Fixed-Income Insights
Today’s Municipal Bond Market in Three Charts
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.
Risks to Consider: 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.
Diversification does not ensure a profit or protect against a loss in a declining market.
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.
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.
The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.
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. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day.
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.
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