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Fixed-Income Insights

While general obligation bonds have outperformed in 2020, we believe revenue bonds’ historical characteristics make them an attractive choice for long-term investors.

Read time: 5 minutes

As we have detailed in past weeks, the municipal bond market has been through a roller coaster ride in 2020. A deeper look at performance reveals wider than normal differences among muni market sectors. This week, we will take a closer look at the performance of general obligation bonds versus revenue bonds.

As a reminder, general obligation (GO) bonds are backed by the “full faith and credit” of a government, and are issued by entities such as states, cities, counties, and school districts. Revenue bonds are backed by revenues from a specific projects or facilities (such as toll roads, water/sewer systems, or airports).  

General Obligation Bonds

The general obligation (GO) index1 has returned 2.92% year-to-date (through June 25)2 outperforming the broader market index.3 The average rating of credits in the GO index is between AA1 and AA2, which means they are very high-quality issuers.  In terms of market value, GO bonds, at $462 billion, represent 28% of the $1.6 trillion total of the overall muni bond market. Since GOs seem to receive a large share of the media coverage of muni bonds, it might be surprising to some people that they aren’t a bigger portion of the overall market.

So, why have GOs outperformed the market this year?  We believe the answer is their high credit quality.  The average rating of the broader market index is between AA2 and AA3, so GOs on average are higher quality.  While much media attention is paid to two states in the lower tiers of investment grade, Illinois and New Jersey, most GOs are in the higher credit rating tiers.  After a tough March, the first part of the municipal bond market to rally back was the high quality segment.  One of the triggers for the rally seemed to be indications of financial support for muni bond issuers from Congress. Signals of liquidity support from the U.S. Federal Reserve may have also boosted sentiment.  These developments allowed investors to become more comfortable with GOs, in our view.

A look at year-to-date returns by rating category illustrates investors’ focus on credit quality. Based on Bloomberg Barclays index data, the AAA-rated portion of the broad muni index gained 3.40%, AA bonds were up 2.65%, and A bonds returned 1.34%; BBB bonds were down 2.30%.  The fact that GOs, on average, carry higher credit ratings benefited their performance, in our view.

Going deeper into credit, the high yield muni index4 posted a negative return of 2.84% this year–much better than where it was a month ago, but still down. This has pushed credit spreads out much wider than they were a few months ago. The only times spreads have really been wider were during the 2008–09 credit crisis and the period from 2014 to 2016 when Puerto Rico was downgraded to enter the index (2014) and then defaulted (2016) which caused most of the Commonwealth’s credits to be removed from the index (see Figure 1). While GOs are 28% of the investment grade municipal bond index, they are only approximately 8% of the high yield index so they don’t have as much of an impact upon returns in lower quality portions of the market, which are dominated by revenue bonds.

 

Figure 1. High Yield Municipal Bond Spreads Remain Wide

Spread of Bloomberg Barclays High Yield Municipal Bond Index versus Bloomberg Barclays Municipal Bond Index, January 1. 2005–June 25, 2020

Source: Bloomberg. Data as of June 25, 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 or expenses, and are not available for direct investment.

 

Revenue Bonds

The revenue bond index,5 with a year-to-date return of 1.62%, has lagged the GO index. The total market value in the revenue bond index is approximately $1.1 trillion –more than double the size of the GO index.  Of the range of revenue sectors, the four with the largest market value in order are transportation, special tax, healthcare, and water & sewer.

So, why have revenue bonds underperformed the market this year?  The answer is their lower credit quality which is still very strong and fits into the range of the investment grade market, which has historical default rates close to 0%, based on a 2019 Moody’s study.  The average rating of credits in the revenue index is between AA3 and A1, lower than the average of the market index. Of the four largest revenue sectors, the one with the best year-to-date return is water & sewer at 3.28% which has credits with an average credit quality between AA1 and AA2 making it similar to the high quality of GOs.  The worst performing of the four is healthcare, returning 0.94%, with the average quality between A1 and A2.

When looking deeper into the characteristics of the revenue bond index, it is interesting that the average maturity and yield are higher.  The average maturity is just under 15 years while the yield to worst is 1.74%. While it makes sense that the yield is higher because the credit quality is a little lower and bonds are longer on average, one might wonder why revenue bonds would be longer. One major reason is that revenue bonds cover the costs of capital projects that can take a long time to begin to generate revenues at a level where they can fully pay back interest and principal.

GOs versus Revenue Bonds: A Look at the Record

Given GOs’ outperformance this year, one might ask: How have the different indexes performed over the past few years, and is this year different?  The answer to the second part of that question is “yes.” In more typical years, investors could get additional yield from revenue bonds, potentially adding to stronger performance. The offset is the higher volatility of credit performance because they are lower rated. Nonetheless, the revenue index has outperformed the GO index in five of the past six years (Figure 2).

 

Figure 2. Revenue Bonds Have Generally Outperformed in the Past Few Years

Source: Bloomberg. Data as of June 25, 2020. Revenue Bond and GO (General Obligation) refer to specific subsets of the Bloomberg Barclays Municipal Bond Index (Broad Municipal Bond Index).

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 or expenses, and are not available for direct investment.

 

When people ask how the municipal bond market has been performing this year, it is not a simple answer due to these variations.  Even for the month of June it is not easy.  So far, the GO index for June has a total return of 0.31% while the revenue bond index is up 1.03%.  Since the economic outlook is becoming clearer and there is more evidence that credits can maintain their value through this time, lower tiers of credit quality have been outperforming.  Also, uncertain times historically have sparked a “flight to quality” in the muni market, a key factor in GO’s 2020 outperformance, in our view.

Our main objectives in examining the year-to-date differential between GOs and revenue bonds are to show the range of performance this year and to highlight the historical long-term advantage of revenue bonds. These can be very strong credits that require more investment analysis to understand.  For example, this year airports are seeing lower volumes but they have strong balance sheets so they are weathering the storm well.  While hospitals have been challenged by the suspension of elective surgeries, we believe most systems have strong financials that can be analyzed to understand how they are prepared for these times. We typically overweight revenue sectors because we believe we can get extra yield compensation for these investments. To do so, we think it is critical to analyze issuers’ revenue streams to be able to understand the math underlying the potential stresses they can handle to keep paying their interest.

A Final Word

In looking at the performance of different muni sectors in 2020, one key takeaway for us is that the municipal bond market and its credits, by and large, are resilient and have been maintaining their historically very low default risk.  There is always a range of performance from the various sectors, and this year those with higher credit quality have outperformed, but the lower quality ones are continuing to gain momentum.  It has been a volatile ride but with municipal bond credits stabilizing, and the Federal government providing some assistance, we believe the market looks much stronger than it did a few months ago.

 

1As represented by the general obligation subset of the Bloomberg Barclays Municipal Bond Index.

2All year-to-date performance figures cited in this article are as of June 25, 2020.

3As represented by the Bloomberg Barclays Municipal Bond Index.

4As represented by the Bloomberg Barclays High Yield Municipal Bond Index.

5As represented by the revenue bond subset of the Bloomberg Barclays Municipal Bond Index.

 

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.

Spread-to-worst measures the dispersion of returns between the best and worst performing security in a given market, usually bond markets, or between returns from different markets.

Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

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.

The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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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