Quarterly Fund Commentary
Ivy Municipal High Income (prospectus)
June 30, 2010
Manager(s):
Michael Walls
Market Sector Update
The municipal bond market rally continued into the second quarter of 2010. Although the historically large amounts of cash flowing into the sector slowed, steady flows and attractive yields resulted in strong demand from retail and traditional municipal buyers. These buyers, along with very little supply, allowed municipals-particularly high-yield municipals-to outperform most other asset classes.
As we moved into the second quarter, buyers, excited by attractive yields, continued to allocate cash into the municipal bond sector. Although the government continues to spend at record amounts and many investors are concerned about inflation, strong demand for municipal debt continues. We believe the strong bid can be traced to two factors. First, with the enormous legislative spending initiatives before Congress, including the passage of the health care bill, it is only a matter of time before investors see significant increases in their tax burdens. Investors are shifting significant amounts of their net worth into tax-sheltered investments. The second economic factor was a lack of supply. Many investors were concerned about the level of new issuance in 2010. With most state budgets strained, many investors anticipated that 2010 would be a record year for issuance; however most of the new state borrowing has come in the form of taxable debt. Through Build America Bonds, the Obama administration and Congress have helped states lower their cost of borrowing by accessing the taxable market. This has resulted in a very large reduction in tax-exempt issuance. Going forward, we expect Build America Bonds to continue as the preferred source of borrowing for states in the short term, which should bode well for the total return prospects in the high-yield municipal market.
Portfolio Strategy
Although the flood of cash into the municipal bond sector slowed when compared to the first quarter flows, they were still strong on a historical basis. In the near term, positive fund flows should continue to cause bond prices to rise and spreads to tighten. We believe the level of new issuance has been grossly overstated as most of the federal stimulus will come in the form of taxable Build America Bonds. This stimulus should help states manage their deficits in the short run, thus likely preventing them from over saturating the market with additional tax-exempt debt. High-yield issuance continued to improve in the first quarter. We believe strongly any new high-yield supply will not be enough to satisfy overwhelming demand. All indications point to higher bond prices and lower yields in the foreseeable future. Late last year, the fund began aggressively selling its shorter duration, higher credit quality bonds. These bonds allowed the fund to have ample liquidity and downside protection for what was the worst municipal bond market in history. Beginning in 2009 and continuing into 2010, we began buying lower rated, longer maturity bonds. Our goal was to take advantage of what we felt was an unrealistically oversold market. We will continue to lengthen the duration of the fund and look for attractive higher yielding bonds as spreads continue to trade at historically wide levels.
Outlook
In the second quarter of 2010, cash flows into the high-yield municipal bond sector continued at a solid pace. Flows into the Fund were strong and we are optimistic that this trend will continue. With the supply of new bond issuance continuing to be minimal and the talk on Capitol Hill about increasing individual income tax rates, we are very comfortable with the continued positive outlook for the high-yield sector. With lower-to-medium-grade spreads historically attractive, we continue to believe spreads will tighten and liquidity will improve in the market. We will continue to look for opportunities in the high-yield sector while making sure to have ample liquidity. We will stay fully invested and continue to stay broadly diversified across municipal sectors and geographic regions.