Ivy Municipal High Income Fund

12.31.20

Market Sector Update

  • The municipal market posted strong returns in the quarter with highest returns in the below investment grade (high yield) credit space. Credit spreads continued to tighten with the magnitude of compression incrementally greater the further out on the credit curve, while the yield curve flattened meaningfully.
  • Mutual fund flows into the asset class continued to be robust, as well as high levels of reinvestment flows from bond maturities, bond calls and coupon income. Tax-exempt new issue supply was not enough to satisfy the insatiable investment demand. High absolute yields compared to the taxable fixed income market also brought in many crossover buyers, i.e. insurance companies, banks and foreign accounts.
  • As yields on the highest quality bonds hovered near all-time low levels, investors moved further out on the credit spectrum, including high yield, in search of higher absolute yields. Credit spreads on BBB rated bonds declined 48 bps while spreads on high yield bonds compressed 55 bps. This reach for yield is occurring while many issuer credit metrics are deteriorating with each passing day. Creditor protections in many lower quality new issues are also being relaxed substantially, while many others are thinly capitalized projects, unproven technologies, or both. In the current yield-seeking environment, investors are showing little concern for bearing this increased credit risk.
  • In our view, there is not a sector in the municipal bond space that will be able to avoid the negative drag brought about by the COVID-19 pandemic. We are beginning to see distressed situations in the high yield space with more frequency. To date, this has been heavily concentrated in the following sectors: CCRC (continuing care retirement community), lifecare/nursing, student housing projects, as well as financing for projects with unproven technologies that attempt to turn a waste product into a viable commodity.

Portfolio Strategy

  • The Fund posted a positive total return for the quarter while underperforming both the peer group and its benchmark. The portfolio duration is slightly shorter than its benchmark, and the portfolio is defensively structured with a higher quality emphasis.
  • At quarter-end, exposure to non-rated bonds was approximately 23%. While admittedly off the low spread level observed earlier in the year (pre-COVID 19 pandemic), high yield spreads are currently well below both 5-year and 10- year averages.
  • Persistent credit surveillance will be critical in this environment.
  • We continue to favor revenue bonds over tax-backed debt. While providing higher yields, we also endeavor to avoid deteriorating fiscal and pension issues that are prevalent with lower quality general obligation (GO) issuers. While GOs had fared well in previous Chapter 9 bankruptcies, this trend changed after Detroit's bankruptcy, and we expect a similar unfavorable outcome in the Title IV filing in Puerto Rico.

Outlook

  • We remain confident in our belief that investment grade municipal bond defaults will continue to be much lower than any other fixed income alternatives except U.S. Treasuries. However, we expect to see downgrades in the investment grade space, as we believe there is not a sector or issuer that can completely avoid the negative impact of the pandemic. We expect an acceleration of both distressed and defaulted issues in the high yield space and believe this trend is likely to continue and even accelerate. However, we believe that the default rate will remain lower than the taxable high yield space with higher recovery rates, as has been the history between the two asset classes. We will continue to monitor high yield issues for more attractive entry points, but with current high yield spreads very tight relative to both 5-year and 10-year averages, we believe that it is prudent to not chase the market. We will continue to strive to avoid any issuer that will be impacted severely.
  • We continue to take a long-term approach with credit selection. We will not compromise the overall credit quality of the Fund by chasing lower quality opportunities with poor bondholder protections and deteriorating credit profiles in this very uncertain environment.
  • The Municipal Liquidity Facility (MLF) expired at year-end. While not widely utilized, it should be noted that the Federal Reserve is no longer in a position to be the lender of last resort in a crisis.
  • State and local governments, as well as almost all revenue bond sectors in the market are facing unprecedented shocks to their revenue streams. Additional assistance from the federal government is widely viewed as the best solution to stave off more budget cuts, mass layoffs, essential program cuts and tax increases in this difficult environment. Unfortunately, the $900 billion Phase 4 stimulus package passed by Congress at year-end provided no assistance to struggling state and local governments, as well as other issuers in the municipal bond market.
  • One concern we have is the heavy concentration of assets in a select few high yield municipal bond funds. As of last year, five fund families controlled 80% of all high yield assets. That level of concentration has been a contributor to the unprecedented volatility that has occurred in the market this year and may continue to cause higher than normal volatility in the future.
  • The outcome of the Senate runoff election in Georgia on January 5th is critical. If the Republicans hold the Senate, then we would not expect much fiscal assistance to the municipal bond market. However, if the Democrats take control of the Senate, then a large fiscal assistance package to state and local governments could be forthcoming. A Democratic Congress increases the odds of a reflation trade, which would put upward pressure on long treasury yields, and therefore drag high-grade municipal yields higher. A Democratic Congress increases the odds of a reflation trade, which would put upward pressure on long treasury yields and therefore drag high-grade municipal yields higher. This could pressure the high yield space also as investors may rotate into higher quality bonds.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

Risk factors: The value of the Fund's shares will change, and you could lose money by investing. 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. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). Exempt interest dividends the Fund pays may be subject to state and local income taxes. The portion of the dividends the Fund pays that is attributable to interest earned on U.S. government securities generally is not subject to those taxes, although distributions by the Fund to its shareholders of net realized gains on the sale of those securities are fully subject to those taxes. The municipal securities market generally, or certain municipal securities in particular, may be significantly affected by adverse political, legislative or regulatory changes or litigation at the Federal or state level. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/ dealers.