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Michael Walls
Portfolio Manager
Ivy Municipal High Income Fund
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Ivy Municipal High Income Fund - March 2010
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Changing conditions in the high-yield municipal bond market are creating timely opportunities for savvy investors, although decreased tax-exempt issuance is compressing spreads and driving some managers to swap credit for yield. Here, Michael Walls, manager of Ivy Municipal High Income Fund, explains how he’s navigating an evolving market landscape.
As the new year began, I was very optimistic about the municipal high yield market. I’m even more optimistic now. Part of the reason is my belief that, frankly, the picture is going to get a lot worse for taxpayers. There’s been some new discussion in the Obama administration about increasing taxes on Social Security from the current cap to some higher level, which would result in an additional 6.2 percent tax on the income above the current $109,000. Add into the mix taxes resulting from new health care legislation, and the fact that in 2011 the Bush tax cuts are scheduled to expire. When that happens, the top rate will move from 35 percent to 39.6 percent and the second-highest rate will move from 33 percent to 36 percent.
The other issue driving my optimism for the municipal high yield sector is that supply has been even more muted than we had expected. The Federal government has increased the ability to issue Build America Bonds, which are taxable and have allowed issuers to participate that previously couldn’t. In the past, we have had mostly state issuance from the Build America sector, but now we’re starting to see different types of deals. A good example is a recent issue from Municipal Electric Authority of Georgia. They came to market with an electric revenue project to build some nuclear facilities using taxable issuance. In the past, this would have all been tax-exempt issuance. But because of Build America Bonds, they are going to issue only $24 million of tax-exempt munis and the remaining 1.2 billion in taxable debt. That really underscores how supply in the tax-exempt market has been affected. In the past this would have represented a top ten underwriting based on its size. Now all of this supply is being issued in the taxable market. As we had anticipated, this is causing high-grade credit buyers to move down the credit curve, continuing to compress credit spreads. I expect this to continue throughout the remainder of the year.
Lessons not learned
As we study the landscape, it appears that some of our competitors haven’t changed their investment philosophies. You see funds that have been highly volatile in the past because of leverage continue to be managed that way. The only difference now is that investment banks are restricting the amount of monies that they can borrow for the leverage trade. Back at the beginning of 2008, it might have been 25 times leverage, while now they can only barrow three to four times. It’s important to remember that leverage is good if bond prices are going up or stay relatively unchanged. In markets in which prices are going down, losses can be exacerbated. We do not believe that the leverage trade is in the best interest of our shareholders. We will continue to manage the fund in an effort to provide low volatility with the greatest possible total return. We will seek high levels of tax exempt income while providing protection from higher interest rates.
Duration is another topic of concern. Duration is merely a measure of a bond’s sensitivity to changes in interest rates. The assumption that high yield municipals are perfectly correlated to the Treasury market is absolutely false. There is no better example of this than in 2008, when Treasuries rallied and the Fund was down 17 percent. In the past, we have outperformed our peers in down markets because of structure — a large percentage of the Fund is in premium bonds that are priced to shorter calls — and due to the fact that we prefer to invest in sectors that have less volatility. High yield funds are longer-duration funds by nature, as most of the supply in the market is in the 20 to 30 maturities. Although a nine-year duration seems long when viewed in a corporate context, we are actually about market neutral with respect to duration. There are several reasons for that. The first is that we don’t see a catalyst to cause inflation. I don’t believe we can get inflation without a consumer pickup, and we do not see that happening in the short run. Second, with government intervention in the muni market and all of the issuance being taxable, there is a real concern about supply, which will prevent yields in our market from going up. Lastly, increased taxes are driving demand, which will prevent any correlation to moves in the Treasury market. The last thing to remember is, with the smaller size of the fund, it is much easier to shorten duration quickly if we get concerned about high rates. This is something many of our peers cannot say. Duration is not something that should keep someone from investing in the Fund in the short term. In my opinion, there is no better hedge against taxes than a high-yield muni fund.
A focus on revenue sources
We’re a little different in that mostly what we own are revenue bonds, which are backed by individual projects, rather than general obligation bonds. Remember, this fund is called High Income, not High Yield. This is an important point as it is on the high end of the low-quality scale (BBB). We also won’t buy anything that doesn’t have at least 10-year call protection. So, even if something gets called away, with a nine-year duration and 10-year call protection, we’ve pretty much squeezed everything out of it.
Recently, there have been questions and concerns about certain states, California chief among them. California is currently going through its budgeting process, which always allows for some good headlines. California’s economy seems to operate in a boom or bust cycle. Any time there’s a bust cycle, it makes easy fodder for juicy headlines. I think it is important to make a few points here. The problem with California is not a debt problem. What it has is a liquidity problem. Because of the way California’s constitution is structured, it needs a super majority vote to pass any meaningful tax legislation, which makes it much more difficult to get a budget passed. Although California has a diversified tax base, it is much more dependent on income taxes than many other states. Arizona, by contrast, has revenue coming equally from three sources — income tax, property tax and sales tax. In California, 40 to 50 percent of revenue comes from income tax. When the economy is bad and unemployment is high, the tax that’s going to be hurt the worst is income tax. With unemployment currently at 12 percent in California, that’s a problem. Unfortunately, to compound matters, California has passed legislation that has limited increases in other types of taxes, such as property taxes. Despite all that, however, California’s total debt obligations as a percent of revenues are very small at 75 percent in comparison to Greece, which is at 325 percent. Some people want to compare California to Greece, but I don’t believe that is a legitimate comparison. If you look at any of the debt models, they are just not that similar. Unfortunately, in the short term, the state is going to have to make tough decisions with regard to cutting expenditures. Remember, states cannot legally declare bankruptcy, so there may be some headline risk here, but we don’t see any risk of California General Obligation bonds defaulting.
The two states that I am concerned about are New Jersey and Illinois. Here, the problem is particularly a function of their vastly under-funded pensions. Both states’ total debt as a percent of revenues is much higher than California, at 275 percent and 225 percent respectfully, reflecting very serious pension problems. Overall, I don’t think this will affect the high yield market. Again, there might be some headline risk, but I just don’t see it as a threat. It’s important to keep in mind that most state constitutions mandate that they balance their budgets on an annual basis.
Finding yield, avoiding leverage
I’ve also been asked recently about yield. People are wondering if, with demand high and supply low, we’ve been having problems finding yield. The answer is no. Going forward, this will be influenced by flows into the municipal market, but so far we’ve been able to find very good investments in the secondary market. That said, we are not taking on any leverage. We don’t see the upside to the trade. I know people think interest rates are likely to go up at some point and if that is the case I don’t think leverage is a recipe for success.
We’ll continue to monitor the markets, interest rates and inflation indicators, but we remain optimistic about the opportunities in the municipal high-yield market for the foreseeable future.
Past performance cannot guarantee comparable future results. The opinions expressed are those of the Fund manager’s and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 22, 2010, and are subject to change due to market conditions or other factors. Investing in high-income securities may carry a greater risk of nonpayment or interest or principal than higher-rated bonds. 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. These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus carefully before investing.