Municipals: Revenue Bonds Trump General Obligations
We selectively favor bonds supported by dedicated revenue streams.
This sector report is excerpted from the Second Quarter 2016 Fixed-Income Outlook.
While the Puerto Rico situation dominates the news, pockets of volatility are beginning to appear that impact both large urban issuers and small rural authorities in the municipal market. Familiar names, such as the state of Illinois, Atlantic City and Chicago Public Schools, among others, garner the majority of the headlines, but markets are also seeing a growing failure among state and local leaders to find solutions to other problems. With budget impasses becoming the norm, court decisions overturning pension reform becoming more frequent, and labor relations requiring constant attention, the rating agencies have felt compelled to review not just an issuer’s ability to service its debt, but also its ability to govern.
Strong Demand for Municipals Pulls Yields Lower
Flows into municipal bond funds have been strong against volatile credit market conditions, totaling $9.3 billion in the first quarter of 2016. Demand from individual investors has a meaningful impact on the municipal bond market given that individuals and mutual funds represent 70 percent of the total market outstanding.
Source: Lipper, Barclays, Guggenheim Investments. Data as of 3.31.2016.
Against this backdrop of uncertainty, technicals are strong, with inflows into municipal bond mutual funds and ETFs remaining steady, and upgrades outnumbering downgrades. In the first quarter of 2016, the Barclays Municipal Bond index recorded a gain of 1.7 percent, with the Barclays Revenue Bond index outperforming the General Obligation Bond index by 33 basis points. State tax collections, according to the most recent report released by the Rockefeller Institute of Government, are still growing albeit at a slower pace, creating an environment in which credit spreads are tight and municipal yields as a percent of U.S. Treasurys are range bound.
Accordingly, we are selective in this environment and still favor higher-yielding revenue bonds—those supported by dedicated revenue streams, such as utilities, transportation bonds and water and sewer systems—over general obligation bonds. On a risk-adjusted basis, A-rated bonds present an opportunity when compared to higher-rated obligations. The BBB market is less attractive given the historically tight spreads that have resulted from the limited investment opportunities for significant mutual fund inflows.
Better Value in A-Rated Than BBB-Rated Municipals
BBB-rated municipal bonds have historically offered 101 bps of additional yield over A-rated municipal bonds, on average. This yield differential has narrowed to only 61 bps as of March 31, 2016, highlighting better relative value in A-rated municipal bonds.
Source: Barclays, Guggenheim Investments. Data as of 3.31.2016.
—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director
Important Notices and Disclosures
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment-grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating-rate senior-secured syndicated bank loans and other floating-rate securities involve special types of risks, including credit risk, interest-rate risk, liquidity risk and prepayment risk.
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