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Fixed-Income Insights

Here are the key market indicators we’re watching now—and their implications for muni-bond investors.

We’re often asked: “What features of the municipal-bond market are you watching now?” With that in mind, we’ve put together three illustrations of trends muni investors should keep an eye on in the months ahead.

1. Yield Curve: Muni Bonds Still on an Upward Slope
We’ve seen lots of fluctuation in the taxable and tax-free markets in the last few years, and recent developments have been especially eye-opening. Case in point: In 2018, the U.S. Treasury yield curve was flattening while the municipal bond yield curve was steepening. This year, the Treasury curve has flattened further, and actually inverted on March 22, meaning that longer-term rates dipped below short-term rates. By contrast, the muni-bond has retained its upward slope, as longer-term yields remain solidly above short-term yields.

 

Chart 1. Muni Bonds: A Steeper Yield Curve than U.S. Treasuries
Data as of March 22, 2019

Source: Thomson Reuters MMD and Bloomberg.  Data as of March 22, 2019. MMD=The Thomson Reuters Municipal Market Data AAA Curve.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

Why hasn’t the muni curve followed the Treasury curve? The municipal bond market is dominated by retail investors, who make up around two-thirds of the market; corporations make up the remainder. While retail investors became more conservative, seeking to reduce interest-rate risk, corporate holders (especially banks and insurers) reduced purchases of longer-dated muni bonds after the tax rate was lowered from 35% to 21% under the 2017 tax bill. As a result, both segments started to reduce their demand for longer bonds, helping to keep intermediate and short-term rates lower.

2. Credit Quality: High-Yield Munis Have Recently Outperformed
Another key consideration for investors is how muni bonds have performed across the credit-quality spectrum.  The table below shows that high-yield munis (those rated below BBB by major U.S. credit-rating agencies) have outperformed year to date (through March 22), delivering a 3.35% return versus other rating categories, according to Bloomberg Barclays benchmarks. As you can see in the table, high yield, along with BBB-, A-, AA- and AAA-rated munis, have all delivered positive returns in 2018 and 2019 to date.

 

Table 1. High-Yield Munis Have Outperformed Thus Far in 2019
Data as of March 22, 2019

Source: Bloomberg Barclays Indices. Data as of March 22, 2019.
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.

 

For those wondering about Puerto Rico muni bonds, note that most were not included in the high-yield index for this period, as the majority fell out of the benchmark following their 2017 default. But we’ve seen some very strong performance from Puerto Rico bonds this year as some bonds have been successfully restructured. If you incorporate that into the mix, the high-yield market has been outperforming even more for investors with exposure to Puerto Rico. With the strong performance of lower quality bonds, taking credit risk has continued to make sense.

3. Credit Quality: Strengthening Fundamentals
We believe the strong performance of high-yield munis has been helped by another trend: Muni-bond credit quality has been on the upswing. For example, in looking at data from Moody’s for 2018, they upgraded 480 credits and downgraded only 392. This is the fourth year in a row that upgrades from Moody’s have outpaced downgrades. The other ratings agencies also had more upgrades than downgrades in 2018.

 

Chart 2. Recent Data Show Positive Trends in Muni-Bond Credit Quality
Number of municipal bonds upgraded and downgraded by Moody’s, 2016-2018

Source: Moody’s. Data as of March 8, 2019.
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.

 

Thus, we’re seeing strong credit quality for muni-bond issuers. What’s behind the trend? The economy is performing well, thus allowing tax receipts to be strong; oil prices are staying on the lower side, which benefits key sectors like airports and toll roads; health care providers are better able to cover expenses; and the education sector continues to see strong demand.

The Upshot: Finding Opportunities in Municipal Bonds
The factors we’ve discussed here—the higher yields available on longer muni bonds versus Treasuries, munis’ solid performance across ratings categories, and strengthening credit-quality fundamentals—support the broader case for these tax-free securities in today’s environment, in our view.  Even as investor demand for munis has increased, we believe there are still attractive values on offer in today’s market.

 

About The Author

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