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Market View

Here’s why investors may wish to consider a strategy employing short duration, high yield municipal bonds. 

 

In Brief

  • As demand for tax-advantaged investments has increased, we believe investors may wish to take a closer look at short duration high yield municipal bonds.
  • This growing segment of the municipal bond market historically has posted positive performance over time, and has generally fared well during periods when U.S. Treasury yields have increased sharply.
  • Given their attractive yields, reduced interest-rate risk, and solid historical performance, short high yield munis might be a good area for investors to consider within the municipal-bond space.

 

Two weeks ago, we identified potential opportunities on the longer end of the municipal bond curve. In this follow-up, we’ll look at a different muni strategy with what we think are appealing features for today’s market.

As demand for tax-advantaged investments has increased, a wider range of municipal-bond mutual funds has become available. One category that has been growing over the past decade has been short high yield municipal bond funds.  This category combines individuals’ interest in receiving relatively high tax-exempt income with potentially lower interest-rate risk.

Take a look at Chart 1. In 2009, our favored proxy for the segment, the 1–8 year maturity portion of the Bloomberg Barclays High Yield Municipal Index (1–8 High Yield Muni Index), had a market value of about $5 billion.  In 2014 it grew to approximately $8 billion; at the end of 2019 it reached $17 billion.

 

Chart 1. The Short High Yield Muni-Bond Market Has Seen Significant Growth
Market capitalization of the Bloomberg Barclays High Yield Municipal Bond 1-8 Year Index, December 31, 1995–December 31, 2019

Source: Bloomberg Barclays Indices. Data as of February 12, 2020.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.


Performance and Yield Characteristics
Since 1996, the 1–8 High Yield Muni Index has had only three negative performance years (2008, 2015 and 2016). If one had made a hypothetical investment split 50% (50/50 blend) between the 1–8 High Yield Muni Index and the similar maturity sleeve of the investment-grade Bloomberg Barclays Municipal Bond Index (1-8 Muni Index), they would have experienced only two down years in that period: -2.42% in 2016 and -4.53% in 2008.  After each of those years, the following year was positive for the 50/50 blend: +3.29% in 2017 and +10.7% in 2009, so they rebounded relatively quickly.  Through December 31, 2019, any investors having their money in the short high yield muni market for any time period of three years or more would not have lost money on that investment since 1996.

Further, short high yield munis historically have outperformed other categories, including U.S. government bonds and the broader domestic fixed-income market (as represented by the Barclays Aggregate Index) during periods when the yield on a 10-year U.S. Treasury increased by 100 bps or more (see Table 1).
 

Table 1. A Short-Duration, High-Yield Muni Strategy Historically Has Performed Well in Periods of Rising U.S. Treasury Yields
Index returns during periods of greater than 100 basis-point increases in the 10-year U.S. Treasury yield (month-end returns)

Source: Bloomberg. Data as of February 14, 2020.
1FTSE Treasury Benchmark 10-Year Index.
2Bloomberg Barclays U.S. Aggregate Bond Index.
3Bloomberg Barclays Municipal 1-8 Year Index.
4Bloomberg Barclays Municipal High Yield 1-8 Year Index.
5A 50/50 blend of the Bloomberg Barclays Municipal 1-8 Year Index and the Bloomberg Barclays Municipal High Yield 1-8 Year Index.
*Reflects losses from bonds related to financially distressed issuer First Energy Solutions and associated entities. First Energy and its affiliates had $2.1 billion in municipal bonds outstanding when the company ultimately filed for bankruptcy on March 31, 2018, according to a Bond Buyer report published April 5, 2018.
Past performance is no guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Another notable attribute of short municipal high yield bonds is that the incremental yield, or credit spread, for taking on the credit risk is often more compared to the maturity benchmark than it is for longer bonds.  Bloomberg’s BVAL yield curve1 can be used to determine the credit spread.  For example, on October 22, 2019, U.S. Steel issued bonds in the municipal market with maturities of 2024 and 2030.  The 2024 issue was priced at 367 basis points (bps) over the AAA benchmark yield on the BVAL curve, which that day meant a yield of 4.875%.  The 2030 maturity had a yield 360 bps higher than its AAA benchmark, which led to a yield of 5.125%.  So investors could get more yield by investing longer, but receive less of a credit premium.

Another example was a deal for Brooklyn (N.Y.) Navy Yard launched on February 4, 2019.  This high yield deal had a maturity in 2028 which was priced 314 basis points over the AAA curve for a yield of 5.31%.  The 2040 maturity on the same deal was priced 279 basis points over AAA for a 5.72% yield.  Once again, an investor in this issue received less of a credit risk premium over AAA for lending in the longer maturity. It appears that there is not as much difference between yields of shorter bonds (such as 5 years) and longer bonds (such as 30 years) on the high yield side when compared to the spreads of investment grade bonds.

Supply/Demand and Credit Considerations
One might ask why the yield spread is wider for short high yield municipal bonds than long ones.  We believe the main reason is that there is a supply/demand imbalance in municipals.  The majority of high yield municipal bond investors are seeking to maximize yield, which means that they want longer bonds with more yield than shorter ones. They want the best total return they can get and they are willing to accept more interest rate volatility.  In our view, the majority of short maturity municipal bond buyers appear to be risk-averse, seeking lower yielding investments with less credit and interest rate risk in order to have more certainty about how their investments will perform even if that means sacrificing superior returns.

This places the short high yield municipal bond market in a strange position.  Its credit risk is higher than short term investors typically want and its yield is lower than typical high yield investors want.  This combination reduces demand for short high yield municipal bonds compared to longer ones, meaning that they need to have higher yields to attract investors to take the high yield risk.  This ends up being a potentially perfect fit for investors who are interested in a combination of higher tax free income and lower interest rate risk.

When comparing short high yield municipal bonds to longer high yield municipal bonds, there are also different ways of evaluating the risks which could make research analysts consider shorter bonds to have possibly higher credit quality than longer ones.  One example: Short-term bonds issued by continuing care retirement communities (CCRC) are funded by entrance fees, while longer issues are paid down from operating income from monthly residence fees over the long term. In this case, it could be argued that forecasting shorter-term occupancy trends could be done with more precision, and with less associated credit risk, than longer-term operating income projections.

Short High Yield Munis: A Well Diversified Sector
What types of investments are in funds focused upon the short high yield portion of the municipal bond market?  For the most part they are similar to the long term high yield municipal bond market but the weightings are different.  Table 2 shows the sector weightings in (i) the 1–8 High Yield Muni Index and (ii) the 50/50 blend.


Table 2. Short High Yield Muni Index Sector Composition Data Points to Broad Diversification
Sector weightings as of February 11, 2020

Source: Bloomberg Barclays Indices. Data as of February 11, 2020.
1Bloomberg Barclays Municipal High Yield 1-8 Year Index.
2A 50/50 blend of the Bloomberg Barclays Municipal 1-8 Year Index and the Bloomberg Barclays Municipal High Yield 1-8 Year Index.

GO Local=local-government general obligation bonds. IDR/PCR=Industrial development revenue/pollution control revenue. Special tax=bonds paid by revenues derived from taxation of a particular activity or asset.
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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Summing Up

We think short high yield muni bonds could be appealing for many investors. This sector has had attractive performance and has wider credit spreads than longer bonds. Short high yield munis have a supply/demand imbalance because of typical investor preferences with municipal bonds, and their credit performance may be more predictable than longer bonds due to the shorter time to maturity. The sector is well diversified, in our view, and is a growing part of the high yield muni market. Given their attractive yields, low interest-rate risk, and solid historical performance, short high yield munis might be a good area to consider for those focused on tax-advantaged investments.

 

1The BVAL Municipal AAA Yield Curve uses real-time trades and contributed sources to reflect yield changes in the municipal market as they happen.

 

MARKET VIEW PDF


  Market View

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The Lord Abbett Short Duration High Yield Municipal Bond Fund seeks to deliver a high level of income exempt from federal income tax. Learn more.
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