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Market View

Even though the asset class has outperformed other investments during the latest episode of market volatility, tax-equivalent yields recently exceeded yields on similarly rated alternatives.

Where have investors found relief from recent financial market turmoil, in which equity and fixed-income markets were characterized by wide price swings? In a previous Market View, we spotlighted one asset class that displayed low volatility: short-dated corporate bonds. But short corporates weren’t the only investment category able to weather the market mayhem. We’d like to call attention to another type of security that displayed similar calm under pressure: municipal bonds.

As Dan Solender, Lord Abbett Partner & Director, pointed out in a September 18th column on the Lord Abbett website, munis were a haven during a volatile summer for financial markets. He noted that price volatility on representative muni-bond strategies was only a fraction of that displayed by asset classes such as high-yield bonds, large-cap equities, and emerging-market bonds.

But what about munis’ investment performance? As Table 1 shows, a broad index of the municipal-bond market largely outperformed other fixed-income and equity categories for the quarter-to-date, calendar year-to-date, and one-year periods ended September 24, 2015. 

 

Table 1. Municipal Bonds Have Held Their Own During a Volatile Time
Total return for indicated asset classes for quarter-to-date, calendar year-to-date, and one-year periods ended September 24, 2015

Source: Barclays, MSCI, Bloomberg, Merrill Lynch, and J.P. Morgan. “Barclays Aggregate” refers to the Barclays U.S. Aggregate Bond Index. High-yield bonds represented by the BofA Merrill Lynch U.S. High Yield Master II Index. “S&P 500” refers to the S&P 500® Index. “MSCI EAFE” refers to the MSCI EAFE Index. Emerging-market bonds represented by the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified Index.  Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only and are not intended to predict or depict future results. Performance during other time periods may differ. Due to market volatility, the market may not perform in a similar manner in the future. 

 

Why have munis largely escaped the recent volatility? In his column, Solender pointed out that, unlike other markets that have been whipsawed by fast-moving global developments, the fundamental factors influencing the muni sector have been characterized by less uncertainty, including:

  • The U.S. economy—Solender said most data indicate that the U.S. economy is showing steady, though not overly strong, growth, along with low inflation. “There are no signs of that environment changing much in the near future,” he added. Also, much of the volatility in other markets has been due to economic issues in other regions around the world, while the municipal bond market, which is primarily focused upon the domestic economy, is somewhat shielded from those issues.
  • Global interest rates—Given the low-growth U.S. economy and indications from the U.S. Federal Reserve (Fed) that it intends to raise the fed funds rate sometime soon, “There don’t appear to be any signs indicating significant interest-rate increases in the market in the near future,” according to Solender.
  • Individual investor demand for municipal bonds—Demand has been lukewarm in recent months, but the muni market has done well regardless, which Solender called “a very positive sign.” Also, the week of September 23 was one of the first ones in a while which saw positive flows into municipal bond mutual funds, according to Lipper. “While it is only one week, this could provide more support to the market if it continues,” Solender added.
  • Municipal bond-issuer supply— The supply of new issues of municipal bonds has been higher than last year, but it has only been higher due to outstanding bonds being refinanced rather than actual increases in new bonds outstanding. This has been occurring for a while, Solender notes. These refinanced bonds typically are called in the year or so after they are refinanced, which has created, and should continue to create, an ongoing source of demand as investors seek to replace these called issues.

Even after their recent outperformance, munis still present attractive relative value versus their taxable counterparts. Take a look at Chart 1, which depicts the tax-equivalent yields of a broad muni-market benchmark, the Barclays Municipal Bond Index, as well as a representative index of ‘BBB’ rated munis, versus similarly rated alternatives. 

 

Chart 1.  Tax-Equivalent Yields on Investment-Grade Munis Remain Attractive 
Yield to worst, September 24, 2015

Source: Barclays, Bloomberg, and J.P. Morgan.
Government bonds are represented by the Bloomberg World Bond Government Bond listings. BBB-rated municipal bonds represented by the BBB-rated segment of the Barclays Municipal Bond Index; BBB-rated corporate bonds represented by the BBB-rated segment of the Barclays U.S. Corporate Bond Index. “Barclays Aggregate” refers to the Barclays U.S. Aggregate Bond Index.
*At the 28% tax bracket, the tax-equivalent yield would be 3.08% and 4.69% for the Barclays Municipal Bond Index and the BBB-rated segment of the Barclays Municipal Bond Index, respectively. Tax-equivalent yield calculation for the municipal indexes above assumes the top marginal tax bracket of 43.4% on investment income, which includes the 39.6% 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. 
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment. Lower-rated bonds may carry greater risks than higher-rated bonds. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.

 

While muni yields are not elevated compared with historical standards, they are high relative to similar-risk alternatives. As Chart 1 indicates, the Barclays Municipal Bond Index featured higher yields on a tax-equivalent basis than yields on 10-year U.S. Treasury bonds and the broad bond-market benchmark, the Barclays Aggregate U.S. Bond Index, as of September 24, 2015. Tax-equivalent yields on ‘BBB’-rated muni bonds exceeded yields on similarly rated sovereign debt and U.S. corporate bonds.

What else should investors know about municipal bonds right now? In a Market View published August 26, Solender reviewed other muni-market fundamentals. Two of those points are worth repeating here:

State and local finances—The news for the state and local governments that issue muni securities is generally positive. According to the U.S. Census Bureau, revenues of state and local governments have been steadily increasing since their post–financial crisis low point in the first quarter of 2010, and reached a multiyear high in the first quarter of 2015.

Default rates—Based on data compiled by Moody’s, municipal bonds continued to have far lower default rates than similarly rated corporate debt issues across the ratings spectrum. In fact, many issuers have been seeing their debt upgraded, and some states, such as California, have improved their finances and credit quality materially in recent years.

Will munis continue to post strong relative performance versus other asset classes in the months to come? While there are no guarantees, Solender noted in his September 18th column that conditions remain favorable for the muni market. It appears that many of the factors that influenced munis’ recent summer of outperformance “could continue into the autumn—and beyond,” he said. 

 

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