Five Factors Favoring Short-Dated High Yield Munis | Lord Abbett
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Market View

Here’s why we think short-duration high yield municipal bonds offer attractive relative value in the current market.

Read time: 4 minutes

One part of the municipal bond market that has not recovered as quickly as other sectors from the COVID-driven market selloff of March 2020 is short duration high yield.  During the worst of the March-April volatility, yield ratios on the high-grade segment of the market reached historically high levels, with AAA-rated municipals yielding 889% of U.S. Treasuries at the two-year maturity. With the ensuing market recovery, that ratio has since narrowed to 112% and the Bloomberg Barclays 1-8 Year Municipal Bond Index has returned 2.77% year to date (as of November 1).  By comparison, the year-to-date return of its non-investment grade counterpart, the Bloomberg Barclays 1-8 Year Municipal Bond Index, has been a modest 0.74%.

Considering that underperformance, we believe the short duration high yield segment of the muni market offers a fair amount of relative value for investors. Here are five reasons why:

  1. Historical and current default rates for muni bonds remain low.

While there have been media headlines around the deterioration of fundamental credit quality in the municipal bond market, we believe that this change will be reflected more by credit downgrades than outright defaults.  Here, we think two comparisons may be useful.

First, for the investment-grade area of the muni market, default rates have held near historical lows, as illustrated in Figure 1.  (Note that the Lord Abbett Short Duration High Yield portfolio has an approximate 40% weight in investment grade bonds as of November 12.)

 

Figure 1. 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 municipal side, the market has experienced roughly $1.75 billion in payment defaults year to date through November 12, based on Bloomberg data. That amounts to a default rate of just 0.6% based on the high yield muni market’s total size of $300 billion.     

  1. The absolute relative value of short high yield munis is attractive versus other asset classes, in our view.

A significant component of the short high yield municipal market is industrial revenue bonds, which typically are backed by corporations that have taxable bonds outstanding.  Many of the investments in the industrial revenue sector are rated investment grade, such as the bonds featured in Figure 2 (Baa2/BBB+).  Earlier in 2020, the U.S. Federal Reserve intervened to shore up the corporate bond market but did not provide the same level of support for municipals. In our view, this has resulted in a situation where many municipal bonds in the industrial revenue segment are trading at historically inexpensive valuations relative to their corporate-bond counterparts. We think this should bode well for this important segment of short high yield muni portfolios. 

 

Figure 2.  AEP’s Industrial Revenue Bond Has a Higher Yield than Its Similarly Rated Corporate Issue
Yield ratio of American Electric Power (AEP) 2.5% industrial revenue bond due 2040 versus 4.3% corporate senior notes due 2028, both rated Baa2/BBB+

Source: Bloomberg. Data as of November 12, 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. Short high yield munis’ yield is compelling versus the interest-rate risk.

While much has been made of the increasing interest-rate risk in major bond market indexes, the short duration high yield municipal benchmark has an effective duration of about 3.1 years.   This means that it would likely take an interest rate increase of over 1.00% in a year to produce negative returns.

 

Figure 3. Short High Yield Munis Recently Offered Attractive Yields with Lower Interest-Rate Risk
Yield and duration data for indicated indexes as of November 12, 2020

Source: Bloomberg. Data as of November 12, 2020. 1-8 Year Muni=Bloomberg Barclays 1-8 Year Municipal Bond Index. 1-8 Year HY Muni=Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index.  Muni Bond=Bloomberg Barclays Municipal Bond Index. US Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index. Corporate Bond=Bloomberg Barclays U.S. Corporate Bond Index. High Yield Muni= Bloomberg Barclays High Yield Municipal Bond Index. US HY= Bloomberg Barclays U.S. High Yield 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 and expenses, and are not available for direct investment.

 

  1. The credit curve in municipals is flat and short maturity credit spreads remain attractive.

In our view, buyers should typically be paid a higher risk premium for lending to an issuer for an extended period. However, because there are comparatively few short maturity high yield buyers in the municipal bond market, investors are typically paid a similar amount, and often more, for taking credit risk in shorter maturities.  In the Morningstar high yield municipal category there are 196 funds; however, by our count only six of them focus on the short end of the market.  Also, interest-rate risk and maturity profiles vary among short duration high yield municipal funds.  The relatively flat credit curve in municipals is inconsistent with most other types of fixed income (note the recent steepening in the U.S. Treasury curve) and is a good way to capture attractive returns without excess interest rate risk, in our view.   An example of this can be seen in the recent competitive sale of State of Illinois general obligation bonds on October 20, 2020.  According to Bloomberg, the 2031 maturity bonds with a 5% coupon priced at 3.93%, a spread of 2.94% over AAA-rated municipals of comparable maturity, while bonds due in 2042 priced at 4.35%, a 2.80% spread over AAA municipals.

 

Figure 4. Little Difference in Spreads for Short-Dated and Broader High Yield Muni Indexes
Data for the period May 30, 2003–October 30, 2020

 

Source: Bloomberg. Data as of October 30, 2020. Muni 1-8 Year HY=Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index. Muni 1-8 Year=Bloomberg Barclays 1-8 Year 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 and expenses, and are not available for direct investment.

 

  1. A high yield municipal fund does not mean only below-investment grade rated bonds.

The broad high yield municipal Morningstar category has a variety of funds with differing credit qualities.  While the short duration high yield market offers very attractive risk-adjusted returns, we believe a strategic blend of short-dated high yield and investment-grade munis offers the best opportunity to capture relative value across the short duration rating spectrum and add balance to the portfolio. That approach is illustrated in Figure 4, which depicts the historical performance of a 50-50 blend of high yield and investment-grade munis in the 1-8 year maturity range. The investment grade portion of the portfolio has historically lowered volatility while maintaining a compelling total return profile. Since index data became available in 2001, this blended short high yield and investment grade portfolio has seen positive returns in any 36-month holding period over a time frame which includes the fallout from the 1999-2000 dot-com bubble, the September 11, 2001, terrorist attacks on the United States, the global financial crisis of 2008–09, and the current global pandemic.

 

Figure 5. How a Blend of High Yield and Investment-Grade Short Munis Has Performed Over Time

Source: Bloomberg and Lord Abbett. Data as of October 31, 2020. Data for various return periods for a blend of 50% Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index and 50% Bloomberg Barclays 1-8 Year 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 and expenses, and are not available for direct investment.

 

Summing Up

We believe that short duration high yield muni bonds represent an attractive segment of the municipal market that is often overlooked by investors.  This lack of awareness may reflect the fact that there is no formal Morningstar category for short high yield munis (they are grouped with longer-term high yield municipals).   Since retail investors drive much of the activity in the muni market, this less-noticed part of the market can potentially offer unique pockets of value and opportunity.  In sum, we believe the short-dated high yield segment of the municipal bond market offers good relative value for investors and may be poised to outperform after lagging in the post-March 2020 recovery. 

 

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.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Option-adjusted duration is a duration calculation for bonds that have embedded options.

general obligation (GO) bond is a municipal bond backed by the credit and taxing power of the issuing jurisdiction rather than the revenue from a given project.

Industrial revenue bonds are municipal debt securities issued by a government agency on behalf of a private sector company and intended to build or acquire factories or other heavy equipment and tools.

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. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.

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 1-8 Year Municipal Bond Index is the 1-8 year maturity component of the Bloomberg Barclays Municipal Bond Index, which 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 1-8 Year High Yield Municipal Bond Index is the 1-8 year maturity component of the Bloomberg Barclays High Yield Municipal Bond Index, which is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

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. 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.

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 SOCIAL MEDIAinformation 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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