Municipal Bond Perspective: Approach High Yield with Caution in 2020
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January 2020
Perspective from Franklin Templeton Fixed Income
Municipal Bond Perspective:
Approach High Yield with Caution in 2020
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 securities from more than 50,000 issuers available, many
The municipal bond market presents a number of unique features investors simply lack the expertise and resources required to
and characteristics that set it apart from traditional asset navigate an increasingly complex and fragmented market.
classes, and, as one moves further down the credit ratings scale,
We believe this ownership structure makes the market susceptible
we believe these nuances become increasingly important for
to investment decisions that may be driven by emotions,
investors to consider.
market headlines or other similar factors, further contributing to
For example, the municipal market itself is relatively fragmented in the market’s inefficiencies.
nature, with bond inventories spread out across a vast network
We also believe this ownership structure contributes to the
of dealers and buyers. Trading in the market tends to be limited,
importance of market technicals, which consistently exert
and those bonds that do trade typically do so in a decentralized,
meaningful impacts on municipal market performance—as we
over-the-counter (OTC) market, presenting challenges for retail
observed in 2019—particularly for lower-quality segments of the
investors with regard to market access and price transparency.
municipal bond market.
Liquidity dynamics tend to become even more challenging for
lower quality segments of the market.
High Yield Municipal Bonds: Recapping Key
Only around 10% of the municipal market would be considered Performance Trends from 2019
below investment grade, based on the traditional breakdown
The municipal bond market performed quite well in 2019, and
of credit ratings (i.e., bonds rated BB and below). Due to the small
lower-quality segments of the market posted especially strong
size and limited diversity of bonds with these ratings, many
results. From our perspective, a key driver was the record-setting
BBB issues are considered high yield in the context of the
levels of demand, as investors continued their search for yield in a
municipal bond market. This is one reason why many high-yield
low-interest-rate environment.
municipal bond funds typically hold meaningful exposure to the
BBB segment, which can also provide a valuable source of Against this backdrop, high yield municipal bond funds were a
liquidity compared to even lower quality and non-rated bonds. clear beneficiary, bringing in roughly $18.6 billion in net flows for
the calendar year, shattering previous records, based on
These themes have meaningful implications in a market where
Morningstar flow data.2
almost 2/3 of bonds are held by retail investors, either directly or
through investments in mutual funds.1 With over a million unique
Not FDIC Insured May Lose Value No Bank Guarantee
Lower-Quality Municipal Bonds Outperformed in 2019 Historically, wider spread levels have provided opportunities for
Exhibit 1: Municipal Bond Index Performances credit selection to drive incremental upside results, given the
As of December 31, 2019 potential for spread compression amid improving fundamentals.
% However, spreads have narrowed significantly in recent years
12
10.68 and are well below long-term averages, not only limiting the
9.94 likelihood for continued price returns going forward but potentially
10
exposing some investors to increased downside risks, should
8.10
8 7.54 any number of market factors cause spreads to widen.
7.12
6.73
6 It’s worth noting the mean-reverting nature of price returns, which
consistently average out over time.
4
High-Yield Municipal Bond Index Price Returns Over the Last 10 Years
2
Exhibit 3: Municipal Bond Index Price Returns
As of December 31, 2019
0
Bloomberg Bloomberg Bloomberg Bloomberg Bloomberg Bloomberg %
Barclays Barclays Barclays Barclays Barclays Barclays 15
Municipal Municipal Municipal Municipal Municipal Municipal HY
Municipal Municipal Municipal AA Municipal A BBB Index Muni Index 11.52
Index AAA Index Index Index 9.11
10
6.16 7.19 5.64
For illustrative purposes only and not representative of the performance or portfolio 4.31
4.78 5.48
composition of any Franklin Templeton Funds. 3.88
5
Source: Bloomberg Barclays Municipal Indexes, as of 12/31/19. Indexes are unmanaged 2.49
and one cannot directly invest in them. They do not Include fees, expenses or sales 1.12
charges. Past performance is not an indicator or guarantee of future results. 0
-0.57 -0.26
-1.44
Calendar Year 2019 Set a New Record for High-Yield Municipal Bond -2.36 -2.40
-5 -4.20 -4.16
Fund Flows
Exhibit 2: Estimated Net Inflows
As of December 31, 2019 -10
Estimated Net Flows ($, Millions) -10.92
-11.64
25,000 -15
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
20,000
15,000 Barclays Muni BBB Price Return Barclays Muni HY Price Return
10,000 Sources: Franklin Templeton Capital Market Insights Group, Federal Reserve, NBER
(National Bureau of Economic Research) Macrobond. Important data provider notices and
5,000 terms available at www.franklintempletondatasources.com.
0
For example, when we isolate the price returns for the BBB
-5,000 and high-yield municipal indexes since 2007, we observe
-10,000 average price returns of -0.35% and -0.19%, respectively.3
Meanwhile, we observe average coupon returns (interest
-15,000
payments) of 4.91% and 6.07% for the BBB and high-yield
’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17 ’18 ’19
municipal indexes, respectively.4
Source: Morningstar Direct, as of 12/31/19.
There is no assurance that any estimate, forecast or projection will be realized. We strongly believe that income returns represent the primary
driver of municipal bond performance over time, and, while
it’s impossible to predict for any given year, our outlook leads us
Throughout 2019, such significant inflows presented favorable
to believe that a focus on income generation and downside
tailwinds for the BBB and high yield municipal indexes, driving
protection will be keys to success for high-yield municipal
significant contributions from price returns for both indexes,
investors in 2020, especially when we consider risk and return
as illustrated in the chart below. This has had a material effect on
dynamics at this point in time.
valuations, which in our view warrants increased caution from
investors going forward.
Municipal Bond Perspective: Approach High Yield with Caution in 2020 2
BBB and High-Yield Municipal Index Spreads Are Well Below Long-Term Averages
Exhibit 4: Municipal Bond Index Spreads
As of December 31, 2019
Municipal Yield Spreads (basis points)
500
450
400
350
300
250 223
200
150
100
90
50
0
Mar-10 Dec-10 Sep-11 Jun-12 Mar-13 Dec-13 Sep-14 Jun-15 Mar-16 Dec-16 Sep-17 Jun-18 Mar-19 Dec-19
BAA Muni Yields Minus AAA Muni Yields 20 Yr Avg. BAA Spread (160 bps)
HY Muni Yields Minus IG Muni Yields 20 Yr Avg. HY Spread (320 bps)
For illustrative purposes only and not reflective of the performance or portfolio composition of any Franklin Templeton Fund.
Source: Bloomberg, as of 12/31/19. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an
indicator or guarantee of future results.
Franklin’s Approach: Focused on High Income, This positioning also enhances our ability to be nimble and
Not High Risk opportunistic amid market dislocations, which is when our trading
activity typically accelerates.
Against a backdrop of tighter spreads and lower rates, we also
see several factors that could lead to increased bouts of volatility In such instances, we selectively initiate or add to existing
for municipal bonds in 2020, as noted in our annual outlook. positions in bonds that have unfairly sold off, allowing us to
To the extent we experience a slowing of economic conditions in capitalize on opportunities that present higher book yields without
2020, the impact to state and local governments would likely requiring the excessive risk-taking at the portfolio level. Over
be disparate, leading to potential credit downgrades and time, such trading activity is one of the key reasons why we can
increased yield spreads for heavily burdened issuers. In certain provide above-average levels of tax-exempt income without
instances, we feel that the market and rating agencies have emphasizing lower-quality bonds or using leverage, practices that
underestimated the burden that these liabilities pose to local and aren’t uncommon for many high-yield municipal funds.
state governments.
On the contrary, we generally hold on to our positions when the
Of course, we also recognize that volatility could increase as we market is performing well, and, in many cases, we continue to
move closer to the US presidential election, an event that has hold legacy positions that were initiated in previous market
previously marked the high-yield municipal market’s most recent selloffs. Some of these holdings result in exposure to bonds that
major decline, when the index returned -4.65% in the last two have been advance refunded, a segment that has generally
months of 2016 alone. underperformed versus lower-quality segments of the market, due
to naturally lower price-return contributions.
In any case, our robust credit research process looks to identify
those issuers that appear to have superior financial positions and As we consider risk and return dynamics at this point in time, we
thus should continue to perform well under these circumstances, think these bonds could continue to provide more incrementally
ideally providing downside protection for our clients. attractive income streams while potentially reducing credit risks.
As such, it would be difficult for us to justify trading out of such
We also believe that our consistent achievement of high levels
bonds in favor of others with lower yields and higher credit risks
of tax-free income, without overly aggressive allocations to
given current valuations. In addition, advance refunded bonds are
lower-quality segments, reflects our balanced approach to income
typically more liquid, further supporting our efforts to capitalize on
and risk.
opportunities amid future periods of distress in the high yield
For example, for some time we have not favored lower-quality municipal bond market, whenever they should occur.
and non-rated buckets in our portfolios, where liquidity risks
often become more meaningful in addition to credit risks.
Municipal Bond Perspective: Approach High Yield with Caution in 2020 3Time for a Cautious Approach
We recognize the strong levels of total return observed across
lower-quality segments of the municipal bond market in 2019.
However, given the general level of interest rates and tighter
spreads for high- yield municipal bonds, we believe that now
may be a good time to consider a more cautious approach,
particularly one that still offers the potential for high levels of
tax-exempt income.
Endnotes
1. Source: Municipal Securities Rulemaking Board (MSRB), March 2019.
2. Source: Morningstar Direct, as of December 31, 2019.
3. Source: Bloomberg Barclays, as of December 31, 2019. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
Past performance is not an indicator or guarantee of future results.
4. Source: Bloomberg Barclays, as of December 31, 2019.
Contributors
Sheila Amoroso Daniel Workman, CFA Francisco Rivera
Portfolio Manager Portfolio Manager Portfolio Manager
Franklin Templeton Fixed Income Franklin Templeton Fixed Income Franklin Templeton Fixed Income
Municipal Bond Perspective: Approach High Yield with Caution in 2020 4WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recom- mendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. 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