Ivy Municipal High Income Fund

Ivy Municipal High Income Fund
12.31.18

Market Sector Update

  • The shorter end of the high yield market offered better returns in the fourth quarter, while the long end was slightly negative. While the equity market sold off significantly, all high yield muni sectors continued to see a strong bid except for tobacco which was down 3.87%. The quarter also saw strength across the entire curve with the strongest returns in 7- to 10-year maturities which returned 1.77% and 1.38%, respectively. We believe the weakness in the equity market will lead to a slower moving Federal Reserve (Fed) and the number of hikes in 2019 is unlikely to match 2018.
  • Municipal high yield flows turned negative for the quarter with $2.236 billion leaving the asset class. This was the main reason for the significant underperformance in the tobacco sector. Likewise, this resulted in spreads widening although they are still tight on a historical basis. On a ratings basis, AAA versus BBB spreads widened from 63 basis points (bps) to 94 bps.
  • Although Puerto Rico was the best performing sector in 2018 (+36.8%), and up 0.68% in the quarter, we think the risk outweighs the possibilities for significant positive performance in the future.
  • Longer term, even with the widening in spreads during the quarter we continue to be cautious when evaluating opportunities. As stated previously, spreads continue to be tight in a historical context and new investment options continue to offer little collateral for investors.

Portfolio Strategy

  • The Fund continues to reduce exposure in non-rated bonds – exposure was 29.86% at the end of quarter. Going forward, we will continue to reduce the exposure to roughly 25% of the portfolio with the goal of using the Fund’s liquidity as spreads continue to widen and the new issue market allows for more substantial collateral for investors. We will continue to hold our high book yield investments to provide a strong and stable dividend yield for our investors.
  • We continue to favor revenue bonds over tax-backed debt. We believe revenue bonds provide higher yields and better diversification from general tax and pension issues currently affecting many municipalities. If recent high-profile defaults in general obligations have taught us any lesson, then it is that revenue bonds with strong collateral recovery fare much better in the event of a default.
  • Although the Fund’s performance was enhanced during the quarter due to the weakness in tobacco bonds, we are looking for attractive issues now trading at discounts and offering attractive yields. The Fund’s strategy has always been attractive income with low volatility, but we do intend to increase exposure slowly overtime.
  • Based on our view of Puerto Rico, along with the Fund’s primary mission of creating high levels of tax-exempt income, we continue to avoid these bonds as they possess a high likelihood of offering no income for investors.
  • We will continue to hold our well-above-market yielding bonds while maintaining a duration that is shorter than the benchmark. That said, the Fund intends to slowly lengthen the duration over time. We also plan to use our ample liquidity when we begin seeing more attractive investment opportunities.

Outlook

  • We still believe the municipal market is attractive versus other fixed income asset classes. We expect supply to increase around 20% in 2019 versus 2018. The tougher call is whether the strong demand continues into the new year, and while we think demand will remain strong, we do not expect it to be as strong of a market in 2019 as 2018.
  • Several variables could upend our call. First, a prolonged trade war with China could result in higher consumer prices causing inflation and driving yields higher, which may lead to investors leaving the asset class. Second, the recent government shutdown may affect growth moving forward, but the duration of the shutdown is unknown. Last, the fourth quarter equity market sell off was a positive and negative for municipal bonds. The positive is we expect only one Fed rate hike in 2019 which should help alleviate pressure on market. However, if the equity market is cheap enough then investors may decide to reallocate capital.
  • Going forward, with the Fund’s duration at 54% of its benchmark, we feel appropriately structured to weather the impact of a long trade war and prolonged government shutdown. It is important investors realize prudent managers diversify across states and sectors and always limit the amount of exposure to those variables as well as any individual bond.
  • We believe investors will continue to search for tax-exempt yield even after the tax legislation was passed. We view the tax cuts as favoring lower income brackets, but with the top tax rate at 37% we believe municipal bonds remain highly attractive.

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 December 31, 2018, 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.

Diversification is an investment strategy that attempts to manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets.

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.