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Market View

Short-duration, high-yield municipal bonds historically have featured attractive yields and have carried less interest-rate risk than other fixed-income securities.

Government bond yields in many of the developed economies haven’t just hit the floor—they’ve entered the basement. Negative yields on sovereign bonds are just the most extreme example of the low-yield world in which we live. Income investors, then, face a quandary: where might they find investments that can provide the opportunity for solid income when yields are so extremely low, sometimes even subzero? We can help by identifying some appealing alternatives, and we will discuss them in detail throughout a three-part Market View series, “Finding Income in a Negative-Rate World.” In Part One, we’ll examine short-duration, high-yield municipal bonds

First, though, here’s a bit of background to the current environment. According to J.P. Morgan, the amount of negative-yielding debt instruments globally has reached approximately US$10 trillion (as of June 30, 2016). The preponderance of negative yields in developed economies is shown in Table 1, which renders a “heat map” of global government bond yields across the maturity spectrum. While U.S. government yields haven’t yet hit the red zone, they still are near historical lows.

 

Table 1. Government Debt in Many Nations Features Below-Zero Yields
Yields (in percent) on various maturities of developed-nation government bonds, as of June 30, 2016

Source: Bloomberg and U.S. Treasury Department. Data are as of June 30, 2016.
Past performance is no guarantee of future results.

 

Where can investors turn in such a yield-scarce environment? One attractive option might be the municipal bond market. Investors recognize that munis historically have provided strong returns with relative stability, especially in the face of global market volatility over the past few years. Those investors who have participated in this U.S.-focused asset class have experienced little, if any, impact from concerns over, for example, falling commodity prices, currency gyrations, weakness in emerging markets, and the pace of global economic growth. Chart 1 displays munis’ attractive profile versus U.S. government securities of comparable maturity.

 

Chart 1. Muni Bonds Recently Offered Higher Yield, with Less Risk, Than U.S. Treasuries
Yield/tax-equivalent yield and 20-year standard deviation for indicated categories, as of June 30, 2016


Source: Barclays and Citigroup. Municipal bond maturities represented by components of the Barclays Municipal Bond Index; U.S. Treasury maturities represented by specific-maturity Citi Treasury Benchmark Indexes. Data are as of June 30, 2016.
At the 28% tax bracket, tax-equivalent yields would be 1.63%, 2.18%, 2.82%, and 3.10% for the Barclays Municipal Bond 5-Year, 10-Year, 20-Year, and 22+ (Long) 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 reflect 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.

 

For investors who desire tax-free income, but are concerned about potential interest-rate increases over time, shorter-dated munis with lower duration ought to merit consideration. And within that category, one specific segment may offer the most compelling opportunity: short-term high-yield munis, which historically have provided higher tax-equivalent yield versus government bonds of comparable maturity. Investors focused on volatility also should note that while this asset class is high yield (i.e., rated below investment grade) due to its short-duration nature, it has displayed less volatility than the broad muni market—and only a fraction of that of the overall high-yield muni category, as seen in Chart 2. The chart also depicts another intriguing possibility, a portfolio with an equal blend of short-term high-yield munis and investment-grade munis of similar maturity. Such a combination would result in a further reduction of volatility, while still retaining a sizable component of high-yield securities to augment income. 

 

Chart 2. How Do Short-Duration, High-Yield Munis Compare in Terms of Historical Volatility?
Five-year standard deviation (through June 30, 2016) for indicated categories

Source: Barclays. One to eight-year high-yield munis represented by the Barclays High Yield Municipal Bond 1-8 Year Index; one to eight-year investment grade (IG) munis represented by the Barclays Municipal Bond 1-8 Year Index; the broader municipal market represented by the Barclays Municipal Bond Index; the high-yield municipal market represented by the Barclays High Yield Municipal Bond Index.

Past performance is no guarantee of future results. For illustrative purposes only and does not reflect 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.

 

A look at recent history also points up one potential advantage of short-duration, high-yield munis. According to Lord Abbett research, a representative index of short-term, high-yield muni bonds outperformed munis in other categories, U.S. government bonds, and the broader U.S. fixed-income market during the last six periods when there were increases of 100 basis points or more in the yield on the 10-year U.S. Treasury note. The short-term, high-yield muni index also generated positive returns in each of these periods, and outperformed the Barclays U.S. Aggregate Bond Index, the Citi Treasury Benchmark 10-Year Index, and the Barclays Municipal Bond Index in each period. That performance speaks to the asset class’s potential usefulness as a portfolio diversification tool. Based on Barclays data, the same short-term high-yield muni index historically has had a low correlation with other fixed-income categories, including a negative correlation with U.S. Treasury securities.

In addition to interest-rate risk, investors may be wondering about the credit risk profile of short-duration, high-yield munis. Dan Solender, CFA, Lord Abbett Partner and Director of Municipal Bonds, has noted three factors in their favor:

  • Issuers of revenue bonds (the vast majority of the high-yield segment) typically are not scheduled to start paying back principal until a few years after issuance, so the actual amount of debt service that needs to be paid is lower in the early stages of the issue. 
  • Shorter issuance time frames are more predictable from an analytical perspective. 
  • If credit issues do occur that would cause a rating downgrade, shorter-termed bonds will reach maturity dates and return par to investors well before longer-maturity bonds as long as the bonds continue paying interest.

What, then, should be the next step for those interested in this asset class? Selecting and purchasing individual bonds may be a daunting undertaking for individual investors. As we have often reminded investors, muni ownership patterns have changed. With the market featuring a lower inventory of available securities for purchase, and an increased need for more robust credit research, individuals have favored actively managed vehicles such as mutual funds and separately managed accounts. The markedly different nature of the muni market argues in favor of active managers, who have greater access to muni-bond inventory and sophisticated security valuation and credit research capabilities.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

ONE MUNI GAME PLAN:
GO SHORT—AND HIGH
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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