Three Reasons to Consider Municipal Bonds | Lord Abbett
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Market View

Lord Abbett muni-bond experts highlight current trends in credit quality, supply/demand dynamics, and relative valuations

Read time: 3 minutes

In a recent webinar with investors, a panel of Lord Abbett experts, including Partner and Director of Tax-Free Fixed Income Dan Solender, Portfolio Manager Greg Shuman, and Director of Municipal Bond Research Eric Friedland, outlined some reasons why municipal bonds remain a potentially attractive asset class for investors seeking tax-free income in the months and years ahead.

  1. Historically Stable Credit Quality

During the pandemic-fueled economic turmoil that characterized 2020, municipal credit quality held up relatively well, in our view. Figure 1 provides a window on this by looking at S&P rating actions in 2020 (through September 30) across approximately $2.7 trillion in municipal credit securities.

 

Figure 1. S&P Municipal Credit Rating and Outlook Changes During 2020

Source: S&P Global Ratings. Data as of 9/30/20 (most recent available). S&P Global Ratings is a U.S.-based credit rating agency and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities.

 

To be sure, 22% of the ratings actions were negative, but a closer look reveals that only 5% of them were actual rating downgrades—the others were largely outlook changes. Another significant data point, in our view, is in the bottom right-hand corner, which shows that unchanged ratings, or affirmations, accounted for 76% of S&P's rating actions. To us, that underscores our point that there was stability in muni credit quality last year.

Of course, there may be more downgrades to come in 2021 and 2022, but we do not believe the numbers will be anywhere close to market expectations from earlier in the pandemic crisis.

  1. A Positive Supply/Demand Dynamic

We believe the supply/demand situation in the municipal bond market looks attractive. Figure 3 shows that while municipal bond issuance in 2020 reached a record, an increasing share of the total was from taxable municipal bonds. The amount of tax-exempt municipal bonds issued declined from the prior year.

 

Figure 2. Muni Issuance Has Climbed – but Taxable Bonds Are Accounting for a Greater Share

New issuance by category (bars) and taxable bonds as a percent of total muni issuance (line), 2005 - 2020

Source: Bond Buyer, as of December 31, 2020. The historical data are for illustrative purposes only, and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

As a reminder, the increased issuance of taxable muni bonds reflects provisions from the 2017 U.S. tax legislation related to the refunding and refinancing of municipal bonds. And absent any significant change in U.S. tax policy, the trend of higher issuance of taxable muni bonds does not appear to be changing anytime soon.

We think the implications for the tax-exempt side of the market are clear: the current strong demand, and slower pace of new issuance, for tax-exempt municipal bonds could potentially help support the market for some time to come.

  1. Opportunities in Lower-Rated Issues

We are often asked where we are finding potential value in the municipal bond market. To answer that, we think the information in Figure 3 is helpful.

 

Figure 3. A Closer Look at Muni-Bond Spreads
Credit spreads by rating category, February 1, 2011-February 4, 2021

Source: Bloomberg. Data as of 02/04/2021. Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. Chart displays the Bloomberg Barclays High Yield Municipal Bond Index, Bloomberg Barclays BAA-Rated Municipal Bond Index, Bloomberg Barclays A-Rated Municipal Bond Index, and Bloomberg Barclays Municipal Bond Index (Broad Muni Bond). 
The historical data shown in the chart above are for illustrative purposes only and do not represent 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. Past performance is no guarantee of future results.

 

The chart shows that spreads on A- and BBB-rated bonds have roughly returned to where they were at the end of February 2020. As you go down in quality one more notch, the high yield muni segment was still about 25 basis points wider.

And while on a historical basis, spreads appear relatively tight, we think that you must look at these levels in the context of broader capital markets. Many other asset classes have recovered to pre-pandemic levels, or in fact are trading through where they were before the pandemic started. Even with the strong recovery posted by muni bonds from the 2020 volatility, their gains have trailed those of other investments. We think that as investors recognize the potential relative value on offer in the muni market, especially in the BBB and high-yield segments, the market may have an opportunity to narrow that gap in 2021.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The credit quality of fixed-income securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

Glossary and Index Definitions

 

The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. Bonds must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The Bloomberg Barclays BAA-Rated Municipal Bond Index and Bloomberg Barclays A-Rated Municipal Bond Index are ratings-specific subsets of the Bloomberg Barclays Municipal Bond Index.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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