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Market View

High-yield municipal bonds historically have outperformed their high-quality taxable and tax-free counterparts, while providing the opportunity for attractive tax-free income.

In Brief

  • High-yield municipal bonds outperformed their high-quality taxable and municipal counterparts over the last three-, five-, and seven-year periods.
  • The bulk of the returns generated from high-yield municipal bonds has come from tax-free coupons.
  • High-yield municipal bonds historically have offered excess tax-equivalent yield relative to high-yield corporate bonds with lower risk potential, as measured by default rates and the long-term standard deviation.
  • In addition, high-yield munis have provided diversification benefits due to their low correlation to high-yield corporates.
  • Short-duration high-yield municipal bonds represent an alternative source of tax-free income, with historically lower volatility and interest-rate sensitivity relative to longer-maturity high-yield municipal bonds.
  • Investors should note that high-yield munis are of lower credit quality and feature higher volatility than investment-grade munis. 

Municipal bonds have delivered attractive returns so far this year, with the representative benchmark Bloomberg Barclays Municipal Bond Index gaining 5.16% through October 24. As discussed in a previous Market View, this performance comes despite investor concerns surrounding the 2016 U.S. presidential election around increased supply of muni issues coming to market, higher interest rates, and changes to the U.S. tax code. Note that none of these concerns have played out as investors have feared.

Overall, tax-free bonds appear relatively healthy in terms of fundamental, technical, and valuation factors. State and local government tax receipts have trended higher since 2010, year-to-date issuance through September-end has actually fallen compared with the same time period last year, and muni bonds still exhibit value relative to U.S. Treasury securities and corporate bonds.

Taking a longer-term view, Table 1 shows that investment-grade municipal bonds (as represented by the Bloomberg Barclays Municipal Bond Index) have outperformed high-quality taxable bonds (as represented by the Bloomberg Barclays U.S. Aggregate Bond Index [“Aggregate Index”]) over the last three-, five-, and seven-year periods. Interestingly, high-yield municipal bonds (as represented by the Bloomberg Barclays High Yield Municipal Index [“High Yield Muni Index”]) outperformed both the Aggregate Index and high-quality munis.  What is more, the total return figures do not consider the tax benefit associated with income from municipal securities. Considering that the bulk of the High Yield Muni Index’s total return comes from its tax-free coupon, the tax-equivalent return over five years would be more than 8% versus the 4.7% nominal figure shown.  
 

Table 1. High-Yield Munis Historically Have Outperformed High-Quality Taxable and Tax-Free Bonds

Source: Bloomberg Barclays Index data. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett portfolio or any particular investment and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different.

 

Although investing in below-investment-grade tax-free bonds may come with more volatility relative to higher-quality bonds, total returns historically have proven to be higher. [There is no assurance that such an approach will consistently lead to successful investing.] As mentioned, most of that return is derived from tax-free income. Chart 1 shows just how significant the yield differential can be relative to the 10-year U.S. Treasury note, high-quality munis, and even high-yield corporate bonds.

 

Chart 1. High-Yield Municipal Tax-Equivalent Yields Recently Outpaced Leading Alternatives
Yield data (tax-equivalent yields* for municipal indexes) as of September 30, 2017

Source: Bloomberg Barclays Index data, Credit Suisse, and Bloomberg (10-year Treasury data). Investment grade municipal bonds represented by rating-specific specific components of the Bloomberg Barclays Municipal Bond Index. Investment grade corporate data represented by rating-specific components of the Bloomberg Barclays U.S. Corporate Bond Index. High-yield municipal bonds represented by the Bloomberg Barclays High Yield Municipal Bond Index. High-yield corporate bonds represented by the Credit Suisse High Yield Corporate Bond Index.
*At the 28% tax bracket, the tax-equivalent yield would be 2.84%, 3.47%, 4.42%, and 7.43% for the AA-Rated, A-Rated, BBB-Rated, and High-Yield Municipal 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 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. U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. Corporate bonds are subject to interest rate risk and credit risk. In particular, their value will change as interest rates fluctuate, based on the inverse relationship of bond prices to interest-rate movements.  Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.  High-yielding, non-investment-grade bonds have higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

 

At this point, an investor may well ask, “What are the added risks for which I’m being compensated?” By definition, high-yield municipal bonds carry below-investment-grade credit ratings. However, despite the significant tax-equivalent yield advantage of high-yield munis, the relative risks of the asset class versus corporate bonds of comparable credit quality historically have been lower, based on long-term default rates and volatility (as represented by standard deviation). Table 2 depicts the results of a Moody’s default study which showed that non-investment-grade municipal bonds’ average rolling 10-year cumulative default rate of 8.17% was significantly lower than the nearly 30% for high-yield corporate bonds. In addition, based on data from Morningstar, the 10-year standard deviation of high-yield municipal bonds is 8.33, compared to 10.62 for high-yield bonds. [Please note all investments carry a certain degree of risk, including the possible loss of principal, and there are specific risks that apply to each investment strategy.]

 

Table 2. Historically, High-Yield Muni Default Rates Have Been Lower Than Similarly Rated Corporates
10-year cumulative default rates for indicated ratings categories, 1970–2016

Source: Moody’s, “Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970–2016,” published June 2017. Data show the average 10-year cumulative default rates of Moody’s rated corporate and municipal bonds for a study covering the period 1970-2016. Data are the most recent available.
*Rating outlooks are not assigned to all rated entities.
While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds.  Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Investors who hold high-yield corporate bonds may question extending their exposure to below-investment-grade securities by adding high-yield munis to their portfolios, even if there are differences in tax treatment. It’s important to note, however, that high-yield municipal-bond exposure historically has provided diversification benefits due to the asset class’s low correlation to its taxable counterparts. The correlation of non-investment-grade, high-yield bonds to high-yield corporates was 0.20, 0.29, and 0.47, respectively, over the three-, five-, and 10-year periods through September 30, 2017, according to Morningstar. In addition, high yield municipal bonds don’t correlate with U.S. Treasury securities as much as higher quality tax-free bonds, making them less sensitive to changes in Treasury rates.

It is no surprise, then, that in the current low-rate environment, the appealing long-term returns and high tax-equivalent yields have attracted investor attention to the asset class. To be sure, investors in high-yield muni bond funds withdrew more than $6 billion in the last three months of 2016, but that drawdown was more than mitigated by $7.4 billion in net inflows year to date through the end of September 2017, according to Morningstar. 

Puerto Rico Update
High-yield municipal bond investors continue to raise questions about Puerto Rico’s municipal debt, especially after the devastation wrought by Hurricane Maria. Recall that Puerto Rico bonds accounted for less than 5% of the Bloomberg Barclays High Yield Municipal Index at the beginning of 2014, but that figure surged to 31% by September 2014, as the bonds were downgraded to below investment-grade status. Yet again, there has been a notable change to the composition of the index, as Puerto Rico bonds, in large part, have defaulted, and thus have been dropped from the index. This has brought the index’s exposure to Puerto Rico debt to as low as 3.9% as of October 24. Consequently, high-yield municipal mutual funds have reduced position sizes to bring their exposures more in line with the index.

A Short Answer
Finally, for those looking for a source of tax-free income with lower duration and volatility than conventional high-yield municipals, short duration high-yield municipal securities might be an appealing approach. Short high-yield munis (as represented by the Bloomberg Barclays High Yield 1-8 Year Municipal Bond Index) have demonstrated a high correlation with high-yield municipal bonds, but lower volatility, over the last 20 years.

Further, returns on short-duration high-yield bonds have been positive in six of the last seven periods that the yield on the 10-year U.S. Treasury bond rose by more than 100 basis points. In fact, the one rising-rate period when short high-yield muni bonds posted a negative return was influenced by heavy selling pressure in the abovementioned bout of post-election investor uncertainty during the fourth quarter of 2016. To reduce volatility and boost liquidity, investors may wish to consider a blend of both halves of the credit spectrum, combining high-quality, short-term municipals with below-investment-grade, low-duration tax-free bonds. [Investors should consult their financial advisor about investment strategies that are appropriate for their investment objectives, risk tolerance, tax status, and liquidity needs.]

 

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CONTRIBUTING STRATEGIST

RELATED FUND
The Lord Abbett High Yield Municipal Bond mutual fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.
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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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