Waddell & Reed

Portfolio Perspectives

High Yield Munis: Is the best offense a strong defense?

Story Highlights

  • The municipal finance market is being influenced by a wide range of issues on the federal and local level.
  • Although many may focus on credit risk, duration risk must also be considered at current levels.
  • We believe the current environment merits moving the Fund to a more defensive stance.
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Investment Team

Manager Name

Michael J. Walls

Portfolio Manager

The municipal bond market was under the influence of politics throughout the 2012 campaign season. Investors may have felt the need to increase muni holdings before 2013 to capture potential tax benefits, or instead opted to shed munis in favor of other assets out of fear that those muni tax benefits would be capped or completely eliminated. In the post election environment, federal budget concerns have only increased the urgency with a tax hike virtually assured.

Although tax benefits are critical to valuations in the municipal bond sector, they are not the only factor influencing the market. Like other bond sectors, munis are also facing questions about the long-term interest rate environment and how an eventual move higher may impact muni credits. Finally, when looking at the muni sector, there are always questions about potential defaults, especially in an environment of lackluster growth.

The combination of these elements stresses a point that we have long held: It is important to take the long view when analyzing municipal bond funds, particularly high-yield funds, which seek higher potential returns and, as a result, often take on increased risk.

Looking at the big picture

In terms of credit risk, it is our continuing view that fears of widespread muni defaults are simply unwarranted. The markets have been dealing with a heightened concern about muni defaults since 2010, when a high-profile banking analyst predicted a massive wave of muni defaults in the near term.

As most in the municipal finance industry expected, that prediction was not realized. Although there have been defaults, including such high profile cases such as Jefferson County, Ala.; Stockton, Calif. and Harrisburg, Penn.,¹ these events have not surprised the public finance markets, nor have they been a sign of systemic problems within the sector. As was the case with each of these, potential muni defaults are usually identified by market participants well before they occur. Perhaps more importantly, as with these three examples, each muni default is caused by its own unique set of circumstances, not by a single issue that is endemic to the sector. Obviously, there are sectors or municipalities that may pose higher risk, but we do not see system-wide risks in terms of credit.

There are, however, other risks to the sector. As with all fixed-income funds, municipal bond fund investors must consider not only credit risk, but also duration risk, or the risk that interest rates will rise from their historic lows, thereby making the individual municipal bonds with extremely low yields less valuable. Although the Federal Reserve has vowed to hold rates at historic lows until at least mid-2015, we believe the interest rate picture overall has become clouded. In addition to the Fed’s low-rate commitment, bond yields have been driven lower by investors placing a high value on the relative safety of fixed income when compared against assets perceived to be of higher risk. This activity has led to occasional commentary about a bond market bubble which some have discounted.

However, we currently believe the bond market has entered bubble territory and while the market may remain at or near current levels for some time, there is an inevitable reversal ahead when investors begin to demand higher returns or decide to move into other assets. Catalysts could include either clear signs of inflation or greater investor confidence about equities. When that happens, we do not believe the Fed will be able to restrain the entire yield curve at its current levels, and risks at the long end of the yield curve may be significant.

As a result, we have moved the Waddell & Reed Advisors Municipal High Income Fund to a more defensive stance and we are currently pursuing a strategy of higher coupon bonds priced to shorter call dates. This move is in line with our overall strategy about the amount of risk we are comfortable with and the importance of credit selection in a high-yield bond fund.

We recognize that this strategy may result in short-term underperformance against funds with longer maturity structures, however, we believe these moves are important to help the Fund over the longer run. For example, as Treasury rates rise, it will become more feasible for some municipalities to refund their outstanding high-yield debt. As a result, we expect bonds with higher coupons and shorter call dates to be refunded, thereby providing the Fund with cash to reinvest in new asset purchases in what would be an overall higher interest rate environment.

¹ The Waddell & Reed Advisors Municipal High Income Fund did not hold any bonds issued by these municipalities

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Nov. 29, 2012, and are subject to change due to market conditions or other factors.

Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. The lower-rated securities in which the Fund may invest may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

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