Building a Case for High Yield Munis | Lord Abbett
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Market View

Here are four reasons why we believe high yield municipal bonds may hold appeal for investors looking for attractive tax-free income.

Read time: 4 minutes

After a few years of outperformance for lower-quality investments in the municipal bond market, the COVID-driven selloff in March 2020 reversed that trend, as evidenced by comparative year-to-date returns.  The high yield and BBB-rated segments of the municipal market have returned just 2.63% and 2.36% year to date through November 20, respectively;  by comparison, AAA-rated bonds have returned 5.11%.1  While the higher-quality part of the market has performed well this year, we believe the lagging recovery among lower-quality issues may present an opportunity for investors.  Here are four reasons why we think high-yield munis offer attractive relative value:

  1. The high yields are attractive relative to investment grade

While many high-quality fixed income markets have extremely low yields, high yield municipals still offer attractive yields on a relative basis.  In a low-yield environment, investors could be drawn to the high yield municipal space, given the relatively low default rates, and attractive yields. In our view, the current yields offer reasonable compensation for the credit risk taken and if demand stays strong, credit spreads could potentially narrow from current levels, leading to better performance for lower-quality bonds.

 

Figure 1. High Yield Munis’ Yield Ratio versus Investment Grade Is Near Multi-Year Highs
Yield ratio (yield to worst basis) of the Bloomberg Barclays High Yield Municipal Bond Index versus the Bloomberg Barclays Municipal Bond Index, May 30, 2003–November 20, 2020

Source: Bloomberg. Data as of November 20, 2020. YTW=Yield to worst.
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.

 

  1.  A few defaults are likely to happen, but we think the volume will remain low.

While there have been media headlines suggesting that the fundamental credit quality in the municipal bond market has deteriorated and will continue to do so, we believe that this change has been small so far. Any such changes in credit quality would most likely be reflected more by minor credit downgrades than outright defaults, in our view.

Here, we think two comparisons may be useful. First, for the investment-grade area of the muni market, default rates have held at historical lows, as illustrated in Figure 2.  (Note that the Lord Abbett High Yield Municipal portfolio has an approximate 35% weight in investment grade bonds as of September 30.)

 

Figure 2. Municipal Bonds Have Featured Historically Low Default Rates
Average 10-year cumulative default rates, 1970–2018

Source: Moody’s, “Moody’s US Municipal Bond Defaults and Recoveries, 1970–2018,” August 2019. Data show the average 10-year cumulative default rates of Moody’s rated corporate and municipal bonds for a study covering the period 1970-2016. *Rating outlooks are not assigned to all rated entities. Data are the most recent available.

 

On the high yield side, while some observers have suggested that there have been significant increases in muni-bond defaults, that is not really what is happening.  While there have been a few more defaults among high yield muni bonds in 2020, the past few years have seen a very low number of defaults; a small increase from that low level would not have been out of the ordinary, in our view, even if the pandemic had not hit. The high yield municipal bond market has experienced roughly $1.8 billion in payment defaults year to date through November 12, based on Bloomberg data. That amounts to a default rate of just 0.5% based on the high yield muni market’s total size of $300 billion.  

  1. Relative value likely will lead to a recovery in fund flows, in our view.  

The municipal market is unique in that retail buyers have a far greater direct impact on the market versus other fixed income asset classes since, according to U.S. Federal Reserve data, they own two-thirds of the outstanding bonds through managed products or brokerage accounts.  This means that the mutual fund flow pattern can have a significant impact on overall credit quality performance.  While fund flows have been robust to many parts of the municipal market in 2020, particularly into shorter maturities, they’ve been negative for the high yield segment (see Figure 3). 

 

Figure 3. High Yield Muni Fund Flows Are Negative for 2020, but Have Turned Positive in Recent Weeks

Source: Lipper. Data as of November 18, 2020. Figures shown represent funds that report on a weekly and monthly basis. ETF=Exchange-traded funds.
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.

 

As investors begin to realize that many of most dire predictions about the impact of COVID-19 on the U.S. economy—and the municipal bond market— have not panned out, flows may turn around and potentially drive better performance.   This is a trend we’ve already seen in the last few weeks, as shown in Figure 3. If this continues, it would conform to a historical performance pattern stretching back more than a decade (see Figure 4).

 

Figure 4. Bond Fund Outflows Historically Have Signalled Opportunities in High Yield Munis

Source: Bloomberg, Morningstar and Lord Abbett. Historical data as of November 20, 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.

 

  1. Credit pressures likely will not be shared evenly.

While there are number of parts of the high yield municipal bond market that are under pressure, many sectors are performing well.  As an example, bonds backed by tobacco consumption, sales taxes, and charter schools, have not seen declines anywhere near what was originally predicted in March during the heart of the market sell-off.  Tobacco consumption has increased this year and that improves the credit quality of those bonds.  Charter schools are supported by state funding tied to per-pupil enrollment; state funding is not expected to decrease materially in the intermediate term.

Meanwhile, sectors such as senior living and public-private partnership (P3) student housing deals have seen stress, but we believe many of the constituent issuers are still well positioned to weather the current situation due to having government support and/or strong enough balance sheets.  As an example, many senior living facilities were helped by being eligible for loans under the Payroll Protection Program as part of the CARES Act.  In the student housing sector, many universities have stepped in to provide financial support to struggling dormitory facilities, despite being under no obligation to do so; this assistance has been provided in order to help these issuers maintain their future access to the market.  Of course, the financial stress from COVID-19 on these two sectors requires a cautious approach. However, an experienced research team with rigorous credit analysis capabilities gives an investment manager the potential to identify pockets of value amid the stress.

Summing Up

We believe that the high yield segment of the municipal bond market currently presents an attractive relative value proposition (see Figure 5).  While COVID-19 has weighed on some high yield muni issuers, the impact has not been evenly shared, and many other issuers have maintained or even improved their credit quality.  At the same time, a large swath of the sector has been penalized with wider spreads and underperformance even though only a small portion of high yield municipal bonds are likely to face major difficulties.  With increasingly fewer options to find attractive yields in fixed income, we think the high yield municipal market deserves a closer look from investors.

 

Figure 5. High Yield Municipal Bonds Offer Compelling Yields in a Low-Rate Environment
Yields on various taxable and tax-exempt fixed income indexes, as of November 20, 2020


Source: Bloomberg Barclays Indices. Data as of November 20, 2020. Performance depicted here represents Bloomberg Barclays indexes (see definitions in the disclosure section at the end of this article). YTW=Yield to worst. Tax-equivalent yields on Municipal Bond Index and High Yield Municipal Bond Index; assumes 40.8% tax rate (tax-equivalent yields will differ based on underlying tax rates).
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.

 

1Performance figures are for ratings-specific subsets of the Bloomberg Barclays High Yield Municipal Bond Index (high yield) and Bloomberg Barclays Municipal Bond Index (BBB- and AAA-rated issues).

 

IMPORTANT INFORMATION

This Market View 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.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

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. Investments in Puerto Rico and other U.S. 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.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

basis point is one one-hundredth of a percentage point.

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of the tax-exempt yield on a municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield.

The yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The Bloomberg Barclays Global Aggregate Bond Index is a broad-based measure of the global investment-grade, fixed-income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate indexes. The index also includes euro dollar and euro/yen corporate bonds, Canadian government securities, and U.S. dollar investment-grade 144A securities. 

The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. The high yield and emerging markets sub-components are mutually exclusive. 

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 is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. Bonds 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 Bloomberg Barclays 22+ Year Municipal Bond Index is a maturity-specific component of this index. The Bloomberg Barclays Taxable Municipal Bond Index is another subset.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Corporate Bond Index includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt.  The index is composed of both U.S. and Brady bonds.

The Bloomberg Barclays U.S. Government/Credit Bond Index is an unmanaged index that is designed to represent a combination of the Government Bond Index and the Corporate Bond Index and includes U.S. government Treasury and agency securities, corporate bonds, and Yankee bonds.

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included.

The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government Index. The index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The Bloomberg Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Municipal debt, private placements, and non-dollar-denominated issues are excluded from the Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.

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 are 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.

No investing strategy can overcome all market volatility or guarantee future results. 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 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 this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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