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Market View

Municipal bonds continue to defy market volatility, offering an oasis of tranquility for investors. Here’s why.  

With stock markets grabbing the headlines in January, municipal bonds’ steady performance has received little notice. But for investors seeking a calm port in a storm, munis are looking attractive. As Table 1 shows, a broad index of the municipal-bond market is outperforming equities as well as some fixed-income categories so far in 2016, as it did in all of 2015.

 

Table 1. Municipal Bonds Have Held Their Own During a Volatile Time
Total return for indicated asset classes for calendar year to date (as of January 21, 2016) and one-yearperiods ended December 31, 2015

Source: Morningstar and Credit Suisse. “Barclays U.S. Aggregate” refers to the Barclays U.S. Aggregate Bond Index. High-yield bonds are represented by the Credit Suisse High Yield Index. “S&P 500” refers to the S&P 500® Index. “MSCI EAFE” refers to the MSCI EAFE (Europe, Australasia, Far East) Index. Emerging-market bonds are represented by the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified. 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. 

 

Of course, past performance does not guarantee future results. But there are factors behind municipal bonds’ performance that are distinct from those currently affecting equity and some bond markets, and which suggest that the calm in municipal markets may continue.  

This is because, unlike other markets that are being whipsawed by fast-moving global developments—including collapsing oil and commodity prices, slowing growth in China, and currency declines in emerging markets—municipal bonds are influenced largely by three fundamental factors that are U.S.-focused. These are the state of the U.S. economy, bond-issuer supply, and individual investor demand for munis—each of which continues to provide support for the asset class.

  • U.S. economy—Most data indicate that the U.S. economy is showing steady, though not overly strong, growth, along with low inflation. As the broader economy grows, state tax revenues are increasing, strengthening municipal budgets.  
  • Supply—Given the moderate growth of the U.S. economy, we expect the Federal Reserve Board to increase interest rates at a slow and measured pace in 2016. This means that interest rates will remain at attractively low levels, increasing the likelihood of another large volume of refunding in 2016, as occurred in 2015. But new issues continue to be few as municipalities delay infrastructure spending. So, net supply is expected to be flat—and, therefore, not overwhelming demand.      
  • Demand—The lower volatility and positive price performance of the municipal bond market in 2015 is attracting investors to the asset class and increasing fund flows. Year to date (through January 20, 2016), net inflows to tax-free funds totaled $4.4 billion, according to Lipper. We expect demand to remain relatively strong, supporting market stability in 2016.   

Adding to demand is the fact that, even after their recent outperformance, munis still present attractive relative value versus their taxable counterparts. While muni yields are not elevated, compared with historical standards, Chart 1 shows that they are still high, on a taxable-equivalent basis, relative to similar-risk alternatives, such as the yields on 10-year U.S. Treasury bonds and the broader bond market (as represented by the Barclays U.S. Aggregate Bond Index, as of January 22, 2016).

 

Chart 1. Tax-Equivalent Yields on Munis Remain Attractive 
Yield to worst, January 22, 2016

Source: Barclays and Bloomberg.
Government bonds are represented by the Bloomberg World Bond Government Bond listings. “Barclays U.S. Aggregate” refers to the Barclays U.S. Aggregate Bond Index. All the rest are represented by the Bloomberg Fair Value Yield Curve. *At the 28% tax bracket, the tax-equivalent yield would be 2.47%, 3.15%, and 3.79% for the ‘AAA’ rated, ‘A’ rated, and the ‘BBB’ rated segment of the Bloomberg Fair Value Yield Curve, 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.

 

Ten-year U.S. Treasury yields have remained low (2.03% as of January 22, 2016) in the recent flight to quality, but it’s worth noting that investors are getting almost the same yield tax-free (1.78%, or 88% of the 10-year U.S. Treasury) on a similar-duration ‘AAA’ municipal bond. For investors looking to make an allocation to high-quality intermediate muni bonds, the taxable-equivalent yield on that sector is an attractive alternative to high-quality intermediate taxable bonds, such as the Barclays U.S. Aggregate Bond Index, which offers a yield of 2.43%.

According to Stephen Hillebrecht, Lord Abbett Fixed-Income Product Strategist, there is an even more interesting opportunity by dipping down a notch in credit quality to the lower end of the investment-grade sector. According to Bloomberg, the average yield on 10-year ‘A’ rated municipal bonds was at 2.27% (as of January 22, 2016), while 10-year ‘BBB’ rated municipals offered an average yield of 2.73%. On a taxable-equivalent basis, these yields are 4.01% and 4.82%, respectively, as calculated from the highest tax bracket of 43.4%, and 3.15% and 3.79%, respectively, as calculated from the 28% tax bracket, making them much more attractive than the yields offered by the 10-year U.S. Treasury or the Barclays U.S. Aggregate Bond Index.

Does this increased yield come with greatly increased risk? Not necessarily. In 2015, the financial media focused on the few trouble spots of the muni market, such as Illinois and Puerto Rico. But historically, defaults are infrequent in the muni market. As we discussed in our August 17, 2015 Market View, default rates have been extremely low in investment-grade municipal bonds

In addition, in 2015 the major credit rating agencies released more upgrades than downgrades of municipal bond issuers. We think this trend is likely to continue in 2016, given the outlook for an improving U.S. economy and the increase in tax revenues that would accompany more economic activity, adding to the stability of the municipal market. 

We would be remiss in not reminding investors that, over the long term, equities offer the opportunity to generate higher total return than municipal bonds. Moreover, recent volatility may present opportunities and more attractive valuations not only in equities but also in other asset classes that have suffered, such as high-yield bonds.

But for those investors who are losing sleep at night because of the current volatility in the stock market, municipal bonds are an asset class that may offer the relative tranquility they seek, with the additional opportunity to realize an attractive total return.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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