intermediate-term investment grade municipal bonds.
RELATED FUND
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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