MacKay Municipal ManagersTM employs a relative value investment approach across all of their municipal strategies, with a focus on total return. The team seeks to capitalize on opportunities created by the mispricing of securities and will move along the credit curve based on where they find the best relative value. An emphasis is placed on risk management, and they currently do not employ leverage in the mutual funds they manage, which can increase volatility. The team’s active research-driven process and keen emphasis on risk control may benefit investors seeking attractive tax-free income.

Top Five Municipal Market Insights for 2019 – “Tactical Moves Guide Investors Through Market Uncertainty”

1. DEDICATED TAX AND GENERAL OBLIGATION DEBT OUTPERFORMS AS TAX REVENUE STREAMS GROW

Rationale: The recent expansion in overall economic activity has fueled growth in individual and corporate income taxes as well as sales taxes. State revenues have exhibited strong year over year growth, with 2018 revenues up almost 6% through the third quarter of 2018 (source: U.S. Census Bureau 3Q 2018). We anticipate investors will place a premium on higher quality, tax-backed debt. However, security selection is essential as the recovery of credit fundamentals among state and local governments has been uneven.

Portfolio in Action: Where MacKay Municipal Managers finds value, the team has shifted to a constructive overweight of dedicated tax and general obligation debt (GO) within the portfolios that we manage. This is not a unilateral shift to a GO bond overweight in the portfolios and instead represents strategic increases in select areas we deem to be compelling.

Mid-Year Status: Pending Through June 28, 2019, the dedicated tax and general obligation segment of the market, as measured by the blend of the Bloomberg Barclays General Obligation Bond sub-index and tax-backed (special tax and leasing) sectors, has returned 5.10% on a year to date basis. The Bloomberg Barclays Revenue Bond sub-index, ex-tax-backed (special tax and leasing) sectors, has returned 5.36% during the same period.1While this segment of the market has outperformed the dedicated tax and GO segment by 26 bps so far, we believe this will change in the second half of 2019. Of note, Moody’s reports that municipal credit upgrades have been dominated by the Local Government sector as they represent 102 of 118 upgrades, or 86% through the first quarter of 2019 (2nd quarter data has not yet been published).2

2. MUNICIPAL ISSUANCE EXCEEDS MARKET EXPECTATIONS

Rationale: Cumulative issuance of both tax-exempt and taxable municipal bonds, in our opinion, will exceed expectations as issuers increase funding for capital investment. We anticipate ongoing revenue growth will spur governors to invest incremental cash flows back into their state economies. We expect the growing supply of taxable municipal debt to be readily absorbed as demand increases from pensions and endowments that are seeking to diversify away from their exposure to the BBB-heavy corporate bond asset class.

Portfolio in Action: Based on the premise of increased issuance, MacKay Municipal Managers will closely monitor new offerings, as we routinely do, and evaluate from a credit and relative value perspective prior to investing. To the extent unique structures related to tax exempt municipal bonds, taxable municipal bonds, and infrastructure spending surfaces, we believe MacKay Municipal Managers is well positioned to evaluate and capitalize.

Mid-Year Status: On Target Looking at municipal supply thus far in 2019, issuance has been on target relative to expectations. Through June 27, 2019, year-to-date 2019 issuance is $168 billion with net supply of -$9 billion.3 We believe austerity measures at the state and local levels have led to more modest issuance thus far in 2019. At the same time, we believe supply will increase in the second half of 2019 as issuers increase funding for capital investment, particularly in the 20 states led by new governors motivated to make an early impact on their state.

3. RESTRUCTURING OF PUERTO RICO DEBT PROVIDES OPPORTUNITY TO INCREASE ALLOCATION TO HIGH YIELD MUNICIPAL BONDS

Rationale: The market will, we believe, demand higher yields and wider spreads on the massive volume of restructured Puerto Rico debt. We anticipate the spillover effect from this transition to accrued bonds offers investors the opportunity to increase their allocation to high yield debt at very attractive levels. We expect the opportunity for outperformance in the high yield municipal market to occur in the second half of the year.

Portfolio in Action: MacKay Municipal Managers reduced Puerto Rico exposure to zero from the spring of 2012 to the fall of 2013, as the team anticipated future downgrades and defaults. This thesis came to fruition and the team invested again in the fall of 2013 after headline news led to a dislocation and opportunity to invest primarily in Puerto Rico bonds wrapped with monoline insurance. Since that time, the team has been actively trading to generate additional alpha in the portfolios while gradually increasing select uninsured Puerto Rico bonds at compelling entry points.

Mid-Year Status: Pending Through June 28, 2019, the Bloomberg Barclay’s High Yield Municipal Bond Index returned 6.7% while the Puerto Rico segment of this index returned 11.1% during this same period.4 Defaulted bonds from their largest issuer, Puerto Rico GO bonds, are excluded from the index and have outperformed Puerto Rico bonds in the index during this period. As the Puerto Rico restructuring has progressed in 2019, there have been tactical opportunities to capture value. At the same time, high yield municipal spreads have not widened due to record setting mutual fund cash flows in excess of $40 billion. If cash flows moderate or reverse in the second half of 2019, we believe spread widening presents an opportunity to increase allocations to high yield municipals.

4. MUNICIPAL FINANCING WITH EMBEDDED REAL ESTATE FINANCING UNDERPERFORMS

Rationale: We anticipate the market will penalize sectors and credit structures exposed to real estate market values. Financings tied to selected commercial real estate, raw land housing development and continuing care retirement centers, in our opinion, will come under pressure as peaking market values recede. These same sectors also historically experience higher default rates (source: Municipal Market Analytics Inc.). By contrast, we believe that financings dependent on assessed valuations of existing developed real estate (e.g. general obligation debt) will find favor in the market as debt coverage remains strong.

Portfolio in Action: Separate from traditional “tax-backed” general obligation debt where we have a constructive view, MacKay Municipal Managers has limited exposure to credit structures exposed to real estate market values. In remote cases where we have this exposure, the team believes the nuances of those specific credits offer relative value in terms of security features and dollar price.

Mid-Year Status: On Target Within a municipal market where credit fundamentals have largely strengthened in recent years, municipal financings tied to real estate (hotel, land secured, local housing, retirement, state housing) have represented 53% of first-time defaults taking place in the first six months of 2019.5

5. TACTICAL PORTFOLIO POSITIONING DRIVES PERFORMANCE

Rationale: In contrast to the last number of years when strategic portfolio structure proved beneficial, we believe a tactical approach going forward to be more prudent. Given the uncertainty of the overall markets, tactically adjusting portfolio exposures as market direction becomes evident should, in our opinion, provide more flexibility. As a result, we believe that this approach provides better total return opportunities than strategies anchored to more traditionally passive investment approaches.

Portfolio in Action: MacKay Municipal Managers has always taken an active, strategic approach to managing municipal bond portfolios. In light of market uncertainty, the team has added an additional layer of tactical investment management which leads to more frequent shifts in terms of security selection, sector allocation, and yield curve positioning.

Mid-Year Status: On Target On a year-to-date basis through June 30, 2019 being active and tactical has contributed to returns 6, as follows:


1Bloomberg Barclays Municipal Bond Index (GO and Revenue Bond sub-indices, as of June, 2019). “Tax-backed” sectors include: Electric, Hospital, IDR/PCR, Transportation, Education, Water & Sewer, Resource Recovery, Leasing, Special Tax

2Moody’s – May 15, 2019 Data Report

3 Barclays – July 2, 2019

4 Bloomberg Barclays High Yield Municipal Bond Index and the Puerto Rico sub-index, as of June, 2019

5Municipal Market Analytics (MMA), as of July, 2019

6 Preliminary gross of fees composite performance as of June 30, 2019. See disclosure pages related to composite returns and comparisons to an index. It is not possible to invest directly into an index. Past performance is not indicative of future performance. Index returns are gross of fees. Source: Bloomberg Barclays. Provided as supplemental information to the GIPS-compliant pages at the end of this document.


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