Uncovering Value in Municipal Bonds after the Recent Volatility

Our director of municipal bonds identifies areas of the market where performance disparities may create potential opportunities.

When the media describe bond market performance, they usually quote changes in U.S. Treasury yields and rarely mention municipal bonds.  Historically, using U.S. Treasuries as shorthand for U.S. fixed income overall has worked because the markets have more or less moved in tandem.  Over recent months, however, the performance of Treasuries and municipals has been different; even within municipals there have been major deviations in key segments of the market.

Given that return disparity, we think it makes sense to take a closer look at select areas of the muni market. Here, we present some thoughts about which parts of the market might offer attractive relative value compared to other markets, and why tax-exempt yields can still be very compelling while valuations appear to be so varied.

As of May 21, the year-to-date return on the broad Bloomberg Barclays Municipal Bond Index (muni index) was 0.78%.  The market return has been positive despite the March volatility.  Among maturity benchmarks within the muni index, the only one that is still negative is the long bond sub-index (maturities 22 years and longer) with a decline of -0.40%.

General Obligation versus Revenue Bonds
The muni index can be divided into general obligation and revenue bonds.  The general obligation index is higher by 2.12% while the revenue bond index is only up 0.09%. Since press coverage of the muni market typically focuses on government issuers, one might think that there are more general obligation bonds than revenue bonds, but the opposite is true.  Of the approximately $1.6 trillion market value of the muni index, the general obligation index accounts for $0.5 trillion while the revenue bond index is $1.1 trillion.  Given the attention the media has put on how falling tax receipts may affect state budgets--and the U.S. Federal Reserve’s focus on state and local government support with its Municipal Liquidity Facility--it is interesting that most issuers in the muni market have separate sources of revenue.

Delving further into the revenue bond index, the performance deviations become clearer.  This index is divided into 11 sectors, of which five have had negative year-to-date performance: hospitals, industrial development, transportation, leasing and tobacco. The other six–electric, housing, education, water & sewer, resource recovery, and special tax–have been positive.  The worst are leasing at -2.06% and hospitals at -1.50%.  Leases have been hurt by negative performance from New Jersey, a major issuer within the category. Hospitals have been stressed by not being able to do elective procedures, a key source of revenue, although the outlook largely reflects possible downgrades more than the chance of actual defaults.  The best performing sector is water & sewer, up 2.66%.  This essential service sector is viewed as a relatively safe area in an economic downturn.

Investment Grade Municipal Bonds
How have different levels of credit quality performed?  Similar to everything else, the year-to-date performance of the broad muni index (up 0.78%) referenced earlier does not tell the full story. The breakdown in the credit quality indexes shows returns of 3.03% for the AAA index and 1.90% for  the AA index; the A index, down 0.64%, and the BBB index, down 5.82%, were stung by the volatility during March and April.  During May, all investment grade rating category returns have been positive, including a modest rebound in As and BBBs, though AAAs are still outperforming.

High Yield Municipal Bonds
In looking at the Bloomberg Barclays Municipal High Yield Bond Index (high yield muni index), the difference is more extreme.  The year-to-date return is -7.50%.  Sectors such as hospitals and transportation are down more than 10%.  The electric sector is up a little more than 1% while tobacco settlement bonds have rallied in recent weeks and are down just 2.8%.  Hospitals include senior living facilities which are under pressure from the pandemic while transportation includes toll roads, which have seen reduced driving volumes.  Prices on tobacco bonds fell in March on a higher volume of trading because many muni-bond funds sold them to raise cash to cover redemptions, even though their fundamental credit outlook has not really changed.

There are some other major differences between the investment grade and high yield markets.  The market value of the high yield muni index is much smaller at $122 billion.  When bonds needed to be sold in March to meet fund redemptions, there were fewer choices of bonds to sell and fewer market participants, so there were higher costs for sourcing liquidity.  Also, the high yield muni index has more long bonds, with 50% of its market value being in maturities 22 years and longer compared with just 19% in the muni index.  With long maturities and lower quality issues underperforming, higher liquidity costs, and the negative economic outlook, this part of the market has been punished the most.

Figure 1. Spreads on High Yield Municipal Bonds Have Widened
Spread between Bloomberg Barclays High Yield Municipal Bond Index and Bloomberg Barclays Municipal Bond Index, Dec. 31, 2004–May 21, 2020

Source: Bloomberg Barclays Indices. Data as of May 21, 2020. Spread is the percentage difference in current yields of various classes of fixed-income securities versus another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (one one-hundredth of a percentage point).
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 the spread was wider between 2014 and 2016, Puerto Rico bonds entered the high yield muni index after dropping to below investment grade and then came out of the index after they defaulted.  Other than the 2011 time period after an equity analyst made comments on television about the potential for widespread defaults, which led to a market downturn, spreads are on the wider side now.  The exception was during the 2008–09 credit crisis.

Summing Up
We think that studying the parts of the municipal bond market that have underperformed the most can help uncover areas with attractive relative value. Right now, those would be lower quality bonds, longer maturities, and less essential service revenue sectors.  The municipal bond maturity yield curve has always been upward sloping so given the higher yields for taking on more interest rate risk, it has been rare and maybe non-existent to find a three-year time period historically when longer bonds have not outperformed. Still, to attain these returns, we believe investors must be comfortable with the volatility that sometimes attends longer-dated bonds. Intermediate maturities also look appealing, in our view based upon the attractive risk/return tradeoff.

In our view, bonds with more credit risk have been punished most due to the economic uncertainties.  However, even low investment grade bonds have historical default rates close to 0% and that is unlikely to change, in our view, given the strength of the credits which have withstood all previous economic downturns and the government support for muni-bond issuers now coming from Congress and the U.S. Federal Reserve.  Even high yield municipal bonds have much lower historical default rates than comparable corporate bonds and many of the high yield market sectors are not seeing major outlook changes due to the economy.  High yield municipal bond prices have already been penalized, so much of the downside might already be priced in anyway.

Here’s a final point for investors to consider, one that brings us back to the differences between munis and Treasuries made earlier: Municipal bond yields were recently higher than Treasuries at nearly all maturities, as shown in Figure 2.

Figure 2. Muni-Bond Yields Are Higher than Treasures at Almost All Points on the Yield Curve
One-month to 30-year yield curve for the indicated categories as of May 21, 2020

Source: Bloomberg and U.S. Treasury Dept. Data as of May 21, 2020. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
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.

To us, the chart makes it clear that there is relative value across the curve, and when factoring in their tax-exempt status, tax-equivalent yields on municipal bonds look attractive compared to other fixed-income markets.