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Market View

A strategy employing short duration, high-yield municipal bonds offers the potential for investors to realize higher income while mitigating interest-rate risk.

 

In Brief

  • Short duration, high-yield municipal bonds recently offered higher yields than the broader municipal bond market, with less interest-rate sensitivity.
  • Further, they historically have displayed lower volatility than longer-dated, high-yield munis.
  • They also have featured low correlation to other muni categories, the broader bond market, and U.S. Treasuries.
  • A portfolio blending short-duration high-yield munis with investment-grade short munis potentially may offer a particularly effective means of achieving high tax-free income with less interest-rate risk.

 

A number of recent Market Views have covered the performance of various segments of the bond market thus far in 2018.  While the increase in U.S. Treasury yields in 2018, based on Bloomberg data, has led to negative returns in the broad U.S. bond market (as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, or the Aggregate Index), lower duration, and more credit-sensitive, sectors of the market have outperformed.  The same trend holds true in the municipal bond market.

A Closer Look at Munis’ Year-to-Date Outperformance
In general, municipals have outperformed the U.S. taxable bond market in 2018, as the broad benchmark Bloomberg Barclays Municipal Bond Index (the Muni Index) is flat on the year (through July 31), compared to a 1.59% loss for the Aggregate Index, as summarized in Table 1.  Within municipals, shorter maturities have outperformed, as the less than 10-year maturity portion of the Muni Index has generated positive returns, while longer maturities are in negative territory.

Investors willing to take on some credit exposure have been rewarded, with the Bloomberg Barclays High Yield Municipal Bond Index (the High Yield Muni Index) up 4%. A closer look at Table 1 shows that a specific segment of the high-yield muni space has outperformed this year, and may warrant investor attention: short- duration, high-yield municipal bonds.

 

Table 1. Lower-Rated Muni Bonds Have Eclipsed Investment-Grade Peers in 2018
Data for indicated Bloomberg Barclays indexes, as of July 31, 2018

Source: Bloomberg Barclays Indices. Municipal Bond Index=Bloomberg Barclays Municipal Bond Index. Short Muni=Bloomberg Barclays 1-8 Year Municipal Bond Index. High Yield Muni=Bloomberg Barclays High Yield Municipal Bond Index. Short High Yield Muni=Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index. Short Muni/Short High-Yield Muni Blend=A 50/50 combination of the Short Muni and Short High Yield Muni Indexes. Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

Potential Benefits
As we noted in the June 18, 2018, Market View, high-yield municipal bonds may provide investors with the opportunity for high tax-free income, the potential for attractive long-term returns, and portfolio diversification.  Those who may find the higher income available in high-yield munis appealing, but may be concerned about the potential duration exposure, or are interested in limiting volatility, may want to consider a strategy employing high-yield muni bonds of shorter duration. Such an approach has the potential to offer:

  1. High tax-free income: Remember, a 3.0% nominal yield on a municipal bond represents a tax-equivalent yield of over 5.0% for those in the top bracket (40.8%, including the 3.8% Medicare tax).
  2. Lower interest-rate sensitivity: The lower duration of shorter-maturity high yield munis may lead to better performance during periods of rising rates.
  3. Lower volatility: Lower duration historically has led these securities to display much lower volatility than the broad high-yield muni market.
  4. Portfolio diversification: The Short High Yield muni index referenced in Table 1 (the Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index) has very low correlation with the broader Muni Index, or the taxable bond market (as represented by the Aggregate Index), so adding short-duration, high-yield municipal bonds to your portfolio may provide enhanced diversification.

A Diversified Approach
While short high yield munis have many merits, a diversified approach which blends short-duration high-yield with short investment-grade municipals may be a prudent approach for many investors. This blend may enhance diversification and liquidity relative to a pure high-yield strategy.  As illustrated by the 50/50 blend featured in Chart 1, this blended strategy could provide a higher yield than the broad muni market, with about half the duration exposure.

 

Chart 1.  Short High Yield: Opportunity for High Tax-Free Income with Lower Duration
Yield and duration of representative indexes, as of July 31, 2018

Source: Bloomberg Barclays Indices. Municipal Bond Index=Bloomberg Barclays Municipal Bond Index. Short Muni=Bloomberg Barclays 1-8 Year Municipal Bond Index. High Yield Muni= Bloomberg Barclays High Yield Municipal Bond Index. Short High Yield Muni= Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index. Short Muni/Short High-Yield Muni Blend=A 50/50 combination of the Short Muni and Short High Yield Muni Indexes. Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

The benefits of this diversified approach are evident when examining volatility, as measured by standard duration (see Chart 2). The Short High Yield Index historically has had lower volatility than the broader High Yield Muni Index. Indeed, as of July 31, 2018, the Short High Yield index had a 10-year standard deviation of 4.77, versus 8.12 for the High Yield Muni Index. However, a blended approach combining the Short High Yield Index and the investment-grade Short Muni Index further limited volatility, bringing the standard deviation down to 2.89.

 

Chart 2. Short High-Yield Munis Historically Have Had Lower Volatility Than Longer-Maturity Counterparts
Ten-year standard deviation of indicated indexes, as of July 31, 2018

Source: Bloomberg Barclays Indices. Municipal Bond Index=Bloomberg Barclays Municipal Bond Index. Short Muni=Bloomberg Barclays 1-8 Year Municipal Bond Index. High Yield Muni=Bloomberg Barclays High Yield Municipal Bond Index. Short High Yield Muni= Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index. Short Muni/Short High-Yield Muni Blend=A 50/50 combination of the Short Muni and Short High Yield Muni Indexes.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

The potential diversification benefits offered by short high-yield munis on their own are evident when examining their correlation with other muni-bond categories, the broader bond market (the Aggregate Index), and U.S. Treasury securities (see Chart 3).

 

Chart 3. Shorter-Dated High-Yield Munis Offer the Opportunity for Effective Portfolio Diversification
Ten-year correlation with the Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index, as of June 30, 2018

Source: Zephyr StyleADVISOR. Municipal Bond Index=Bloomberg Barclays Municipal Bond Index. Short Muni=Bloomberg Barclays 1-8 Year Municipal Bond Index. Short High Yield Muni= Bloomberg Barclays 1-8 Year High Yield Municipal Bond Index. 10-year Treasury=Citigroup 10-Year U.S. Treasury Bond Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

Summing Up
The better tax-equivalent yields available in the muni market certainly have appeal for income investors. But, as Lord Abbett Partner and Director of Municipal Bonds Dan Solender pointed out in a recent Muni Matters column, investors have poured money into shorter-dated munis to reduce interest rate risk.  As a result, the muni curve has become much steeper relative to the Treasury curve, according to data from Thomson Reuters MMD. Those muni investors wishing to emphasize shorter-duration securities may find themselves in a bit of a quandary, as the strong demand for very short, high-quality bonds has made them less attractive on a relative value basis. Thus, investors seeking less interest-rate sensitive muni securities may find that the lower rungs of the credit-quality ladder may offer better opportunity.

For those seeking to reduce interest-rate risk, a strategy employing short duration, high-yield municipal bonds, in tandem with short-dated investment grade munis, may prove particularly appealing, as it has the potential to lower overall interest rate risk, while still providing the opportunity for attractive income and total return.

 

MIDYEAR OUTLOOK

Get insights from our investment leaders on key topics for the second half of 2018.

Our Experts Give Their Macro Views
• What Is the Yield Curve Telling Us? 
• Positioning Portfolios
• Muni Matters: Five Key Takeaways

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

CONTRIBUTING STRATEGIST

RELATED FUND
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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