Virtus Tax-Exempt Bond Fund
4Q 2016 COMMENTARY
FUNDAMENTALS — Fundamentals continue to be supportive of local municipalities’ credit profile as rising home prices have improved property tax collections. State revenues, however, have been in decline. High fixed cost burdens, including heavy debt loads and underfunded pension liabilities, will continue to be a challenge for many municipalities.
TECHNICALS — Technical market conditions have been less supportive in recent months as demand has slowed. Tax reform will be a focus of municipal bond investors in 2017 as it may have a major impact on overall demand for tax-exempt income. The potential for additional municipal issuance from proposed increases in infrastructure spending may also weigh on the market.
VALUATIONS — Municipal yields have risen dramatically since the end of the third quarter as a result of weaker demand and increased supply. Taxable equivalent yields now reflect greater value. There is uncertainty and caution surrounding the impact that significant tax reform could have on the demand for tax-free municipal bonds, and ultimately their yields and valuations.
IMPORTANT DEVELOPMENTS THIS QUARTER
Overview: The municipal bond market struggled in the fourth quarter as a result of rising U.S. Treasury yields, increased issuance, and softer demand. As the market began to price in a higher probability that the Federal Reserve (the Fed) would raise its target federal funds rate by year-end, U.S. Treasury yields began their ascent at the beginning of the quarter, and municipal yields followed. In the aftermath of Donald Trump’s election victory, municipal yields continued to rise along with those of Treasuries, fueled by worries about the potentially negative impact of the newly elected president’s espoused tax cuts and infrastructure spending. By the end of November, municipal yields had risen 100 basis points across much of the yield curve, underperforming other fixed income sectors.
The strong demand for municipal bonds that persisted for much of the first half of 2016 was one of the main drivers of performance. That demand weakened in the third quarter as municipal bond mutual fund flows turned negative in November. Though issuance slowed as the year ended, supply had surged earlier in the quarter as municipalities tried to stay ahead of potential Fed rate hikes and take advantage of investors’ search for yield with high yield offerings.
By December, the higher municipal yields had attracted non-traditional municipal buyers, providing some needed support to the market. As year-end approached and the U.S. Treasury market stabilized, the tone of the municipal market improved despite the continued mutual fund outflows. Following negative municipal bond returns in October (-1.05%) and November (-3.73%), the Bloomberg Barclays Municipal Bond Index turned positive in December (1.17%) to end the quarter down 3.62% and the year up 0.25%.
Municipal Credit: Fundamentals remain supportive of local municipalities’ credit profile as the housing market continues to rebound in many areas of the country, boosting property tax collections. State revenues, however, have slowed as a result of a decline in corporate and personal income tax collections. High fixed cost burdens, including heavy debt loads and underfunded pension liabilities, will continue to be a concern for many state and municipal governments.
For the first time in many years, lower quality issuers underperformed higher quality. As the demand for high yield municipals began to wane, high yield municipal bond funds experienced the largest outflows.
By far, the largest challenge to municipal credit remains the extent of underfunded pension obligations. Pension funds across the country are struggling to weather changing markets and meet assumed rates of return amid the current low interest rate environment. In December, the California Public Employees’ Retirement System (CalPERS) board voted to reduce its investment target of 7.5% to 7% over a period of three years. As a bellwether for pension funds, CalPERS is setting a precedent that may increase the stress on budgets further as municipalities struggle to close the gap in liabilities.
MUNICIPAL BOND PERFORMANCE SUMMARY
Everything that worked well through the first nine months of 2016 – longer maturity, longer duration, lower quality, and sub-5% coupons – reversed course in the fourth quarter, especially in November after the presidential election. For the quarter, the U.S. municipal bond market returned -3.07%, as measured by the BofA Merrill Lynch 1-22 Year U.S. Municipal Securities Index (ML Index), which serves as the Fund’s benchmark.
As a result of the rapid rise in rates during the quarter, shorter to intermediate maturity bonds outperformed longer maturity bonds. Specifically, bonds with maturities beyond 22 years, by far the best performing area of the market for most of the year, became the weakest segment as the yield curve steepened and investors shunned these bonds. In another reversal from the past several quarters, the top performance across the various rating categories was skewed to higher quality bonds. Lower investment grade bonds (single A and BBB) performed poorly. In another stark contrast, below investment grade bonds produced the weakest quarterly performance across all rating tiers – down 5.8% as measured by the Bloomberg Barclays Municipal Bond High Yield Index.
HOW THE FUND PERFORMED
Overall, our caution going into the fourth quarter benefited relative performance. Despite the potential for rates to move lower, we were hesitant to extend duration, especially with paltry yields at the long end of the curve. When the pickup in supply and negative mutual fund flows began to happen, we were positioned advantageously relative to our peers.
- The larger contributors to relative performance were bonds in the one- to five-year maturity range, as well as high quality issues.
- 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 BBB and below investment grade issues, 3%-4% coupon bonds, and bonds with the longest maturities. With the exception of BBB-rated bonds, these were all areas of the market where the Fund had a lower allocation than its peers.
CURRENT FUND STRATEGY
At quarter-end, the Fund had a 29.2% allocation to A-rated bonds, a 10.0% exposure to BBB-rated credits, and 2.50% to below investment grade bonds. Exposure to not rated, pre-refunded bonds was 5.3%.
The Fund’s duration was 5.47 years on December 31, 2016, compared to that of the ML Index at 5.62 years. Since the beginning of 2014, we have reduced the Fund’s duration by well over 1.5 years.
We continue to overweight the five- to 10-year maturity range and A and BBB-rated bonds, which we believe offer the best mix of yield and interest rate risk. We also look to add exposure in the 15- to 20-year maturity range and to select lower-rated bonds, especially with the widening of spreads in the fourth quarter of 2016. We still believe this area of the curve represents the best value (capturing 88% and 97%, respectively, of the yield available on a 30-year bond) with much less duration risk.
Our outlook for municipal bonds is somewhat cautious as we monitor the development of the new administration’s policies and assess their potential impact on the municipal market.
Tax reform is the wild card. Most professional investors believe that lowering the individual tax rate will not have a meaningful impact on demand by individuals. The proposed corporate tax rate changes, however, are expected to have the most direct impact on liquidity and valuations in the municipal market. We may see reduced demand from banks similar to the reaction following tax reform in 1986. In the year ahead, the possibility of decreased demand from banks and subsequent fund outflows remains the primary risk factor for the municipal market.
Despite Trump’s desire to increase infrastructure spending, we expect supply to moderate as we move through the first quarter of 2017 for two reasons: 1) It generally takes a long time for infrastructure spending to materialize. As we have seen in the past, stating that infrastructure spending will increase is different from having shovel-ready projects. 2) Municipalities likely will wait to see what kind of financing options are available before moving forward with issuance. For these reasons, supply should remain manageable during the first half of 2017, with infrastructure spending potentially adding to supply in the second half of the year.
The fund class gross expense ratio is 1.21%. The net expense ratio is 0.85%, which reflects a contractual expense reimbursement in effect through 1/31/2018.
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. Performance of the Tax-Exempt Bond Linked Benchmark prior to 6/30/2012 is that of the Bloomberg Barclays Municipal Bond Index. The Bloomberg Barclays Municipal Bond Index is a market capitalization-weighted index that measures the long-term tax-exempt bond market. The index is calculated on a total return basis.
Indexes are unmanaged, returns do not reflect any fees, expenses, or sales charges, and are not available for direct investment.
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.
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities.
Municipal Market: Events negatively impacting a municipal security, or the municipal bond market in general, may cause the fund to decrease in value.
State & AMT Tax: A portion of income may be subject to some state and/or local taxes and, for certain investors, a portion may be subject to the federal alternative minimum tax.
High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities.
Prospectus: For additional information on risks, please see the fund's prospectus.