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Market View

In a difficult environment for fixed income, high-yield municipals have posted strong returns so far in 2018. Here are a few reasons investors may want to take another look.

 

In Brief

  • Rising interest rates may have put a damper on many parts of the bond market, but high-yield municipal bonds have been a bright spot, with the representative Bloomberg Barclays High Yield Municipal Bond Index up over 3% year to date.
  • High-yield munis also have outperformed the broad municipal bond index over the trailing one-, three-, five-, and 10-year periods. Aftertax returns have been even more advantageous.
  • Lower-rated bonds tend to have less interest-rate sensitivity, and the relatively higher current income can be a meaningful contributor to total returns.

 

Rising yields across the U.S. Treasury yield curve have been a headwind across many segments of U.S. fixed income. For the year-to-date period as of June 15, the broad U.S. bond market (as measured by the Bloomberg Barclays U.S. Aggregate Bond Index—“Aggregate Index”) has delivered a loss of -1.94%, with lower-duration and lower-rated asset classes generally performing better in the face of rising rates. 

How have tax-free municipal bonds weathered the challenging interest-rate environment? The broad investment-grade municipal index (the Bloomberg Barclays Municipal Bond Index—“Municipal Bond Index”) has outperformed the Aggregate Index by a considerable margin (-0.49% versus -1.94%, or a difference of 145 basis points, year to date). Looking within the broad municipal index, shorter maturities have outperformed longer ones, and all those components of the index with less than seven years to maturity have positive returns, according to Bloomberg Barclays data. 

If we were to break out performance by credit rating (see Table 1), the lowest-rated segment of investment-grade, ‘BBB’ rated municipals, are flat for the year, outperforming higher-rated issues. Meanwhile, the Bloomberg Barclays High Yield Municipal Bond Index, which is up 3.01% year to date, has been a favorable place to be within fixed income. (Even when excluding the strong performance from Puerto Rico bonds, the index is still up 2.4% on the year.) Lower-rated bonds tend to have less interest-rate sensitivity, and the high current income can be a significant contributor to total returns.

 

Table 1. Lower Rated Municipals Have Outperformed in 2018
Returns for indicated Bloomberg Barclays indexes, year to date through June 15, 2018


Source: Bloomberg Barclays Indices.

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 and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.  

 

A Longer-Term View
High-yield municipals have performed well over this short period, but a longer-term view suggests that this asset class may deserve a closer look. Here are a few reasons:

Aftertax income—Bond yields have been moving higher, with the yield on the 10-year U.S. Treasury bond recently breaking through 3.0% (briefly). But it remains a low-yield environment, where sources of income are still difficult to find, particularly in the U.S. Treasury market. By comparison, yields on municipals are relatively attractive, especially as we move down the credit spectrum. For example, the average yield on the ‘BBB’ rated portion of the broad municipal index stands at 3.5%, and the Bloomberg Barclays High-Yield Municipal Bond Index offers a yield of 4.88%. But since the income from municipals is generally tax free, that income becomes more attractive on a taxable-equivalent basis. [Note: income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply.]  Chart 1 illustrates how those yields translate to an investor in a top tax bracket. High-yield municipals offer a taxable-equivalent yield in excess of 8.0%, well ahead of high-yield corporates.

 

Chart 1. Higher Aftertax Income
Tax-equivalent yields* for selected municipal bond indexes (as of 05/31/2018)

Source: Bloomberg Barclays Index data. Investment-grade municipal data represented by the Bloomberg Barclays Municipal Bond Index and investment-grade corporate data represented by the Barclays  U.S. Corporates Index. High-yield municipal data represented by the Barclays High Yield Municipal Bond Index and high yield corporate data represented by the Credit Suisse High Yield Corporate Bond Index. *At the 32% tax bracket, the tax-equivalent yield would be 3.69%, 4.19%, 5.11%, and 7.14% for the AA rated, A rated, BBB rated, and high-yield Municipal indexes, respectively. Tax-equivalent yield calculation for the municipal indexes above assumes the top marginal tax bracket of 40.8% on investment income, which includes the 37.0% income tax rate and the 3.8% in Medicare tax. This tax rate does not factor in the effect of AMT (alternative minimum tax) or taxes in your individual state. Tax-equivalent yield will vary based on an investor’s tax bracket.

For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.  High-yielding, non-investment-grade bonds have higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit. inflation risk, and liquidity risk. While U.S. Treasury or government-agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Diversification does not ensure a profit or protect against a loss in a declining market.

 

Returns—While many investors are seeking sources of income, total return should be what is most important to consider when considering high-yield municipal bonds. Looking beyond the year-to-date returns, Chart 2 shows that historically high-yield municipals have outperformed the broad municipal bond index over the trailing one-, three-, five-, ten- and 15-year periods.  It should be noted that the high-yield municipal and the investment-grade municipal index have both outperformed the taxable Bloomberg Barclays U.S. Aggregate Bond Index over the abovementioned periods—and that is before we take into account the benefit of municipals’ tax-free status.  On an aftertax basis, the return advantage would be even greater.

 

Chart 2. Historically, High-Yield Munis Have Outperformed Other Bond Categories
Trailing returns in percent by bond category for the indicated time periods, as of 5/31/18 

Source: Barclays

For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment and are not intended to predict or depict future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Below-investment-grade bonds carry greater risk of default and are subject to liquidity risk. Further, while investment-grade municipal bonds are more affected by interest-rate risk and less affected by credit risk, the opposite is usually true for high-yield munis, which also are more sensitive to fluctuations in the economy than their investment-grade counterparts.


Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different.

 

Diversification—The Bloomberg Barclays High-Yield Municipal Bond Index has a very different sector profile than the investment-grade index, as shown in Chart 3.  The high-yield index has very little exposure to general obligation (GO) bonds, and a heavier emphasis on revenue bonds relative to the investment-grade index. Many issues in the high-yield market can be tied to specific projects in several sectors, including health care, education, and industrial-revenue bonds backed by a corporate obligor. This can provide diversity of credit exposure relative to a portfolio with a heavier weight in state and local GO issues.  Certain factors that may affect GO credit, such as pension obligations, budget issues, and political infighting, would not come into play for a high-yield revenue bond, whose credit would be reliant on the revenue from that specific project. But this requires rigorous credit research and specialized expertise in the nuances of the factors affecting credit fundamentals in these areas.

 

Chart 3. High-Yield Munis Provide Diversity of Credit Exposure versus the Broader Index
Municipal index sector breakdown (as of 05/31/2018)


Source: Bloomberg Barclays Indices.  Sector weights for the Bloomberg Barclays Municipal Index and Bloomberg Barclays Municipal High Yield Index.

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. Diversification does not ensure a profit or protect against a loss in a declining market.

 

Not only do high-yield municipals offer sector diversification but they also may help diversify sources of return. The year-to-date performance of high yield municipals helps illustrate this point, as different segments of the market respond differently to various market environments. For example, Treasuries and other high-quality assets are very sensitive to changes in interest rates.  But as you move down in quality, bonds become more credit sensitive—e.g., rising rates are often accompanied by a growing economy, which can lead to higher revenue and improved credit fundamentals. So, narrowing credit spreads could potentially offset the impact of rising rates.

Weathering Volatility
It’s important to note that there clearly have been bouts of volatility in these markets in the past. The municipal bond market has had to deal with a number of issues in recent years, including the credit crisis and Great Recession of 2008–09, the loss of ‘AAA’ ratings by the major bond insurance companies, headlines concerning pension obligations, changes to the tax code, fears over municipals’ tax status, and large defaults by Puerto Rico and Detroit. But investors who have stuck with the asset class throughout periods of negative headlines and short-term volatility have been rewarded with higher tax-free income, and higher total returns than the taxable bond market.   

A Constructive Outlook
In a recent Fixed-Income Insights, Lord Abbett Partner & Director of Municipal Bonds Dan Solender outlined several factors that may be supportive of the municipal bond market. As investors review their municipal bond allocations, the potential of high-yield municipals to enhance portfolios with tax-free income, total return, and diversification should merit serious consideration. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

CONTRIBUTING STRATEGIST

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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