What's in a rating?

Ivy Municipal High Income Fund

Bond quality ratings continue to be an area of focus across the credit markets with extra focus on the volatility in the corporate high yield markets. Questions are being asked about how to gauge which municipal bonds to invest in, and how big of a factor the credit quality of a fund really is. Below Michael Walls, the Portfolio Manager for the Ivy Municipal High Income Fund, discusses how a rating is determined, how he views ratings and his outlook for the municipal bond market.

When reviewing the holdings of funds with a municipal bond component, one thing most people will look for early on is the credit ratings of the underlying investments in the fund.

And this would seem to make sense. You can gauge the potential risk of any fund based on the level of bonds rated at various levels. Any investments listed as “junk bonds” could bring higher returns — but also carry a higher level of risk. A municipal bond issuance that isn’t rated at all should then be considered the riskiest of investments, right? Not so fast.

A bond can be considered unrated for various reasons, not all of which are related to the risk or return associated with the issuance.

Depending on what ratings companies the fund works with, they may simply not know the rating for certain bonds. There are three main companies that supply ratings for municipal bond offerings: Standard & Poor’s, Moody’s and Fitch’s. Each company charges for a bond to be reviewed and a rating issued. Many issuers may only pay for one or two companies to rate their bonds. When that happens, if you subscribe to the third company, that bond will show as “unrated.”

Here is an example. City A wants to issue some general obligation bonds. They contract with Moody’s to review and rate their offering. Moody’s gives them an AA rating. If an investor looks at the information for this issuance on the website for any rating company except Moody’s, this will not show as an AA rating, however — it will show as unrated. The same holds true when that bond is part of a larger fund.

Because it costs to be reviewed and rated, some municipal bonds choose not to be rated at all. Examples of this would be issues from schools, hospitals and smaller governments. For many smaller issuances, it can be deemed not fiscally responsible to pay for a rating.

In addition, some purchases would be for land deals. Because the actual investment is undeveloped land, there would be no rating available. So why buy these bonds? Because the belief is that, someday, that land will be slated for development. When that happens, the bonds will be “pre-refunded,” which will potentially result in an enhanced credit quality and improved valuation, due to escrowed Triple-A U.S. Treasury securities that secure the pre-refunded bonds.

Portfolio positioning

As portfolio manager for the Ivy Municipal High Income Fund, I believe strongly in investing in issuances that make sense in the long run. With the current market offering few new opportunities that aren’t overpriced, it is even more important now to stick with offerings we know and include a cash component in case of a market downturn for municipal bonds. I see the current market as an issuers market, with no truly attractive large deals available right now. Although we have always included non-rated issuances in the Fund, this fact is a large part of why we have looked to the non-rated market for recent purchases. While many funds have bought high-quality municipal bonds that they lever up using a line of credit or inverse floaters, we don’t feel the market is attractive enough to do that right now. The demand for what is available is so strong that these offerings are being broken up into small allotments and the rates decreased because of the demand. While it can be considered standard practice to leverage investments in order to show a credit rating, the Fund does not do that. We feel there is more transparency for the investor if we simply show what we have invested in, rated or not. We have, however, been working on lowering our level of non-rated investments, with a target goal of no more than 35% of the Fund invested in this sector.

So where have we put our focus? Not in all the typical places. We’re underweight against our benchmark in hospitals and healthcare because we are still waiting to see what, if any, reforms may be made to Medicare and the drug industry, and how that could affect bonds in this area. We don’t have a concentration in any one area of the country. We have put the majority of the bonds we own in revenue-specific projects that are not tied to a specific state.

Is this the correct approach? None of us have a crystal ball, but I believe it’s the right path given the opportunities we see in the current environment.

Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 2018, and are subject to change due to market conditions or other factors and no forecasts can be guaranteed. The information 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.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. 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.

Quality: Our preference is to always use ratings obtained from Standard & Poor’s. For securities not rated by Standard & Poor’s, ratings are obtained from Moody’s. We do not evaluate these ratings, but simply assign them to the appropriate credit quality category as determined by the rating agency.