Time to get aggressive: Finding opportunities after the muni sell-off
- Rising interest rates stoked investor fears that were later compounded by Detroit’s bankruptcy filing.
- We are not seeing signs of an increase in municipal defaults.
- We are slowly shifting to a more aggressive stance to take advantage of what we believe to be attractive opportunities
Michael J. Walls
IT HAS BEEN A VOLATILE SUMMER for municipal bond market investors. Late-spring fears about rising interest rates prompted a wave of selling pressure across the bond market that increased as the Federal Reserve struggled to communicate its interest rate policy outlook. Muni investor sentiment suffered again when Detroit filed for bankruptcy and has taken yet another hit amid concerns about Puerto Rico’s debt.
Michael Walls, portfolio manager of the Ivy Municipal High Income Fund, believes that many of the risks that dominated the summer headlines have been overblown by investors, creating a downward spiral. He shares his views about the Fund’s strategy and what he views as a significant buying opportunity.
The sell cycle
A lot of time can be spent talking about the various negative headlines that have created selling pressure on the municipal bond sector. The entire bond market has been significantly impacted by the change in investor sentiment that added more than 100 basis points to the reference 10-year U.S. Treasury between May 1, when it was yielding 1.66%, and the end of July, when it was approaching 3%. As we would expect, this move had a significant impact on bond funds with longer duration.
Within the muni sector, however, many of the negative summer headlines related to municipal finance were events already well-known in the market. Although Detroit has generated a lot of headlines, it is not necessarily “news” that the city was in a dire financial condition.
Looking broadly we are seeing no signs of an uptick in municipal defaults. We believe the most significant issue currently facing the market is the fact that we are in a vicious sell cycle where heavy muni bond fund redemptions prompt a wave of selling that, in turn, lowers prices encouraging another wave of redemptions.
This level of selling is something the market has not experienced for some time. August will be the sixth consecutive month with negative fund flows out of municipal bond funds, according to Investment Company Institute (ICI) data. For some perspective, municipal bond funds only had two negative months over the entire period between June 2011 and February 2013. And the flows have been especially large in recent months with more than $16 billion out of the sector in June and $10 billion out in July. Based on weekly data, it looks like August saw another $10 billion or more in outflows.
This summer sell-off has created a buying opportunity that we see as similar to what we saw in 2008 during the financial crisis or in 2010 when banking analyst Meredith Whitney made an extremely high profile (and incorrect) prediction that a wave of municipal defaults was on the horizon. We believe tax-free yields may be especially attractive to some investors. For example, according to Barclays, the yield-to-worst on the index has risen from a recent low of 5.30% on May 2 to 6.84% on Aug. 31. Assuming a marginal tax rate of 39.6%, the taxable equivalent yield-to-worst for the index is around 11.3%.
While retail investors have exited the market, we have seen an increase in trading activity from institutional buyers whom we believe are coming into the muni market because of the dramatic yield rise on tax-free paper. We are seeing yields on high-grade muni paper that are now higher than what is available on similar quality corporate, taxable paper. This dislocation is especially rare. According to Bloomberg, AAA general obligation munis as a percentage of Treasuries are over 100%. They normally trade at a discount because of the tax benefit, so valuations are cheaper relative to Treasuries.
The portfolio’s holdings of floating-rate securities and auction-rate securities helped to provide liquidity during the market’s redemption wave. In the past, the portfolio was defensive because we felt we were not getting sufficient compensation for the risk. As a result, a majority of the portfolio was in premium bonds with above-market coupons priced to shorter calls.
We are now slowly shifting toward more aggressive structures. We are looking to take advantage of the current valuations, which we believe are highly attractive, and move out on the yield curve, purchasing bonds priced to longer call dates. We believe that the longer maturities currently trading at deep discounts stand to benefit when the market eventually stabilizes. That said, we continue to remain underweight sectors that we believe to be more volatile, but are instead looking at specific opportunities where price declines have opened up entry points that we find attractive.
Past performance is no 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 as of Sept. 6, 2013 and are subject to change due to market conditions or other factors.
Risk 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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