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Market View

High-yield municipal bonds historically have generated higher returns than other taxable and tax-free bond categories, and represent an appealing source of income and potential portfolio diversification.

After going through a difficult period in the fourth quarter of 2016, the municipal bond market has enjoyed a positive start to 2017, handily beating the broad taxable market (as represented by the Barclays Aggregate U.S. Bond Index) in year-to-date performance through mid-May (see Table 1).  

 

Table 1. Key Muni-Bond Categories Have Fared Well in 2017

Source: Barclays. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio 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.
Past performance is no guarantee of future results. Performance during other periods may have been different.

 

This may be a surprise to many investors, given the steady flow of news headlines focused on the credit troubles of Puerto Rico, a large component of the high-yield municipal bond market. [Read an in-depth analysis of the Puerto Rico situation in our new publication, The Muni Quarterly.] The strong performance of the municipal bond indexes depicted in Table 1 suggests that investors have been able to separate the credit and market issues specific to Puerto Rico not only from the fundamentals of the muni-bond sector as a whole but also from those of the rest of the high-yield muni bond universe.

When investors are interested in tax-free income, they look to the municipal market; when they think of “high yield,” they tend to look to the below-investment grade corporate bond market.  But they may be overlooking an asset class that combines appealing features of both: high-yield, tax-free bonds.  Here are a few reasons why we believe investors should take a fresh look at high-yield municipal bonds:

1. Income
As the category suggests, high-yield municipals have provided a source of high tax-free income, as illustrated by the benchmark depicted in Table 2.  Staying within the investment-grade arena, ‘BBB’ rated municipals currently offer a yield that is more than 50% higher than that of the broad investment-grade municipal index (although, while ‘BBB’ rated municipals are considered investment grade, many high-yield municipal bond funds maintain a significant allocation to the ‘BBB’ segment).  Moving to below-investment grade bonds, the high-yield muni index offers more than twice the income of the investment-grade muni index (see Table 2).

 

Table 2. High-Yield Municipal Bonds Have Provided Attractive Tax-Free Income
Nominal and tax-equivalent yields for indicated taxable and muni-bond categories, as of May 17, 2017

Source: Barclays.
*Indicates average yield for the Bloomberg Barclays High Yield Municipal Bond (ex-Puerto Rico) Index.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio or any particular investment and are not intended to predict or depict future results. This tax rate does not factor in the effect of AMT (alternative minimum tax) or taxes in your individual state. State and local taxes, if any, fees, and expenses are not taken into account. If they were, certain results would be lower Tax-equivalent yield will vary based on an investor’s tax bracket. 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 no guarantee of future results. Performance during other periods may have been different.

 

In fact, the average yield of 5.4% for the high-yield muni index is competitive with the yield on the taxable high-yield bond market (as represented by the Bloomberg Barclays U.S. High Yield Corporate Index).  This is not a direct comparison, since the high-yield municipal index has a longer duration than high-yield corporates, but these yields do not account for the tax advantage of municipals.  There is some uncertainty about what tax brackets may look like should tax-reform legislation eventually be enacted, but high-yield municipals offer extremely attractive taxable-equivalent yield under a variety of tax brackets.

2. Total Return
Income is only one part of the equation.  What should be most important to investors is total return, after taxes.  Of course, there will be periods when the asset class is out of favor, and investors could realize price declines, as occurred during the financial crisis of 2008–09.  Due to the price volatility in 2008, the high-yield municipal market has had similar returns to the investment-grade municipal market over the trailing 10 years.  However, based on trailing returns as of March 31, 2017, the high-yield municipal index has generated higher returns than the investment-grade index over the trailing one-, three-, five-, 15-, and 20-year periods. 

Chart 1 illustrates that high-yield municipal bonds have outperformed two key taxable bond benchmarks—the Bloomberg Barclays U.S. Government Bond Index and the Bloomberg Barclays U.S. Aggregate Bond Index—as well over every standard trailing time period since the high-yield index’s inception in 1996.  Once again, these total return figures are based on absolute performance.  When you consider that the total return has primarily come from tax-free income, the aftertax performance advantage of high-yield municipals would be much greater. 

 

Chart 1. Historically, High-Yield Munis Have Outperformed Other Bond Categories
Trailing returns by bond category for the indicated time periods, as of March 31, 2017

Source: Barclays. High Yield Muni=Bloomberg Barclays High Yield Municipal Bond Index. Municipal Bond= Bloomberg Barclays Municipal Bond Index. U.S. Government=Bloomberg Barclays U.S. Government Bond Index. U.S. Aggregate Index=Bloomberg Barclays U.S. Aggregate Bond Index.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio 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.
Past performance is no guarantee of future results. Performance during other periods may have been different.

 

3. Potential Portfolio Diversification
Over the long term, high-yield municipal bonds have had little to no correlation with U.S. government bonds (based on the Bloomberg Barclays indexes cited above, the trailing 10-year correlation through March 31, 2017, was 0.0; since inception in 1996, correlation was 0.1).  For those investors looking for income, but who are concerned by rising Treasury bond yields, high-yield municipals represent an asset class that historically has not moved in line with U.S. government debt (see Table 3).  This low correlation may provide diversification benefits, potentially lowering the overall volatility of a fixed-income portfolio.

 

Table 3. High-Yield Munis Have Had a Low Correlation with Other Key Bond Categories
Correlation with the Bloomberg Barclays High Yield Municipal Bond Index for the period January 1, 1996–March 31, 2017 

Source: Barclays. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio 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.
Past performance is no guarantee of future results.
 Performance during other periods may have been different.

 

When investors see the higher yields that are available in high-yield munis, they might assume that they are taking on additional risks in order to get that yield.  Certainly, there is additional credit risk when investing in lower-rated municipals relative to their investment-grade tax-free counterparts.  But this risk needs to be put in perspective: municipal bonds historically have had much lower default rates than similarly rated corporate bonds.  In fact, according to a Moody’s study of defaults covering the period 1970–2015, even ‘BBB’ rated municipals had lower default rates than ‘AA’ or ‘AAA’ rated corporate bonds.  Focusing on below-investment-grade bonds, a review of the Moody’s study reveals that the default rate for high-yield municipals was only about one-quarter of the rate experienced by high-yield corporates. This history suggests that in-depth credit research and ongoing credit monitoring to navigate the market may enhance prospects for this asset class to provide attractive income for investors—along with the opportunity for total return.

Putting It All Together
We would not suggest that a high-yield municipal portfolio would be an appropriate replacement for a high-quality bond portfolio.  Investment-grade municipals historically have offered solid tax-free income, attractive risk-adjusted returns, and potential portfolio stability; thus, investors may want to consider a foundation of high-quality muni bonds, including strategies that can take advantage of opportunities in short, intermediate, and longer maturities in either actively managed or laddered approaches. However, a high-yield municipal portfolio can play a complementary role, offering higher tax-free income, the potential for enhanced total return, and portfolio diversification benefits.  For those that are interested in other sources of tax-free income, but are looking to reduce duration and limit volatility, short-duration, high-yield municipal bonds can provide another attractive option.

In an earlier time, many investors would build their own municipal portfolios of individual bonds.  But, as we  pointed out in the May 8, 2017, Market View, the changing muni-bond landscape has made the “do-it-yourself” approach quite challenging, and so, consequently, many investors and their advisors have turned to professional management to get the benefits of institutional pricing, in-depth credit research, and ongoing credit monitoring.  In particular, the high-yield muni market is an area in which rigorous research is vital to identifying the optimal securities for inclusion in a portfolio. 

 

FEATURED 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.

THE MUNI QUARTERLY

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