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Market View

Two weeks after the commonwealth’s default, a broader view of the municipal-bond market is in order.

On August 3, Puerto Rico’s Public Finance Corporation (PFC) failed to make a $58 million payment to bondholders. As the commonwealth and its public corporations are significant municipal-bond issuers, with nearly $72 billion of debt outstanding, its decision to default on some of its debt raised questions among investors about the broader muni market.

With the dust still settling, we thought this would be a good time to answer some of those questions. We hope to provide financial advisors and investors with a more expansive view of the muni market—and its investment characteristics—than what they may have seen in recent news accounts.

1.  What’s next for Puerto Rico?
As Lord Abbett Partner & Director Dan Solender wrote in a recent post on our blog, “It is unclear where the Puerto Rico situation goes from here.” He notes that the legislature reconvenes on August 17 and can make an appropriation request for payment to bondholders—if lawmakers choose to do so. In September, the commonwealth is expected to present a financing plan, which could provide more clarity on how Puerto Rico would like to deal with its debt situation. The government is choosing to not make any proposals until an internal group puts together a plan, which is due at the end of August.

Solender notes that Puerto Rico’s market access for future financing “is challenged, and would be very costly,” especially given its decision to default on the PFC bonds. On August 18, the commonwealth is expected to bring a bond issue for the Aqueduct and Sewer Authority, which it is presenting as a stand-alone credit, separate from the Commonwealth. The new issue is not expected to be part of the upcoming restructuring plan, notes Solender, who adds that the deal “will help investors to gain an understanding about the Commonwealth’s cost and ability to access the market.” Solender says that Puerto Rico does have future options in addition to this possible deal, but its recent actions are limiting its choices. Lord Abbett “will continue to monitor the situation and evaluate each of the [Puerto Rico] issuers independently based upon the security of their interest payments and the trading prices of the bonds,” he adds.

2.  What’s the state of state and local finances?
The fiscal challenges of Puerto Rico may prompt some investors to take a closer look at the financial status of other issuing governments around the United States. One focus may be on these governments’ collection of tax and other revenues, a primary source of funds for repayment of principal and interest. As Chart 1 shows, the news is generally positive: According to the 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 multi-year high in the first quarter of 2015. Real estate values in most markets are growing, while the employment picture is also improving. Solender notes that some states such as California have surpluses, while all states other than New Jersey and Illinois continue to maintain ratings of Aa3/AA- or higher. 

 

Chart 1. Municipal-Bond Issuer Revenues Have Reached Multi-Year Highs
State and local tax revenues, first quarter 2005 – first quarter 2015

Source: Census Bureau Quarterly Summary of State and Local Tax Revenue. Data indicate trailing 12-month revenue, calculated quarterly. Data are the most recent available, released on 06/23/2015.

 

3.  What about muni-bond default rates?
The news out of Puerto Rico—and the July 2013 default by Detroit—may have investors wondering about the frequency with which municipal-bond issuers have defaulted on their obligations. A look at recent history may be helpful. (See Table 1.) Based on data compiled by Moody’s, municipal bonds have featured far lower default rates than similarly rated corporate debt issues across the ratings spectrum. Solender points out that “municipal bond issuers have not deviated from their history of very low default rates.” He notes that overall, “municipal bond issuers are seeing a lot of upgrades,” and many states such as California have improved their finances and credit quality materially in recent years. “So, the defaults or threat of defaults of a few issuers in the headlines are getting a lot of attention, but these issues are isolated and not carrying over to the rest of the market,” he adds.

 

Table 1. Muni Bonds Have Defaulted at a Small Fraction of the Rate of Similarly Rated Corporate Debt
Average 10-year default rates for indicated categories, 1970-2013

Source: Moody’s, “Moody’s US Municipal Bond Defaults and Recoveries, 1970–2013,” May 2014. Data show the average 10-year cumulative default rates of Moody’s rated corporate and municipal bonds for a study covering the period 1970-2013. Data are the most recent available. While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.

 

4.  What’s the impact on the high-yield muni market?
The Puerto Rico situation remains at the forefront of investor concerns, especially for participants in the high-yield municipal bond market. Unsurprisingly, Puerto Rico bonds have suffered steep price declines, with the Puerto Rico-specific component of the Barclays High Yield Municipal Bond Index down 14.8% year to date through August 14, according to Barclays data. What may be surprising to some is that the rest of the high yield market is holding up well; with Puerto Rico debt excluded, the Barclays High Yield Municipal Bond Index was actually up 3.11% in the same time period.

The relative strength of the rest of the high-yield muni market may point toward an interesting opportunity for investors. Should the Puerto Rico situation stabilize, and more clarity emerge about a potential resolution to the island’s fiscal and market challenges, the high yield sector as a whole may see improved valuations.

Solender notes that while investor demand for munis “is not booming,” it is not extremely negative either.  Mutual fund flows have been slightly negative during most recent weeks, but not enough to put any significant pressure on the market, he says. For the week ending Thursday, August 13,, according to Lipper, muni-bond mutual fund flows were positive at $11 million, which Solender calls “a good sign.”

5.  How is the broader muni market faring?
As Solender notes, so far, the overall municipal bond market has not had a negative reaction to the Puerto Rico situation. Other muni bonds mostly have been stable, and have not moved in correlation with the prices of Puerto Rico bonds. For example, the investment-grade Barclays Municipal Bond Index was up 0.91% year to date through August 14, compared to the 0.51% return of the broad bond-market benchmark the Barclays U.S. Aggregate Bond Index, and the -0.52% return for the Barclays Corporate Bond Index. 

This suggests that investors have been able to differentiate between trouble spots such as Puerto Rico and the broader muni market. Indeed, Solender says that for some time investors have viewed Puerto Rico as a separate credit from the rest of the muni market. Why? According to Solender, the issues are unique to the commonwealth, with the economy performing much worse than any U.S. state, and the government providing negative commentary about its fiscal situation and its willingness to interact with bondholders. 

6.  Do muni bonds still offer good value for investors?
Apart from Puerto Rico, the municipal bond market’s other primary focus this year has been on the direction of interest rates—a key driver of demand for municipal securities--and the potential direction of Federal Reserve policy. While there is much speculation on the Fed’s next move, Solender reiterates his view from March that a large upward movement in interest rates is not likely this year due to the low inflation rate and the moderate growth of the economy. He thinks the technical factors that influence the muni market the most—the supply/demand dynamic and the steady credit quality of muni issuers—remain positive. For all maturities, the ratios of municipal bond yields to Treasury bond yields remain high, meaning that municipal bonds look relatively attractive without even factoring in the exemption of the yield from Federal, and in some cases state and local, income taxes.

Given those factors, and as the market continues to digest the Puerto Rico developments, munis appear to offer appealing relative value versus other fixed-income categories. (See Chart 2.) As Solender told CNBC in a recent interview, municipal bonds feature tax-equivalent yields “that are … very attractive versus taxable markets.”

 

Chart 2. Municipal Bond Yields Remain Attractive
Tax-equivalent yields* for indicated indexes as of August 14, 2015Source: Bloomberg, Barclays, and Credit Suisse. Investment-grade (AA-, A-, or BBB-rated) 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. Corporate Bond 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 (month-end data as of July 31, 2015).

*At the 28% tax bracket, the tax-equivalent yield would be 2.83%, 3.80%, 4.63%, and 9.50% 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 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 represent any specific Lord Abbett mutual fund 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.

 

MARKET VIEW PDFs


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MUNIS ON YOUR MIND?
The National Tax Free Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in investment grade municipal bonds.

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