What part will municipal bonds play in a changing rate environment?

What part will municipal bonds play in a changing rate environment?

October 03, 2016


Story Highlights

  • Interest rates have been at historic lows for years.
  • As potential increases loom, yields could become less valuable for many securities.
  • The municipal bond market may be a more viable option.

As equity markets have reached new highs this year, bonds can get overlooked by some investors. But as an option to temper volatility, and with a potential interest rate increase on the horizon, there can be more reason than ever to consider this sector of the market.

In 2007, the Federal Reserve (Fed) began dropping its key interest rate in response to credit concerns within the economy. While this strategy boosted the stock market, interest rates – particularly for the most conventional and highest-rated securities – have remained at or near historic lows. When the Fed begins to raise rates again, investors in higher-rated securities could face potential losses, as their lower yields become less valuable as rates climb.

As investors look for ways to combat this potential issue, more attention may turn to the municipal bond market. As with all sectors of the bond market, municipals come with various levels of diversity and risk. Although past performance is not an indication of future performance, there are sectors of the bond market that have consistently performed better over time. The municipal bond market is one such area.

The table below shows that not all fixed income securities respond the same way to changing interest rates. As you can see from this chart, either municipal bonds or high-yield municipal bonds — or both — have been among the top three types of bonds in terms of overall performance since 2009. Although interest rate risk can exist in these funds, the main concern would be credit risk. This risk can be mitigated, however, as evidenced by the fact that high-yield municipal bonds have been top performers in two of the last four years.

In addition, municipal bonds can be a competitive and attractive product based upon their tax status alone. Because municipal bonds are exempt from Federal taxes, they can offer a higher tax-equivalent yield than many other bond funds. Tax-equivalent yield is the pretax yield a bond would have to offer to equal the tax-free yield of a municipal bond and is important for comparing taxable and tax-free investments. A taxable bond would need to provide a higher return to compensate for the municipal bond’s exemption from Federal taxes.

Muni Bond
Source: Lipper

Categories are represented by their respective Lipper Category Fund Index. Money Market funds are represented by the Lipper Money Market Fund Index. High-Yield Municipal Bond funds are represented by the Lipper High-Yield Municipal Debt Fund Index. Global Bond funds are represented by the Lipper Global Income Fund Index. High-Yield Bond funds are represented by the Lipper High Current Yield Bond Index. Municipal Bond funds are represented by the Lipper General Municipal Debt Index. Short-Term Bond funds are represented by the Lipper Short-Intermediate Grade Index. Corporate A-Rated Bond funds are represented by the Lipper Corporate Debt A-Rated Bond Fund Index. Government Securities Bond funds are represented by the Lipper General U.S. Government Fund Index. It is not possible to invest directly in an index. Performance figures assume reinvestment of High-Yield Bond dividends and capital gains. This chart does not illustrate or represent the performance of any Ivy Fund. Past performance is not a guarantee of future results.

Lipper Mutual Fund Bond Categories do not constitute and are not intended to constitute investment advice or an offer to sell or the solicitation of an offer to buy any security of any entity in any jurisdiction. As a result, you should not make an investment decision on the basis of this information. Rather, you should use Lipper Mutual Fund Bond Categories for informational purposes only. Certain information provided by Lipper may relate to securities that may not be offered sold or delivered within the United States (or any State thereof) or to, or for the account or benefit of, United States persons.

Just as there are various risks, there are various types of municipal bonds — some more specific than others in their make-up.

Municipal Bonds

Municipal bonds are issued by a wide range of state and local governments, agencies and authorities for various public purposes. The two main kinds of municipal bonds are general obligation bonds and revenue bonds. For general obligation bonds, the issuer has pledged its full faith, credit and taxing power for the payment of principal and interest. Revenue bonds are payable only from specific sources; these may include revenues from a particular facility or class of facilities or special tax or other revenue source.

State and local government authorities and agencies may issue a special type of municipal bond called private activity bonds (PABs). Each Municipal Fund may purchase a PAB only if the interest on it is exempt from Federal income taxation, although such interest may be an item of tax preference for purposes of the Federal alternative minimum tax (AMT). In general, PABs are revenue bonds and are issued by or on behalf of public authorities to obtain funds to finance privately operated facilities such as for energy and pollution control. PABs also are used to finance public facilities such as airports and mass transit systems. The credit quality of PABs usually is directly related to the credit standing of the user of the facilities being financed. Each Municipal Fund may invest an unlimited percentage of its assets in municipal bonds that are PABs.

High-yield municipal bonds

High-yield municipal bonds follow all the same rules as a standard municipal bond, but their selection of bonds is not as wide. Particularly, they will traditionally invest in bonds that are lower-rated or unrated. While these may have a higher level of credit risk because of their rating, they are also usually revenue bonds — which means they have a direct and specific stream of revenue for repayment.

Funds that are non-rated may seem to hold a higher-credit risk. However, they primarily come from two distinct areas:

  1. Bond issues from schools, smaller governments and hospitals. Because an organization has to pay to be rated, many smaller issuances deem it not fiscally responsible to pay for the rating.
  2. Purchases of bonds for land deals. In these cases, the investment is in undeveloped land. The goal is that, when the area is slated for development, the land bonds will be “pre-refunded” before the scheduled call date. A pre-refunding results in enhanced credit quality and an improved valuation due to escrowed Triple-A US Treasury securities that secure the pre-refunded bond.

Both municipal and high-yield municipal bonds are exempt from Federal taxes on all payments or earnings.

State-specific municipal bonds

These are similar to traditional municipal bonds, but at least 80% of the holdings will be within a specific state. This can increase the risk involved in investing in the bond, because it will be more subject to state political, legislative or regulatory changes. However, if invested in by a resident of the state in question, the earnings from this type of bond can be exempt from both Federal and state taxes.

Municipal bond fund offerings

Ivy Municipal Bond Fund —Focuses on providing income free from federal taxes while providing capital appreciation.

Ivy Municipal High Income Fund —Invests in high-yield revenue bonds that are repaid from dedicated sources, such as user fees, rather than high-yield general obligation bonds, which may be subject to overall municipal budget tightening. On the other hand, however, if the project does not generate revenue as predicted, revenue bondholders may not receive interest or a repayment of principal.

Ivy California Municipal High Income Fund—Focuses on securities available within the state, and is primarily available to residents of California. The strategy is to provide a high level of income, which will be available for investment in a diversified portfolio that is exempt from Federal and California income taxes.

Diversification is a method used to manage risk. It cannot ensure a profit or protect against loss in a declining market.

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. Not all funds or fund classes may be offered at all broker/ dealers. Because the Fund invests predominantly in California municipal securities, events in California are likely to affect the Fund’s investments and its performance. As with California municipal securities, events in any of the U.S. territories, such as Puerto Rico, Guam and the U.S. Virgin Islands, where the Fund is invested may affect the Fund’s investments and its performance. These events may include economic or political policy changes, tax base erosion, constitutional limits on tax increases, budget deficits and other financial difficulties, and changes in the credit ratings assigned to municipal issuers of California or U.S. territories.

IVY INVESTMENTS℠ refers to the financial services offered by Ivy Distributors, Inc., a FINRA member broker dealer and the distributor of IVY FUNDS® mutual funds, and those financial services offered by its affiliates.

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