Asset Allocation Change: Increasing High Yield Municipal Exposure

November was the worst month for municipal bonds since September 2008, with the Bloomberg Barclays Municipal Bond Index down -3.73%. As lower-rated credits underperformed higher-rated ones within the market place, MacKay Municipal ManagersTM was quick to use this opportunity to reposition their portfolios. We spoke with John Loffredo, Co-Head of MacKay Municipal ManagersTM, to get his thoughts on the market.

Increasing High-Yield Exposure to 40% from 25%

President-elect Donald Trump’s victory on November 8 surprised investors. Yields were already rising on the heels of significant issuance in the month of October, but the election outcome triggered a reassessment of growth, inflation, and tax assumptions by investors that ultimately exposed liquidity fault lines in the municipal bond market. During this recent cycle, the yields on higher-yielding issues rose far more than those of higher quality names.

To put it into perspective, in the past four weeks, the spread between the AAA and BBB indices has widened considerably; a value proposition John and the team finds compelling. As a reminder, the default rate in BBB municipal bonds is actually lower than that of AAA corporate credits (see Figure 1). What’s more, approximately half of the high yield municipal bond market is BBB-rated.



The team used the opportunity to increase their recommended, base case allocation from 25% high yield to 40%; reducing the exposure to investment grade bonds from 75% to 60%. The change actually brings this recommended allocation back to a time when the spread between AAA- and BBB- rated bonds was at a similar level to today.

Well Positioned to Navigate and Capitalize

MacKay Municipal ManagersTM was well positioned during the latest liquidity skirmish because (i) they don’t use leverage or own entire issues, (ii) they limit their exposure in non-rated bonds, and (iii) they maintain cash on hand to quickly seize opportunities. Thus, they were able to provide liquidity when the price for it became dear.

They were also able to move swiftly because of their research capabilities. While evaluating investment-grade general obligation bonds takes time, as each state is different, there is somewhat of a standard procedure.

By contrast, evaluating revenue bonds - which are more prevalent in the high-yield market – has more variables and complexity involved, including a deep understanding of the cash flows and terms relating to each issue. A research team like MacKay Municipal ManagersTM that is organized by sector across the investment-grade and high-yield market may be in a well-informed position to evaluate relative value across a sector’s credit spectrum.

Favoring Longer-Dated Maturities

In recent weeks, the yield curve has not only moved higher, but also steepened because longer-maturity bond yields have risen more than shorter-maturity yields. As a result, John and the team now see more value in longer-dated issues. This view comes about from a value-based approach rather than a yield-seeking one. The nearby chart illustrates the ratio of municipal bond yields to Treasury yields at during maturities along the yield curve (see Figure 2).



Duration

The team maintains a duration posture of staying within a band around its benchmark. Highly liquid hedges are used as needed to stay within the targeted duration band.

Better Technicals Ahead

As we have pointed out previously, weak technical conditions in October often provide a favorable entry point for long-term investors. In 2016, the surprising election results appear to have shifted the seasonal timing by a month or so, according to John and company. Of note: in December approximately $40 billion of purchasing power should enter the municipal bond market via coupon payments ($14 billion), maturities ($13 billion), and refinancing ($14 billion). The team believes a similar amount of capital will look to reinvest in the municipal market in January as well.

What’s more, historically, both investment-grade and high-yield municipal bonds have performed well following periods of stress (see below). Past performance is no guarantee of future results.



Thoughts on Liquidity

We expect liquidity in the marketplace to remain front and center from a regulatory point of view. Experienced investment teams with a disciplined understanding of the issue may be in a favorable position to separate return from risk when the price (or “premia”) for liquidity rises and falls from time to time.

Parting Thoughts

For investors seeking after-tax income, the municipal bond market continues to offer a robust opportunity set.



About risk

All investments are subject to risk and will fluctuate in value. Funds that invest in bonds are subject to interest-rate risk and can close principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. This material contains the opinions of the MacKay Municipal Managers TM team of MacKay Shields LLC but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2016, MacKay Shields LLC.