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Market View

Following a challenging fourth quarter in 2016, muni performance and mutual fund flows have been improving. 

In mid-December 2016, Market View focused on the slump in the municipal bond market in the final months of the year. At that time, a combination of headwinds—concerns about the potential for higher interest rates and changes to tax policy under the new administration—had led to substantial outflows from tax-free mutual funds and put pressure on municipal bond prices, resulting in losses for municipal bonds in the fourth quarter. What has happened since?

Municipal bond funds continued to see additional outflows in the final weeks of the year. According to Morningstar, tax-free bond funds experienced $17.5 billion of outflows in the month of December alone, for a total of $28 billion over the two-month period following the election.

However, the pace of outflows likely was affected by seasonal factors, such as year-end tax-loss trading. “With bond prices dropping and stock prices rising after the election in November, many thought that it was beneficial to recognize bond losses in order to offset capital gains on stocks,” said Daniel Solender, Lord Abbett partner and director of municipal bond strategies. “With mutual funds, investors needed to sell their shares to achieve this objective,” Solender continued, “although many of the sales were actually exchanges to other funds rather than outright redemptions because investors wanted to remain in the market.”

As we turned the page to a new year, the flow situation has stabilized, and has been positive over the past three weeks. (According to Lipper, weekly reporting funds had net inflows of $974 million, $512 million, and $7 million, respectively, in each of the past three weeks.)

What about performance? Despite the headwinds of large mutual fund outflows, municipals (as measured by the Bloomberg Barclays Municipal Bond Index) posted positive returns in December, generating a return of 1.2%, well ahead of the 0.1% return of the broad taxable bond market (as represented by the Bloomberg Barclays Aggregate Bond Index). This trend has continued in the first few weeks of 2017, with municipals in positive territory, while taxable bonds are modestly negative. As illustrated in Table 1, the broad municipal market has generated a return of 2.0% since December 1, led higher by longer-maturity and lower-rated municipals—those areas that suffered the most in the fourth-quarter pullback.

 

Table 1: Municipal Bond Performance Began 2017 on a Positive Note
Returns year to date (January 25, 2017)

Source: Bloomberg and Thomson Reuters Municipal Market Data. Broad taxable fixed income represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Municipal bonds represented by maturity-specific subsets of the Bloomberg Barclays Municipal Bond Index. High-yield municipal bonds are represented by the Bloomberg Barclays High Yield Municipal Bond Index.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett 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. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

What about going forward? We pose a few questions and answers:

What will happen with interest rates? As we have highlighted many times, accurately predicting the direction of interest rates historically has been very difficult to do. Many have anticipated higher rates for most of the past eight years, only to be disappointed thus far. Yes, it would seem reasonable that rates may be heading higher from here (since the hike on December 14), but the pace and magnitude of that move is very uncertain. And yields have already moved higher, with the 10-year U.S. Treasury bond yield rising by nearly 120 basis points (bps) since July.

What will happen to the federal tax code? Investors are concerned that changes to the tax code may reduce the taxable-equivalent yield on municipal bonds, and, consequently, make tax-free bonds less appealing. Changes in tax brackets and statements about altering the tax-exempt status of municipals are topics that have surrounded the muni market for decades. But as we pointed out in December, history shows that this has not had an impact on the market. According to the Citi Research report we cited, the top marginal tax rates for municipal bonds fluctuated in the range of 28–70% between 1980 and December 2016. But the report found no correlation between municipal yields and the top marginal tax rate. This is likely because the average tax rate for municipal bondholders has remained steady, at around 25%, during the period surveyed. [Results may have differed during different intervals in the survey period.]

What about mutual fund flows? As we also pointed out in December, this is not the first time we have seen large outflows from tax-free mutual funds. The supply/demand imbalance may have a negative impact on short-term performance, as we just witnessed. But if we were to look over longer time periods, the fundamentals typically win out over technical factors. Further, if we were to look back over the past seven years—a period that coincided with multiple periods of large fund outflows—the representative Bloomberg Barclays Municipal Bond Index outperformed the taxable Bloomberg Barclays Aggregate Index, and that performance included the sharp pullback municipals experienced in the fourth quarter of 2016. These returns, however, do not take into account the tax-exempt income that municipals have provided, and so actually understate the outperformance that municipals have delivered. The volatility in mutual fund flows seems to suggest that some investors take a tactical approach to allocating to municipals, but the performance record shows they would have been much better off maintaining an allocation through the cycle.

 

Table 2: Historically, Maintaining a Muni Bond Allocation Longer Term Has Been Beneficial
Returns as of December 31, 2016

Source: Bloomberg and Thomson Reuters Municipal Market Data. Broad taxable fixed income represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Municipal bonds represented by maturity-specific subsets of the Bloomberg Barclays Municipal Bond Index. High-yield municipal bonds are represented by the Bloomberg Barclays High Yield Municipal Bond Index.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett 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. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

There is much uncertainty about several factors that may affect the market. But a few things are very clear:

  • Relative value is more attractive. The ratio of ‘AAA’ rated municipal bonds to comparable maturity U.S. Treasury bonds is the most common measure of relative value for tax-free bonds. According to Municipal Market Data, the muni/Treasury ratio for 10-year and 30-year municipal bonds has risen, to approximately 95% and 100%, respectively, as compared to approximately 85% of Treasuries in August 2016.
  • Investment-grade credit spreads are wider. The additional yield provided in single ‘A’ and ‘BBB’ rated municipals over ‘AAA’ rated bonds has risen. For example, according to the Bloomberg Barclays Municipal Index, ‘BBB’ rated bonds now offer a yield advantage of 165 bps over ‘AAA’ rated bonds, 40 bps higher than the levels seen in August.
  • Yields have adjusted higher—for now. The combination of higher U.S. Treasury yields, more attractive relative value, and wider credit spreads has resulted in higher tax-free yields, especially among single ‘A’ and ‘BBB’ rated bonds. Chart 1 illustrates this move in 10-year maturity bonds, which now offer yields that are 100–160 bps higher than what was available in August.

 

Chart 1. Municipal Yields Have Adjusted Higher Since August 2016
10-year yields (as of January 25, 2017)

Source: Bloomberg and Thomson Reuters Municipal Market Data. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett 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. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

  • Over the long term, municipals have provided attractive risk-adjusted returns versus U.S. Treasuries. Over the past 20 years, 10-year muni bonds (as represented by the Bloomberg Barclays Municipal Bond 10-Year Index) has generated similar total returns to 10-year Treasury bonds (as represented by the Citigroup 10-Year Treasury Bond Index), but has done so with about 40% lower volatility. (See Chart 2.) That would have translated to higher risk-adjusted returns, even in a 0% tax bracket.

 

Chart 2: Historically, Munis Have Provided Very Attractive Risk-Reward Over the Long Term
Trailing 20 years: January 1, 1997–December 31, 2016

Source: Morningstar Direct.
Past performance is no guarantee of future results. 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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The market is full of uncertainty, but given the long-term return profile, the higher yields, and more attractive relative value available in the market today, investors may want to take another look at allocating to tax-free bonds.

 

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