Executive Summary

We’ve seen credit spreads widen, brought on by the economic impacts of the COVID-19 virus, which have moved valuations of taxable municipals to historically cheap levels. The recent widening of spreads in combination with some key factors has created what we feel now is an advantageous point of entry due to: 1) a surge in taxable municipal supply; 2) shorter maturity distribution that is more aligned to corporate investment grade; and 3) elevated levels of U.S. corporate borrowing. We would argue that these conditions warrant further review for inclusion of taxable municipal bonds by institutional clients.

What Is the Opportunity?

State & Municipal issuers are the primary finance mechanism for infrastructure in the U.S.–this includes both revenue backed borrowings for Water & Sewer, Toll Roads, Airports, Universities, and Not-for-profit healthcare, as well as taxbacked general obligation debt. In many instances, it’s the securitized cash flows that drives repayment consistency on municipal debt service, and that’s what drives overall credit quality. Key attributes of the taxable municipal asset class include: high credit quality borrowers, low correlations, and competitive yields to other segments of the fixed income market. This stands in stark contrast to the U.S. investment grade corporate bond market where most of the cash flows are unsecured, driving much more payment uncertainty, particularly in recessionary environments. We see this evidenced in reports published by Moody’s that show that municipals have significantly lower rating migration, and display 2/3 of the spread volatility compared to investment grade corporates1.


Although we don’t expect the municipal market to remain immune to credit pressures stemming from the Covid-19 virus, we take solace in the fact the U.S. states and municipalities entered this period with record high financial reserves and tax collections. Municipal borrowers have also recently benefitted from Federal support in the recently passed stimulus legislation2, which directs funds (amongst other needs) specifically to support hospitals, airports, and mass transit systems. We, at MacKay Municipal ManagersTM, continue to believe there will be limited defaults in the municipal bond market, reflective of historical market trends.

So how has the taxable municipal segment fared recently from a performance perspective? For most of 2019, the total return of the taxable municipal segment trailed the investment grade corporate segment by several hundred basis points as interest rates moved sharply lower and investors reached for yield. We witnessed this even though US corporate leverage was running at the highest % of GDP since 19503, while the US economy’s growth trajectory was slowing. We have seen this reverse course through the first quarter of 2020, with the taxable muni index delivering + .94% total returns versus the investment grade corporate index delivering –4.05%4. As we look into the future, we expect this outperformance trend to continue as the economy officially enters a recessionary phase, which should spur further downgrades of U.S. corporate credits.


From an investment timing perspective, we feel that today is a great entry point to invest into the taxable municipal segment for several reasons:

Supply

Due largely to changes from the 2017 Tax Cut and Jobs Act, we have seen a surge in taxable municipal supply over the last 12 months, which expands the opportunity set for investors. We think this trend will continue as cash strapped municipalities will look to re-finance higher coupon tax-exempt debt to achieve savings, which will keep taxable municipal issuance at elevated levels for the foreseeable future.

Maturity Distribution

Since 2009, the duration profile of the taxable municipal market was much longer than most other segments of the fixed income market. More recently, we have seen a shift in borrowing patterns by issuers to shorter maturities. Although there is still ample supply of long duration securities, this now affords clients an opportunity to invest, and do so with a shorter duration profile.

U.S. Corporate Leverage

Elevated levels of U.S. corporate borrowings have been well documented by research outfits, the media, as well as Central Banks. The fact that there’s USD 7.3 trillion of U.S. Investment Grade Corporate debt, and that approximately half is rated BBB, and of that nearly ½ trillion is rated BBB (-), is known by market professionals.5 What concerns us is the pace of downgrades has accelerated with the onset of the pandemic, collapse in oil prices, and the virtual shutdown of the U.S. economy. Recently, we saw Ford and Occidental Petroleum fall out of the investment grade segment when their ratings were dropped to below investment grade, and we believe there are more to come.6 Wall Street research strategists are raising their estimates of fallen angels this year to USD 200-400 bn7,8 which will apply further pressure on the market.


Historically Cheap Entry Point

We recently analyzed the taxable muni index9, wanting to gain an historical perspective on the recent spread dislocation in the market. We reviewed 17 years of data, and found the frequency of occurrence of index spreads wider than 200 basis points only occurred approx. 20% of the time. Based on history, the index achieved strong total returns over a 1-3 year investment horizon10.


Finally, it’s been our experience that given the highly fragmented nature of the municipal marketplace, taken in combination with lack of Street credit research, allows proprietary research and skilled asset management to add incremental returns to client portfolios.

FOOTNOTES

1. Rating drift (Δ) measures the net average number of notches a credit changes over the study period. It is defined as the average upgraded notches per issuer minus the average downgraded notches per issuer. Volatility metrics (σ) measure the incidence, magnitude, and direction of rating changes. Rating volatility measures the gross average number of notches a credit will change over the study period, in this case one year.

2. Morgan Stanley Research, Municipal Strategy North America, CARE for Munis Mar 27, 2020.

3. Federal Reserve St Louis, source BEA & Board of Governors.

4. Source: ICE BofA Indices, Bloomberg March 31, 2020.

5. Source: ICE BofA BBB US Corporate Index; March 31, 1990 – December 31, 2019.

6. Source: Morgan Stanley Corporate Credit Research, “The ReBBButtal” March 7, 2019.

7. Source: BofA Global Research, Credit Market Strategist March 20, 2020.

8. Issuers cited do not represent portfolio positions of MacKay Shields, nor does the firm express any views, positive or negative, on such issuers.

9. Source: Bloomberg Barclays Taxable Muni US AGG Eligible TR Index Value ticker: BTXMTRUU

10. Historical analysis by MacKay Shields of a financial index provided for illustrative purposes only. Portfolio holdings, volatility and other portfolio characteristics of an actual investment may differ materially from the index. Unlike the index, actual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in the index are contained in any given investment portfolio. The performance of the index assumes reinvestment of dividends but does not reflect the impact of fees, applicable taxes or trading costs which, unlike the index, may reduce the returns of an actual investment. Because of these differences, the performance of the index should not be relied upon as an accurate measure of comparison to making an actual investment in any given asset class. Investors cannot invest in an index. Index returns do not represent the returns of any client portfolio or strategy actually managed by MacKay Shields and should not be construed as such. MacKay Shields' portfolios are actively managed and would vary from any applicable or benchmarked index. Individual performance of each investor will vary. Past performance is not indicative of future results. Source: MacKay Municipal Managers: April, 2020

COMPARISONS TO AN INDEX

Comparisons to a financial index are provided for illustrative purposes only. Comparisons to the index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike the index, portfolios within the composite are actively managed and may also include derivatives. There is no guarantee that any of the securities in the index are contained in the portfolio. The performance of the index assumes reinvestment of dividends but does not reflect the impact of fees, applicable taxes or trading costs which, unlike the index, may reduce the returns of the portfolio. Investors cannot invest in an index. Because of these differences, the performance of the index should not be relied upon as an accurate measure of comparison. It is not possible to invest directly in an index.

ICE BofA, used with permission. ICE BOFA IS LICENSING THE ICE BOFA INDICES AND RELATED DATA "AS IS," MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BOFA INDICES OR DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THEIR USE, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND MACKAY SHIELDS LLC, OR ANY OF ITS PRODUCTS OR SERVICES.

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The following benchmarks may be referred to in this document:

ICE BofA Taxable Municipal Index

ICE BofA U.S. Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated investment grade taxable municipal securities publicly issued in the U.S. domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch). In addition, qualifying securities must have at least one-year remaining term to final maturity, at least 18 months to maturity at point of issuance, a fixed coupon schedule and a minimum amount outstanding of $250 million. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Original issue zero coupon bonds and ""global"" securities (debt issued simultaneously in the eurobond and U.S. domestic markets) qualify for inclusion in the Index. Tax-exempt U.S. municipal, 144a and securities in legal default are excluded from the Index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.

ICE BofA AA U.S. Corporate Index

ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. Original issue zero coupon bonds, 144a securities (with and without registration rights), and pay-in-kind securities (including toggle notes) are included in the index. Callable perpetual securities are included provided they are at least one year from the first call date. Fixed-to-floating rate securities are included provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities (“cocos”) are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Equitylinked securities, securities in legal default, hybrid securitized corporates, euro dollar bonds (USD securities not issued in the U.S. domestic market), taxable and tax-exempt U.S. municipal securities and DRD-eligible securities are excluded from the index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.

ICE BofA AAA US Corporate Index

The ICE BofA US Corporate AAA Index value, a subset of the ICE BofA US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publically issued in the US domestic market. This subset includes all securities with a given investment grade rating AAA.

ICE BofA A US Corporate Index

The ICE BofA US Corporate A Index, a subset of the ICE BofA US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publically issued in the US domestic market. This subset includes all securities with a given investment grade rating A. ICE BofA BBB US Corporate Index

The ICE BofA US Corporate BBB Index, a subset of the ICE BofA US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publically issued in the US domestic market. This subset includes all securities with a given investment grade rating BBB.

Bloomberg Barclays Taxable Muni US AGG Eligible TR Index

Taxable municipal bonds have been eligible for the US Aggregate Index since 2003. These securities are classified within the Local Authority sector and qualify for the US Credit Index. Must have at least one year to final maturity regardless of call features. Must have at least $250 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. Must be fixed rate, although it can carry a coupon that steps up or changes according to a predetermined schedule.

Bloomberg Barclays U.S. Aggregate Bond Index

The Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.