Investment Grade and High Yield Municipal Bonds Stand Out
It's a strange time indeed to be a fixed-income investor. Ordinary relationships between risk and yield have, for the time being, been turned upside down. Normally, it's the riskiest assets that command the highest yields, while lower-risk bonds offer lower yields. But today, investment grade and high yield municipal bonds stand out in the current environment, both nominally and from a tax-equivalent perspective, even when compared to riskier options.
As the chart below illustrates, investment grade municipal bonds have become nominally (shown in dark blue in the chart) attractive, offering higher yields to investors than U.S. and global government bonds. While investment grade muni bonds are nominally competitive compared to other investment grade fixed-income assets, high yield muni bonds are currently in an even more favorable position, offering nominal yields that outstrip traditionally riskier assets, including high yield emerging market bonds and high yield corporate bonds.
Comparative Index Yields (As of February 16, 2017)
Source: Bloomberg Barclays. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.
This abnormal situation was spurred in large part by the large sell-off in muni bonds, both high yield and investment grade, following the surprise election of Donald Trump in November 2016. As muni bond prices dropped, their yields rose. Somewhat puzzlingly, corporate high yield bonds proved much more resilient throughout the muni bond sell-off, and consequently, have not seen their yields rise to the same extent.
An Inversion of the Norm
Although investment grade muni bonds and their high yielding muni bond cousins are nominally (again, in dark blue) providing more competitive yields than other investment grade bonds and high yield bonds, respectively, their yield advantage comes into even sharper focus when tax-equivalent yields (illustrated by other colors in the chart) are calculated. Tax-equivalent yields take into account the federally tax-free coupon that municipal bonds offer, as well as the tax bracket of a given investor. As the chart clearly shows, when investment grade muni bonds' tax-free coupons are taken into account, their yields approach those of emerging market corporate bonds, even though emerging market corporate bonds tend to be riskier.
In a clear inversion of the norm, where riskier assets usually offer higher yields, high yield muni bonds are currently offering significantly higher tax-equivalent yields than nominal yields of U.S. corporate high yield bonds and global high yield bonds. This situation should be particularly notable for investors looking for higher yield in risky assets, such as emerging markets high yield bonds or high yield corporate bonds - they can currently tap into the same nominal yield from an asset class that has displayed less risk in the form of muni bonds.
Although tax-equivalent yields will vary depending on a given individual's federal tax bracket, they provide an after-tax boost to nominal yields regardless the income level. By taking taxation into account, it's clear that currently muni bond investors may be able to "have their cake and eat it too" - higher yields with lower risk (as measured by historical default rates1). It's uncertain how long this situation will persist; however, in the short term, these higher yields with relatively low historical risk present enticing buying opportunities for fixed income investors.
Looking forward, it's well known that the Trump Administration has expressed a desire to lower tax rates. If these tax cuts come to pass, the effect these new policies may have on bond yields largely depends on whether the tax cuts actually have the intended stimulating effect on the economy. Muni bonds, with their tax-free coupon, may become slightly less attractive if tax rates are lower, but would continue to provide tax-exempt income. If the economy grows at a higher rate as a result of lower tax rates, this could prove inflationary, driving rates up, including bond yields. This Administration's proposed infrastructure spending could likewise drive bond yields upward, as yields would need to rise in order to clear excess supply.
1 Source: Moody's Investors Services; "U.S. Municipal Bond Defaults and Recoveries, 1970-2015".
Global Agg: Bloomberg Barclays Global Aggregate Bond Index includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities. U.S. Treasury: Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Inv. Grade Muni: Bloomberg Barclays Municipal Bond Index includes investment-grade tax-exempt debt. U.S. Agg: Bloomberg Barclays U.S. Aggregate Bond Index includes government and corporate securities, mortgage pass-through securities, and asset-backed securities. U.S. Corp: Bloomberg Barclays Corporate Bond Index includes taxable corporate debt from U.S. issuers. EM USD Corp: Bloomberg Barclays EM USD Corporate Bond Index includes USD denominated debt from corporate emerging markets issuers. EM Sov Local: Bloomberg Barclays EM Local Currency Government Bond Index includes local currency denominated government debt from emerging markets issuers. EM Sov USD: Bloomberg Barclays EM USD Government Bond Index includes USD denominated government debt from emerging markets issuers. Global High Yield: Bloomberg Barclays Global High Yield Bond Index includes hard currency denominated government, agency and corporate debt from global issuers. U.S. Corp High Yield: Bloomberg Barclays U.S. Corporate High-Yield Bond Index includes below investment-grade corporate debt from U.S. issuers. Muni High Yield: Bloomberg Barclays Municipal High Yield Bond Index includes below investment-grade tax-exempt bond market.
Taxable-equivalent yield represents the yield a taxable bond would have to earn in order to match-after federal taxes-the yield available on a tax-exempt municipal bond (excluding AMT). Municipal bonds may be subject to state and local taxes as well as to federal taxes on gains and may be subject to alternative minimum tax. The chart displays the yields of the Barclays Municipal Bond Index and the Barclays High Yield Municipal Bond Index on a tax-equivalent yield basis and compares such yields to other asset classes as represented by the indexes described above. Fixed income investments have interest rate risk, which refers to the risk that bond prices generally fall as interest rates rise and vice versa. Only U.S. government bonds are guaranteed by the full faith and credit of the United States government. All other bonds are not guaranteed by the full faith and credit of the United States and carry the credit risk of the issuer. Municipal bonds are exempt from federal taxes and often state and local taxes. U.S. Treasuries are exempt from state and local taxes, but subject to federal taxes. Other securities listed are subject to federal, state and local taxes. Prices of bonds change in response to factors such as interest rates and issuer's credit worthiness, among others.
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Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer's financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.
The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.
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