As we head into 2020, municipal bonds will likely remain attractive for many tax-sensitive investors, but their performance potential could prove to be relatively muted compared to 2019, according to Sheila Amoroso, director of our Municipal Bond Department. She and her team say this is due to the general level of interest rates and tighter yield spreads, particularly for lower-rated segments of the municipal market. They believe that while now may be a good time to consider a more cautious approach, they still see potential for high levels of tax-exempt income.

Municipal Market Nuances in a High-Yield Context

The municipal bond market presents a number of unique features and characteristics that set it apart from traditional asset classes, and, as one moves further down the credit ratings scale, we believe these nuances become increasingly important for investors to consider.

For example, the municipal market itself is relatively fragmented in nature, with bond inventories spread out across a vast network of dealers and buyers. Trading in the market tends to be limited, and those bonds that do trade typically do so in a decentralized, over-the-counter (OTC) market, presenting challenges for retail investors with regard to market access and price transparency. Liquidity dynamics tend to become even more challenging for lower quality segments of the market.

Only around 10% of the municipal market would be considered below investment grade, based on the traditional breakdown of credit ratings (i.e., bonds rated BB and below). Due to the small size and limited diversity of bonds with these ratings, many BBB issues are considered high yield in the context of the municipal bond market. This is one reason why many high-yield municipal bond funds typically hold meaningful exposure to the BBB segment, which can also provide a valuable source of liquidity compared to even lower quality and non-rated bonds.

These themes have meaningful implications in a market where almost 2/3 of bonds are held by retail investors, either directly or through investments in mutual funds.1 With over a million unique securities from more than 50,000 issuers available, many investors simply lack the expertise and resources required to navigate an increasingly complex and fragmented market.

We believe this ownership structure makes the market susceptible to investment decisions that may be driven by emotions, market headlines or other similar factors, further contributing to the market’s inefficiencies.

We also believe this ownership structure contributes to the importance of market technicals, which consistently exert meaningful impacts on municipal market performance—as we observed in 2019—particularly for lower-quality segments of the municipal bond market.

High-Yield Municipal Bonds: Recapping Key Performance Trends from 2019

The municipal bond market performed quite well in 2019, and lower-quality segments of the market posted especially strong results. From our perspective, a key driver was the record-setting levels of demand, as investors continued their search for yield in a low-interest-rate environment.