Virtus Tax-Exempt Bond Fund
3Q 2016 COMMENTARY
FUNDAMENTALS — Fundamentals are generally sound, but underfunded pension obligations are becoming more worrisome. The impact of lower-than-expected returns on pension funding levels is pressuring municipal budgets to increase annual contributions.
TECHNICALS — Technicals remain strong, with demand outpacing issuance. Near-term concerns are the potential impact of the November election results, which may influence the value of the tax-exemption, and of increased new issuance ahead of the December FOMC meeting and possible rate hike.
VALUATIONS — Municipals appear more fully valued versus U.S. Treasuries but still offer reasonable value, especially on a taxable equivalent basis.
IMPORTANT DEVELOPMENTS THIS QUARTER
Overview: The municipal bond market experienced mixed performance during the third quarter. July and August saw an extension of the year’s strong performance as demand continued to outpace supply. The technical support weakened, however, as the end of the quarter approached. Treasury yields began to rise, and tax-free interest rates followed, as the markets priced in a higher probability of a Federal Reserve rate hike. At the same time, municipal supply increased as municipalities issued bonds to get ahead of potential Fed rate hikes and perhaps to catch up on issuance delayed as a result of Brexit-related disruptions. The markets also were receptive to lower-rated credits as investors reached for yield across all areas of the fixed income market. As a result of the rise in yields and surge in supply, municipal bond performance turned negative for the first time in over a year.
The municipal market has otherwise been resilient in the face of a number of market events and conditions, including repercussions from the Brexit vote, Puerto Rico’s defaulting on its general obligation bonds and select public corporations, oil price volatility, the increasing and decreasing probabilities of a Fed rate hike, the U.S. presidential election process, and the problems surrounding underfunded pension plans across the country. Aside from Puerto Rico, defaults have been very low in the sector.
The demand for municipal bonds continues unabated, with 52 consecutive weeks of inflows into mutual funds totaling more than $50 billion. While long-term funds represent the bulk of the assets in terms of flows, the highest percentage increase of assets under management for the year to date has occurred among high yield funds. Though interrupted by the recent increase in supply, strong technicals have been the driving factor in municipal market strength.
Municipal Credit: The economy continues to expand, but the slow pace of growth continues to have an adverse effect on state budgets. State and local sales tax growth is still positive, but shows signs of slower growth. Collections in the second quarter of 2016 grew by only 1.8% year-over-year. Local property taxes, however, continue to benefit from an improving housing market and rising home prices.
By far, the largest challenge to municipal credit remains the extent of underfunded pension obligations. Pension funds across the country are struggling to meet assumed rates of return in the current low interest rate/stagnant stock market environment. As an example of a particularly serious situation, CALPERS returned 0.6% in its last fiscal year, far short of its assumed rate of return of 7.7%. The impact of lower-than-expected returns on pension funding levels increases the stress on municipal budgets to increase annual contributions and divert funds from other spending.
Rule 2a-7:A reform package affecting prime and tax-free money market funds, which was put in place during the financial crisis, went into effect on October 14. Known as Rule 2a-7, the package includes new disclosure requirements, additional diversification and stress testing, and more importantly, will no longer allow tax-free institutional money market funds to maintain a constant net asset value of $1 per share. This rule was established to prevent a potential systemic collapse of money market funds in a financial crisis like the one the market experienced in 2008. This change has resulted in massive outflows from tax-exempt money market funds and a large spike in the yields available on variable rate demand notes. As the market tries to digest the increased supply of variable rate notes, yields on these securities will remain elevated. This dislocation in the municipal market has created opportunity. The yield available on some of these floating rate securities is equal to that on bonds maturing in two or three years, and will not lose value should the Fed pursue a less accommodative interest rate policy.
Federal Reserve:While the FOMC kept the benchmark rate at 0.25% to 0.50%, three dissenters favored a hike at the September meeting. Chair Janet Yellen stated that the case for an increase had strengthened, but the policymaking body was willing “to wait for further evidence of continued progress toward its objectives.” September saw a flattening of the dot plot of the Fed’s medium- and longer-term expectations, which include one quarter-point rate hike this year and two in 2017. Absent disappointing economic data or negative global developments, probabilities hover around 57% for a December rate hike. Municipal yields will likely track U.S. Treasury yields, but with less volatility.
Interest Rates:The yield on the benchmark U.S. 10-year Treasury ended the quarter at 1.60%, up from 1.47% at the end of June but down from 2.27% at year-end 2015. Yields are lower across fixed income year-to-date as global central banks have maintained easy monetary policies. Relative yields in the U.S. are attractive, which has driven demand. Bloomberg reported that, as of September 30, negative-yielding bonds now account for almost $12 trillion. Japan represents roughly half of that total, with the bulk of the remainder from France, Germany, the Netherlands, Spain, and Italy.
MUNICIPAL BOND MARKET PERFORMANCE
The Bloomberg Barclays Municipal Bond Index returned -0.30% for the third quarter, the first negative quarter since 2Q15 and only the second in more than three years. September’s negative result of -0.50% followed two slightly positive months in July (+0.06%) and August (+0.13%). The reversal in performance following the year’s otherwise strong showing was due to municipal rates moving higher in sympathy with U.S. Treasury rates. Technical conditions also contributed to the turn as issuers took advantage of the lower rate environment in advance of the expected increase in the Fed funds rate before year-end, as well as to get ahead of the November election.
This rise in rates during the quarter helped shorter- to intermediate-maturity bonds outperform longer-maturity bonds. Bonds with maturities beyond 22 years, the consistently best performing area of the market for many months, produced the weakest results as the yield curve steepened and investors shunned these bonds. As in the past several quarters, the top performance across the various rating categories was skewed to lower investment grade securities. Single A (-0.10%) and BBB-rated (-0.27%) bonds experienced the best relative performance, while AAA (-0.47%) bonds produced the weakest. Below investment grade bonds continued their impressive run during the quarter with a return of 1.29%. Puerto Rico (+6.75%) was largely responsible for the result, despite defaulting on its general obligation payments on July 1. Additionally, lower coupon bonds underperformed as rates increased.
HOW THE FUND PERFORMED
The stronger contributors to relative performance were bonds in the five- to 10-year maturity range and those with lower investment grade ratings.
The Fund’s smaller allocation to longer maturity bonds compared to its peer group, along with its higher coupon profile, helped relative performance during the quarter after being a relative underperformer over the past year.
The weaker relative performers during the quarter were pre-refunded bonds, higher quality issues (AAA and AA), and bonds with the longest maturities, all areas of the market where the Fund had a higher allocation than its peers (with the exception of long maturity bonds).
CURRENT STRATEGY POSITIONING
At quarter end, the Fund had a 29% allocation to A-rated credits, an 8% exposure to BBB credits, and 1.7% to below investment grade bonds.
The Fund’s duration was 5.24 years on September 30, a quarter-year shorter than at the start of the year, compared to that of the Bloomberg Barclay’s Index, which was 5.52 years. Since the beginning of 2014, we have reduced the Fund’s duration by well over 1.5 years.
We continue to maintain exposure to the five- to 10-year maturity range and to A-rated bonds, as these bonds offer a reasonable mix of yield and interest rate risk.
Additionally, we continue to look to add exposure to the 15- to 20-year maturity range and select A-rated bonds with spread, as these bonds offer higher yields and less interest rate risk than 25+ year maturity bonds. While the Fund’s additions to the 15- to 20-year maturity range hurt relative performance earlier in the year, recent results have been beneficial. Unfortunately, these bonds have not performed as well as longer-dated bonds year-to-date. We still believe this area of the curve represents the best value with much less duration risk.Although we could see rates move lower as many high grade European sovereign debt yields are currently trading at or below zero percent, we are cautious about extending duration when the long end of the curve is barely yielding 2.5%.
Municipal yields will likely continue to track moves in the Treasury market, though historically the moves have been far less volatile for municipals.
As the Fed is expected to hike interest rates just once in 2016, we expect demand for tax-exempt income to continue. Taxable equivalent yields remain fairly attractive versus other fixed income products. In addition, we expect that the municipal market will continue to benefit from demand by global investors who are looking for higher quality investments that offer attractive yields and alternatives to sometimes negative-yielding bonds in their home markets. While municipalities have increased their borrowing needs over the shorter term mostly to refund older debt, many continue to exercise austerity measures in the face of anemic tax revenue growth and sizable demands on budgets, including improving on pension funding levels.
All eyes will be on the upcoming presidential election and the potential impact that the outcome may have on the value of municipals. While the candidates have very different views on taxes, each has been fairly quiet on the municipal tax exemption. Both candidates, however, have proposed significant spending on the country’s aging infrastructure. Such spending would have the potential to increase issuance of municipal bonds.
We believe that higher quality municipal bonds still offer reasonably good relative value, and that owning the lowest-rated bonds does not adequately compensate for the risk. The strong demand for lower-rated issues has decreased the yield advantage of taking on the additional credit risk. In addition, we have limited our exposure to the very longest maturities as the yield curve has flattened. As such, a 20-year maturity bond yields only 0.15% less than a comparable bond with a 30-year maturity, and has significantly less interest rate risk.
Class A operating expenses are 0.85% and gross operating expenses are 1.00%.
Operating expenses reflect a contractual expense reimbursement in effect through 4/30/2017.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains. Net Asset Value (NAV) returns do not reflect the deduction of any sales charges. POP (Public Offering Price) performance reflects the deduction of the maximum sales charge of 2.75%. A contingent deferred sales charge of 0.50% may be imposed on certain redemptions within 18 months on purchases on which a finder’s fee has been paid.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. please visit Virtus.com for performance data current to the most recent month-end.
Index: The Tax-Exempt Bond Linked Benchmark consists of the BofA Merrill Lynch 1-22 Year U.S. Municipal Securities Index, a subset of the BofA Merrill Lynch U.S. Municipal Securities Index including all securities with a remaining term to final maturity less than 22 years, calculated on a total return basis. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment. Performance of the Tax-Exempt Bond Linked Benchmark prior to 6/30/2012 is that of the Bloomberg Barclays Municipal Bond.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.