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Fixed-Income Insights

Municipal bonds have featured attractive yields, relative safety compared with other fixed-income securities, and lower volatility than U.S. Treasuries.

 

In Brief

  • With the prospect of stimulus measures by global central banks—and further pressure on bond yields—following Great Britain's “Brexit” vote on June 23, municipal bonds may merit a closer look. Here, we identify three reasons why:
  • Attractive tax-equivalent yields—Adjusted for taxes, recent yields on municipal securities have appeared quite favorable in relation to those on comparable taxable corporate bonds.
  • Relative safety—The overall credit rating profile of the U.S. municipal bond market is much stronger than that of the global corporate bond sector. 
  • Low volatility—The lower volatility of municipal bonds versus U.S. Treasury securities is another potential advantage.
  • The key takeaway: Investors seeking income, safety, and low volatility in the fixed-income portion of their portfolios may be surprised to discover that the municipal market is a compelling option.

 

In a world of low or even negative interest rates, income-seeking investors may want to look for yield in the U.S. municipal bond market. If low volatility, safety of principal, and, yes, attractive income are an investor’s objectives for the fixed-income portion of their portfolio, municipal bonds may be an asset class that deserves more scrutiny. In an era when negative interest rates elsewhere in the world have pulled yields on many U.S. securities below expected inflation, municipal bonds may offer better aftertax returns with less volatility—and lower risk of default—than many taxable alternatives.

Higher Comparable Yield
At first glance, yields on municipal bonds seem uninteresting to most investors. However, adjusted for taxes, recent yields on municipal securities have appeared quite favorable in relation to those on comparable taxable corporate bonds. Such a comparison can make municipal bonds suddenly very compelling. Chart 1 compares the tax-equivalent yields of ‘AA-’ or ‘A’ rated municipal indexes to those of ‘AA-’ and ‘A’ rated taxable corporate indexes. In each case, on a taxable-equivalent basis, the municipal indexes yield close to 1.0% more than the taxable counterpart.

 

Chart 1. Historically, Municipal Bonds Have Featured Higher Tax-Equivalent Yields Than Comparable Corporate Bonds
Yield or tax-equivalent yield* for indicated indexes, as of May 31, 2016

Source: Barclays. Investment-grade municipal data represented by ratings-specific components of the Barclays Municipal Bond Index and investment-grade corporate data represented by ratings-specific components of the Barclays U.S. Corporates Index. *At the 28% tax bracket, the tax-equivalent yield would be 2.56% and 3.06% for the ‘AA’ rated and ‘A’ rated 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.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular 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.

 

The comparison is even more favorable in the high-yield sector, as Chart 2 shows.  The representative Barclays Municipal High Yield Index yielded 6.42% at the end of May 2016, or 11.34% on a tax-equivalent basis based on the 43.4% tax bracket. The latter figure is 3.50% above the 7.84% yield for the taxable JP Morgan U.S. High Yield Index.

 

Chart 2. High-Yield Municipal Bonds Historically Have Offered Higher Yields Than Corporate Counterparts
Yield or tax-equivalent yield* for indicated indexes, as of May 31, 2016

 

Source: Barclays and J.P. Morgan. High-yield municipal data represented by the Barclays High Yield Municipal Bond Index and high-yield corporate data represented by the JP Morgan U.S. High Yield Index. *At the 28% tax bracket, the tax-equivalent yield would be 8.92% for the High Yield Municipal Index. 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. Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular 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.

 

For investors who are taxed at the top marginal rate, and for those in the lower brackets as well, municipal securities may offer meaningful income advantages over taxable corporate bonds, whether on terms of risk appetite for investment grade or for high yield.

Safety First
Safety of principal may be even more important to some investors than yield. Here, too, the relative safety of municipal bonds may be an appealing feature. To begin with, the historical overall credit rating profile of the U.S. municipal bond market has been much stronger than that of the global corporate bond sector. According to a Moody’s report published May 31, 2016, some 93% of municipal issuers are rated in the ‘A’ category or higher, compared with 25% of global corporate issuers.  This difference in underlying quality is reflected in cumulative default experience.  According to Moody’s, the 10-year average cumulative default rate for all municipal bonds during the period 1970–2015 was 0.15%.  For global corporates, it was 10.16%, nearly 68 times worse. 

Investors wanting to invest exclusively in speculative-grade (that is, lower than investment-grade) bonds will find that municipals compare favorably in a key category. In Table 1, the cumulative 10-year default rate in 1970–2015 for speculative-grade municipal issues was 8.18%, compared with 29.42% for global corporates. Investors in high yield may recognize and identify with one-year figures more readily. In that case, Moody’s one-year average default rate for speculative-grade municipals during the 1970–2015 period was 1.33%, compared with 4.07% for global corporates.

 

Table 1. Municipal Bonds’ Historical Default Rates Are Far Lower Than Those of Global Corporate Bonds
One- and 10-year default rates by category, 1970–2015

Source: Moody’s. Data show the average 10-year cumulative default rates of Moody’s rated corporate and municipal bonds for a study covering the period 1970–2015. Data are the most recent available. While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Low Volatility
In addition to income and safety (in the form of relatively attractive yield and a low default experience), the lower volatility of municipal bonds versus U.S. Treasury securities also may be appealing to investors.  Chart 3 illustrates the yield and volatility characteristics of longer-dated municipal bonds relative to a 10-year U.S. Treasury index. The volatility of long muni bonds (as represented by an index with maturities over 22 years) has been less than that of 10-year Treasuries, yet the tax-equivalent yield is substantially higher. A 10-year muni bond index may provide an even better illustration of the volatility advantage of municipal bonds. Comparing a representative 10-year muni index to a 10-year Treasury index shows that munis of that maturity offer a higher tax-equivalent yield with 40% less volatility.

 

Chart 3. Municipal Bonds Have Offered Higher Yield, Less Risk Than U.S. Treasuries
Tax-equivalent yield and 20-year standard deviation for indicated indexes, as of May 31, 2016

Source: Barclays and Citigroup. Municipal bond maturities represented by components of the Barclays Municipal Bond Index; U.S. Treasury maturities represented by specific-maturity Citi Treasury Benchmark Indexes. 
At the 28% tax bracket, tax-equivalent yields would be 2.50% and 3.57% for the Barclays Municipal Bond 10-Year and 22+ (Long) 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. 
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Lower-rated bonds may carry greater risks than higher-rated bonds. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.

 

Investors wanting to manage the volatility of their fixed-income portfolio may find that with munis, they can extend to longer maturities to capture greater yield without the increased volatility associated with Treasury securities. The lower volatility of municipals is due in part to the lack of international and institutional investors who are more active in taxable markets. The buy-and-hold perspective of many U.S. municipal investors may also contribute to the market’s relative stability.

A Compelling Income Alternative
Today’s income investor may wish to give municipal bonds a closer look. Tax-equivalent yields offer income that is unavailable on taxable bonds with comparable quality and maturity characteristics.  Historical default rates among municipal bonds are much lower than those of comparable quality issues in the taxable market. And historical volatility suggests municipals have offered more attractive characteristics in this area as well. 

The municipal market may be a compelling choice for investors seeking income, safety, and low volatility in the fixed-income portion of their portfolio. Active managers may be able to add value in today’s muni market by targeting parts of the yield curve that offer better relative value, and by providing sophisticated credit research capabilities. Experienced active managers can draw on a range of muni-bond strategies to help investors meet their income objectives—while they enjoy the tax benefits that this asset class has to offer. 

ABOUT THE AUTHOR

RELATED FUND
The Lord Abbett High Yield Municipal Bond mutual fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.

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