It’s not normal. When a fixed-income sector beats the S&P 500 over an extended period and by a meaningful amount, investors do a double take.

[REITs]

Muni Investors Shouldn't Smoke Tobacco

Tobacco bonds, which represent nearly one quarter of the muni high-yield market, have outperformed stocks by 3% annualized over the past three years. That’s been largely because of demand for a liquid sector in a market where supply has been particularly limited. It’s been a wild ride. But wild rides are often bumpy, and this one has been no exception.

The annualized volatility of the tobacco bond sector, as measured by standard deviation, was almost as high over the last three years as the equity market itself, and nearly twice as high as the rest of the high-yield muni market.

What is generating this kind of whipsawing volatility? Tobacco bonds’ payments are based on cigarette consumption. That means that anything affecting cigarette shipments—for better or for worse—affects the pricing of tobacco bonds. Federal proposals to reduce nicotine in cigarettes. More state or federal tobacco tax hikes on the table. Suggestions to add graphic photos on packaging. Regulations on indoor smoking. Growth of the e-cigarette. As the outlook for any of these trends up or down, so do tobacco bonds. And it’s important to keep in mind that the overall trend in cigarette smoking has been on a downward trajectory for decades.

Lastly, and perhaps most critically today, tobacco bonds have run out of room to rise. Three years ago, prices were practically at fire-sale levels. They are currently near par, with nowhere left to go but down. In fact, tobacco bonds’ returns have begun to sour in recent weeks compared to other sectors.

High volatility combined with high valuations is an indication that it’s time for muni investors to reduce their holdings of tobacco bonds in favor of more attractive and less volatile sectors of the high-yield municipal bond market, such as senior living and hospitals.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Alliance Bernstein