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Market View

Municipal bonds, currently featuring higher yields than comparably rated fixed-income issues, may also benefit from market supply and demand factors.

Amid the ongoing recovery in the municipal bond market following the sell-off in 2013, investors may not realize that while demand has increased for these tax-free securities, the supply of available munis on the market is actually shrinking, according to data from the Federal Reserve. Projected declines in muni supply in the months to come, based on results of a survey by the Securities Industry and Financial Markets Association (SIFMA), may be one reason for investors to consider the asset class now.

Munis have several factors in their favor right now. Tax rates are higher than they have been in recent years. Demographic trends also may be on their side, as baby boomers reaching their peak earning years, or entering retirement, may spur additional demand for securities that provide tax-free income.

The improved sentiment toward the asset class is reflected in the net investment flows to municipal bond funds thus far in 2014. Year to date through June 11, data from Lipper indicated net inflows of $5.4 billion, following net outflows of $62.6 billion in 2013. These inflows come amid a strong rebound in the muni market since September 2013, and they may reflect demand for the very attractive tax-free yields currently offered across various muni-market segments (see Chart 1). 

 

Chart 1. Muni Yields Remain Attractive Relative to Other Fixed-Income Categories
Tax-equivalent yields for selected municipal bond indexes and yields for similarly-rated taxable indexes (as of 05/31/2014)

Source: Barclays and Credit Suisse. Investment-grade municipal data represented by rating-specific segments of the Barclays Municipal Bond Index; investment-grade corporate data represented by rating-specific segments of the Barclays U.S. Corporates Index; high-yield municipal data represented by the Barclays High Yield Municipal Bond Index; high-yield corporate data represented by the Credit Suisse High Yield Index.
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. At the 28% tax bracket, the tax-equivalent yield would be 2.88%, 3.86%, 5.06%, and 9.02% for the AA Rated, A Rated, BBB Rated, and High-Yield Municipal indexes, respectively.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. 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. The income derived from municipal securities may be subject to the alternative minimum tax. Federal, state and local taxes may apply. 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.

 

This is where the supply issue looms large. The decrease in the size of the outstanding municipal market detailed in Chart 2, as measured by Flow of Funds data from the Federal Reserve, is a reflection of the reduction in the dollar amount of muni issues in the market since 2011. Over this period, there has been an aggregate negative net supply of approximately $44 billion (this estimate includes only the long-term—i.e., 13 months or longer—maturity portion of the market).

This means a smaller muni market at a time of increasing investor demand. As of March 31, 2014 (latest data available), the overall size of the municipal market stood at $3.66 trillion, according to the Fed. This level is $68 billion, or 1.8%, lower than the size of the market at the end of the first quarter of 2013, and approximately 3%, or $111 billion, lower than the size of the market peak in the fourth quarter of 2010, when it stood at $3.77 trillion. As we mentioned in the May 19, 2014 Market View, new muni issuance is low, meaning that fresh supply has not appeared for what should be this ongoing increase in demand. Indeed, Bloomberg News reported on June 23 that municipal issuance year to date through June 13 had fallen to $123 billion, down 20% from the 2013 pace.1

 

Chart 2. Muni Supply Has Fallen from Its 2010 Peak
The size of the outstanding municipal market, first quarter 2010–first quarter 2014Source: Federal Reserve Flow of Funds. Data as of 3/31/14.

 

Investors who want to take advantage of relatively attractive yields also may take some comfort in the expectation that 2014 muni issuance will decline, according to Zane Brown, Lord Abbett Partner and Fixed Income Strategist. Indeed, respondents to a survey conducted by SIFMA expected total municipal issuance, both short- and long-term, to reach $349.5 billion in 2014, down from $366.1 billion estimated issuance in 2013. Reduced issuance could result in a reduction in the supply of available muni securities after consideration of maturing debt and refinancings, said Brown. “A reduction in supply could support investors who purchase municipals in 2014,” he added.

Even amid the favorable backdrop, the muni market presents some challenges for individual investors. The supply issue, along with other factors, may argue in favor of professional management. The rigorous credit analysis professional management teams can provide is more important than ever with the decline in municipal-bond insurance; indeed, less than 13% of muni bonds were rated ‘AAA’ by Standard & Poor’s, Moody’s, and/or Fitch, as of March 31, 2014, according to Barclays, compared with nearly 70% at the end of 2007.

Further, inventory has fallen at dealers who hold municipal bonds, according to Fed data, which could make it difficult for those without the buying power of established asset managers to identify and purchase suitable securities to construct a muni portfolio. For individuals, navigating the current muni market on their own can be a difficult undertaking. And it appears investors are beginning to realize this, as investment flows into actively managed municipal funds have been increasing, according to J.P. Morgan research.

Still, the current interest-rate environment and recent changes in U.S. tax law underscore munis’ appeal. According to Brown, as investors weigh the impact of higher marginal state and federal taxes, which in some states could exceed 50% on a combined basis, and the additional 3.8% Medicare tax on investment income, “municipals could appear relatively attractive.”

 

William Selway and Brian Chappatta, “Bridges Crumble as Muni Rates at Least Since ’60s Ignored,” Bloomberg, June 23, 2014.

 

RELATED TOPICS

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  Market View
  U.S. Market Monitor

RELATED FUND
The Fund seeks to deliver a high level of income exempt from federal income tax by investing primarily in lower-rated municipal bonds.
RELATED FUND
The Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in intermediate-term investment grade municipal bonds.

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