2016-05-02

Many market segments have recently been roiled by volatility, along with uncertainty on interest rates and what actions the U.S. Federal Reserve might (or might not) take. Amid this uncertainty, municipal bonds have continued to stand their ground. In this webinar, hear from Delaware Investments portfolio manager Greg Gizzi as he offers an expert view of the municipal market and what’s driving it.

In the webinar, you’ll get a detailed overview of the current state of munis, as well as the fundamental factors driving municipal bond performance last year and into the first quarter of 2016. Gain insight into aspects such as:
<ul>
<li>An assessment of the high-yield portion of the municipal market</li>
<li>How to differentiate headline defaults from other type of credit risk</li>
<li>The impact of supply of issues in the muni market</li>
<li>How a national muni fund can complement a state-specific fund</li>
<li>Understanding the seasonal patterns of municipals</li>
</ul>

Video Image:



Duration:

0000 - 00:58

Recorded Date:

Tuesday, April 26, 2016

Transcript:

Municipal Market Overview and Outlook - April 2016

On behalf of my colleagues here at Delaware Investments, I want to thank all of you who will join us for our third capital markets coaching clinic focusing on the municipal bond market. We will focus on a vast array of topics, but the goal is to provide you with information to help you advise your clients navigate the existing landscape that confronts us as investors in the marketplace today. We’ll cover things such as what last year’s technical condition and performance in the market can tell us about 2016. We’ll address diversification for investors in high-tax states and whether or not that is sufficiently achieved by buying state specific funds. We’ll address the seasonal pattern in the municipal market, and address the question that is often asked if, from a historical perspective, when is the best time for investors to invest in the municipal market?

On behalf of myself and Mei Baiocchi in product, who will be joining me for the clinic, we look forward to your participation and hope it’s a valuable experience for all of you.

Mei Baiocchi

This is Mei Baiocchi and I will be moderating today's session. We want to welcome you to Delaware Investments Municipal Bonds Overview and Outlook. Today we're focus on the drivers of the muni market performance so far this year, provide some insight on hot topics, as well as an outlook for 2016, and provide an understanding of the seasonal patterns of municipal bonds.
Our guest speaker today is Senior Vice President and Senior Co-Portfolio Manager, Greg Gizzi. Greg has 31 years of industry experience and has been with Delaware Investments since 2008. And we are very excited to have Greg here with us today. We'll go ahead and get started. Greg, let's begin by talking about your outlook for the year.
Sure.
What kind of year are you expecting from municipal markets?

Greg Gizzi

Sure, May. It is not a typo on your screen. We put last year's analysis... last year's outlook I should say for those of you that were with us in the fall, up there, because simply if you look at that outlook, it's identical to what our outlook is for 2016. We're essentially looking for modest returns, low to single digit returns, predicated on the fact that the income generated from munis should be enough to offset any price degradation that would result from higher rates. The obvious difference heading into 2015, we were waiting for the Fed to embark on its next period of rate hikes, and obvious that we'd commenced that period with the first hike back in December, and we all know that we've had an interruption in those rate hikes, considering all the global cross currents that have occurred in the subsequent economic weakening here in the US as well. So the outlook would be the same. We think it's going to be what we call a 'coupon-less' year. We're going to talk about the Barclays Index, simply because it's the best proxy for the muni markets. If you look at that index, it earns about 35 basis points in income per month, which is roughly a 4.2% return in the year. So with potentially higher rates by year's end, a little bit of price erosion, we still think we're going to get positive returns.

Mei Baiocchi
So positive returns despite potential rate hikes?

Greg Gizzi

Yeah. That's a good question. It comes up a lot, and what you have up there now is a slide that some of you may have seen before. During the course of the last few years the street was expecting the Fed to ultimately raise rates, a number of pieces were written, trying to give investors an idea of what the most recent rate hike period was that would best approximate the next rate hike period, and this whole fourth row, sixth period was by far the way the consensus view. It was that view because it was very similar environment. We had a 1% Fed plunge rate at the time. We were coming off - unlike now, we're coming off of two 5+% GDP quarters when the Fed did embark back in June of '04 its rate hike. But it was a 1% Fed Fund that was construed as artificially low. The point of this slide is very simple. We have 425 basis points of rate hikes before all is said and done. Fed Fund got up to five and a quarter. And despite that, if you see the different asset classes along the bottom x-axis there, every single fixed income asset class had a positive return. So rising rates don't necessarily mean negative returns for fixed income. And I might add that the two of the best performing segments in this slide here are muni high yield and muni aggregate. Second was taxable high yield. And it shows also that these are actually not grossed up returns. These are actual returns not grossed up for the exemption. So yeah, you can have positive returns in a rising rate environment.

Mei Baiocchi

Can we talk about what's been working for investors so far in 2016? Where's performance coming from in the municipal market?

Greg Gizzi

Sure. Before I do that, let me give you guys a little bit of an insight into how we look at the marketplace, and I think investors are starting to develop a similar view based on how assets are finding their way into municipal investments, the vehicles of choice that are being used by advisors like yourselves. This is the Barclays Algorithm Index I referred to before, and this is a slide that I think is very telling. What this does is divide the two components of total return, which are price return and income return, and it demonstrates one simple thing. When you look at the different time periods - I can tell you this works for 25 years as well, just as it did on the slide - by far and away the return is really generated from the income component of total return, not price return. So in a very simplistic way of looking at this, it's really incumbent on advisors or managers to select the right credits, earned income in excess of benchmarks, more so than it is to really predict interest rates. So with that in mind, it really comes down to an income story when you're talking about fixed income.
As we look at that index, we can slice and dice the index in many different ways. What this does is on a year-end date basis, it takes a look at what the drivers from a credit standpoint - what the drivers of return have been, and you can see investment grade is cut off its triple B. That's the lowest investment upgrade category from a rating perspective. That's been the best-returning segment of the credit curve. So triple Bs have outperformed triple As by close to 80 basis points. The Barclays High Yield Index - we know that a high yield shows at 3.42% total return ex Puerto Rico. If you include Puerto Rico, it's been diminished by about 50 basis points, two and three quarters, but certainly the lower you go on the investment grade rating category, the better the return has been. And then when we take a look at the segmentation by maturity, you're going to see also a trend that was very similar to last year. Further out on the curve, the better the return, so credit in curve are really what's driving performance in the market for all - it was definitely the story in 2015, and thus far 2016 has been the same story.

Mei Baiocchi

Greg, I know this is similar to last year, with the drivers being curve in credit, but historically is this a common theme in the market?

Greg Gizzi

Yeah, it is. So what we've done here is done the same segmentation from a longer time frame. I want to note here these are the credit index returns for one, three, and five-year periods. The three-year triple B-- you might know if you're paying attention-- the triple B category is actually lower than the A. The reason that is, it's because in that three-year period was the migration of Puerto Rico credits from the investment grade index into the high yield index. And by the rules of the index, in the month that that occurs, they don't get moved into the ensuing month, and as a result, the negative performance during the actual downgrade stays in that investment grade category. So aside from that three-year period, it's the same story from a credit standpoint, triple Bs being the best contributor to performance followed by A's. And then we do the same thing for maturity. You can see it's a very similar story. Further out on the curve, further the return. Keep in mind something that we remind investors, the muni curve is the currently much steeper than, say, a treasury curve or a corporate curve. The 30-year muni fixed income curve is really the approximation for inflation expectation, but because of the potential for tax reform, muni investors get paid more to go out on the curve. So from a positioning standpoint, we like taking our best alpha generating ideas on the best part of the curve, the long run of the curve.

Mei Baiocchi

The team often talks about the positive technicals in the municipal markets. Can you explain to us what exactly you're referring to when you talk about the "technicals"?

Greg Gizzi

Sure. This has been written about quite a bit here in the first quarter. It became readily apparent last year as the taxable markets, both high yield and investment grade, were seeing significant widening, predicated on commodities and energy coming off pretty dramatically, when really municipals did not bat an eye, and, in fact, our credit spreads tightened during the same time frame. The supply demand technical is really what we're referring to when we talk about market technicals. And let's start with the demand side, how we look at it from our perspective. We look at tax-exempt bond fund flows on a weekly basis as a barometer for demand. And the reason we do that is because - recall that munis from an ownership standpoint are approximately 70% owned by households, and that's via either mutual funds, ETFs, direct purchases, et cetera, but it is really, has been, and I think will continue to be a retail product, given its tax advantage. That being said, we're coming into this week, which will be the 29th consecutive week if we see positive flows. We've had 28 or 7 consecutive months of positive returns, year-to-date that puts tax-exempt bond fund flows, a positive $17.7 billion. Just to put that into perspective, the entirety of 2015 was 13.7. We've already seen more flows in the bond funds than we did all of last year, and we've got supply, which is down roughly 12%. Let's talk about supply.
I want to remind you guys that municipal issuers in the issuing of municipal debt is somewhat different than the corporate world. Muni issuers more than corporate issuers utilize their option-ality. Think in terms of yourself going out to a bank and taking out a 30-year mortgage. You would astutely never surrender the right to refinance your mortgage if in fact rates fell and it became advantageous to lower your debt expense. Well, that's the story with munis. Most issues come in a term structure with a ten-year optional call. So what that means is we can retroactively look at what supply was, going back ten years ago, and approximate what kind of refinancing or non-new money issuance we expected in a given year. So the refinancing activity we see today will come from '06, '07, '08, which were strong issuance years. And as a result of the fact that we've seen municipal rates fall down near historical lows with the 10-year within 13 basis points, and the 30-year within 7 basis points of historical lows, we're starting to see a pickup in refunding activity. Roughly 50% of activity in the new issue market has been refunding-related. So when we take these two things together, we've got all variety of supply assets down about 12%, and we've had real consistent positive fund flows. That is a real strong technical situation for the market, and we've seen good demand for the product. The one thing I'll note, the estimate for 2016 is arranged there. There was quite a wide range on estimates coming from dealers on the street. The average was 385 billion. I can tell you that over the last couple of weeks, we're starting to see estimates getting tweaked - the average getting tweaked higher up towards last year's level, around about $400 billion level, as the result of the low-interest rate environment.

Mei Baiocchi

This leads us to a subject the team was talking about back in January - the seasonality of the municipal markets. Can you share with us what this seasonality of the market is?

Greg Gizzi

Sure. As I travel the country and meet with advisors like yourself, I often get asked this question about when do you invest in the market? When is the best or most optimal time for muni investors to enter the market? Everyone's familiar with the January effect, with December being a very large coupon payment and January being a large coupon payment. But you can actually look at this empirically, and that's what we're going to do for you here. We were telling people - actually, as I was marketing - my colleagues and I were marketing earlier in the year, we were telling people that January, even though it was a very strong month, we wouldn't be buying munis, simply because that positive technical was in the marketplace, and it was exacerbated because actually January was a very low issuance month. So we saw really strong returns about almost like a 1.29% index return, which was really strong if you were to analyze that, and we told people that you'll see a better seasonal opportunity in March, and here's why.
So let's start out first with this slide that shows what really is a pretty decent negative correlation between supply and muni returns. What you have here is the Barclays Municipal Bond Index graph against supply, and aside from the taper tantrum, which is in the upper left side of the slide here, in which basically nothing worked during the taper tantrum, you have a pretty decent correlation. So as supply picks up, returns fall. When you take that a step further - this is a 15-year period when what we've done is looked at average return in the marketplace, and we're assuming that that return is reflective of that technical environment, and what we're noticing-- there are 3 distinct periods that over a 15-year period consistently come up as opportunities in the marketplace. And those are March, June, and October. If you just think about it intuitively, February, March, you're in the midst of the third quarter of the fiscal year, you're coming off of January, which again tends to be a low issuance month, where there's a lot of money around in the market, and at the same time supply starts to pick up-- late February and March, you're getting people preparing for tax time. So the technicals typically change. I will ascorbate that to tell you, 2016, and this is a testament to how strong the technical was-- 2016, this actually did not work, because it will work for the first two weeks of the month. If you aggressively buy in the first two weeks of March, by the end of March, the index would have put up a positive return. So we will give those periods, March which precedes tax payment, June which basically preceded the summer slowdown - the vacation month, the last school month, we start to get typically a supply-- a little supply boost in the marketplace while staying technical - and then again in October, as we head back from Labor Day, typically we see a surge in supply as well. So from an empirical standpoint, if you were in there buying in the down month of March, June, and October, from a historical perspective, it's been a wise entry point.

Mei Baiocchi

Last fall, when you did this webinar, you highlighted some surprises for 2015. What has surprised you in 2016 so far?

Greg Gizzi

We're going to stick to munis because there's a lot of things, and I won't get into politics, but there's a lot of surprises here in '16 so far. But I think the real-- from the muni perspective, the real driver is exactly what we've been talking about. Rates staying low, after - certainly the environment or the landscape- seemed to be more challenging coming off of the rate hike in December, with much more hawkish rhetoric coming out of Federal Reserve governance. And we all know what happened. We got a continued down trade in oil and energy. We've got now and again a bunch of negative yields globally in sovereign debts, and again, aside from employment, next to actually weakening data, we all know that the first quarter GDP number looks to be sub 1%. So on top of what seemed to be a fairly challenging start to the year, we've now got a scenario where it looks like the market is starting to believe a lower for longer scenario would be the one that would play out. So certainly as a result of low rates, that refinancing boost again representing about 50% of the issues supply again, that again would be a surprise for us. We were looking for aggregate supply to actually fall about 5% to 10% this year.
The last thing would be, and I want to highlight this because I've been asked this recently, as I traveled around, by advisors, if you again segmenting the Barclays Index, and again we just used the Barclays Index as the best proxy, would be the employment of the S&P 500 for an equity manager. It really is the market when you're talking about muni tax exempt portfolios. You can segment the market into states indices, even Puerto Rico is not a state that has its own component within the Barclays Index. And what you noticed is the last two years, we've seen the Puerto Rico investment grade state index outperformed the aggregate market, and people are wondering why. I can tell you last year, the index put up a 3.3% return for all of '15. The Puerto Rico component was up 4.7%. As we sit here today, the index is up 2.39%, and the Puerto Rico state index is up 3.08. What's happening is that the insurers have been in the market-- in the secondary market buying back their debt, and simply stated, if you think about it, if there's an adverse ruling which allows Puerto Rican entities to restructure, and some of which a fair amount is actually insured, essentially the insurance companies by buying back their debt to secondary will owe themselves money. So that's less capital that will have to outlay, buying them now at significant discounts to par, right? Some of these means trading as low as 20 cents on the dollar. The other thing is, if in fact there's some positive event that happens, and in fact, the liability for insurance companies turns out to be less, or there is some kind of recovery down the road for some of the obligations they hold, then they get a windfall. Insurance companies - they've done this before in other sectors where it's worked out. So if you noticed that Puerto Rico investment grade, of which by the way there's very little paper, it's just essentially insured bonds, and there's actually A rated Puerto Rico hospital that still exists on the marketplace, A2 rated, that's been confirmed. That's essentially what's been going on so far.

Mei Baiocchi

I think now is a good time to switch gears and talk about what many advisors are faced with today. Why invest in municipal bonds at these near historical low rates, and what is the case for municipal bonds?

Greg Gizzi

Great question. Another one that comes up as advisors asked me, "How do I talk to a client without making them think I'm totally nuts for suggesting to them that they buy munis in this marketplace?" I want to start out first by telling you what our philosophy is, and I think it would behoove you to start to think about your muni allocations in this way. We're traditionalists in the sense that we believe munis play one specific role in a proper asset allocation. And munis is essentially first and foremost are for the preservation of wealth. It is a high net worth vehicle. Yes, there have been very good opportunities. Some people that have just been exposed to our marketplace over the last few years think it's a great trading tool because we've seen some fairly decent moves in interest rates, capital appreciation opportunities, but first and foremost we think that the proper role of munis is for wealth preservation. Yes, you want to optimize or maximize your return for your client. And certainly I think buying-- getting yourself some exposure to some of the higher income portions of the marketplace would be a wise thing to do. But recognize that your clients hiring you for specific reasons when they give you municipal money, and I think it's very easy, considering some of the outside gains relative to history that we've seen in this space, to really lose sight of that. Let's talk about the case for munis today.
I want to go back to just take a look at 2012. Because what happened in 2012? At the end of the year we had a fiscal cliff, and debt ceiling negotiation-- ultimately what resulted was legislation that raised taxes. We all had a marginal tax rate increase. And in addition, we had the start of the funding of ObamaCare. So all in, your tax liability was increased overnight, and during that time period, obviously, it was a difficult time. The States were still recovering from the great financial crisis. We've also had subsequent increases at the state local levels in some tax jurisdictions. So what's resulted is-- and this is a simplistic look at-- we took a New York City water bond and said, "Okay, in 2012, if we're using 2016 yields, in 2012 what was the grossed up return of that bond?" And you can see in the left-hand side, it was four and a quarter. Well, as a result of those tax changes in 2012, what is the grossed-up yield on that bond insurance 2016? And in 2016 it's 5.11. And this is for a client-- by the way, a national client. If you were in New York, your actual rate is actually higher, your returns. You can see just by the fact that the tax structure was changed, you've gotten more taxable equivalent yield.
So when we take it a step further and say, "Okay, well, how do we stack up currently against some of our other fixed income alternatives?" The story continues to be compelling, and I remind you that as I started out my discussions I talked about the outperformance of munis versus corporates through the balance of last year. We've seen certain segments in the corporate bond market rebound. And by the same token, we have not seen munis sell off, so the fact that corporates have recovered on a relative basis were not as attractive as they were last year, when corporates and high yields were getting sold pretty hard, but the story remains the same. If you look at-- we used a ten-year just triple A GO level, and again many states are going to trade it as spread, this, but we used-- took a ten-year triple A muni market data GO scale, which is the scale that gets printed every day objectively and represents what the consensus view is for a triple A yield on our marketplace. If you took that yield that we took a couple of days ago - the 11th - and gross that up, the yield for a 10-year bond, the grossed up yield would be a 2.82 taxable-equivalent yield. Taxable-equivalent yield is just another way of saying what do I need to get on a taxable basis to be agnostic at the same yield for a tax exempt level? So 2.82 grossed up yield, the ten-year was a 1.72 at the time. You can see on a grossed up basis, much cheaper than treasury. In fact, we're almost at 100%, if you look at the nominal yield, and again we used triple A J&J here as a real strong trading corporate gain, and the yield on that was a 2.32. So the taxable-equivalent yield advantage is still there in the marketplace, and we flip the slide here.
And the next thing I want to remind you, not only are we getting a higher ultimate taxable-equivalent yield in our marketplace. What this is-- this is a tool I suggest all you have on your desk if you don't have it already. Moody's once a year updates the ten-year average cumulative issuer-weighted default chart. And what this does is it segments out munis by rating, and it compares it against our corporate brethren. And again, it's average cumulative issuer-weighted default rates. And it's astounding every time I look at this. Look at the triple B, which is the lowest investment grade category in the muni index. Triple B, the incidents of default, 0.37%, is lower than triple A corporates. Not only are you talking about an instrument that is garnering more yield, but certainly on a risk-adjusted basis, munis are usually better or much safer asset class.

Mei Baiocchi
What about recent views from the team on credit? What has the general view been, and how has that played a role in the market today?

Greg Gizzi

So we have generally been positive on credit, and I think if you look at upgrades versus downgrades, something that we track on an annual basis, last year Fitch in 2015-- they upgraded 549 issuers against 504 downgrades. So they had more upgrades than downgrades. For Fitch, it was the first time in seven years that this occurred, that you had more upgrades than downgrades. If we look at Moody's - Moody's upgraded 148 issuers and downgraded 65. And that was the second consecutive year that Moody's had more upgrades than downgrades. Let's think about for a moment-- let's think about what really vexed municipal credit. And I'm going to divide it into states and then local credits. When you think about a state, state income that's generated is dominated by income tax and sales tax. So think about the economic environment. The one strong point has been jobs. As jobs grow, incomes grow; the amount of income collected grows, the amount of tax revenue grows. So it's no surprise that states have done better as the economy has recovered.
Again 50% is income tax, 41% is paid tax, so 91% is in those two tax buckets, okay. At the local level, it's dramatically different. And what the local level is all about is property taxes. So the numbers there-- property taxes at the local level represent 81% of revenues. Failed tax represent 13%. Okay, so the point is, again, as we've seen, real estate markets recovered, and we know that we've seen cities - New York, San Francisco, Miami, Denver - all reached pre-recession peak and surpassed them. Just looking at K Shiller values for instance. So as, and again, I'm not suggesting this has been a uniform recovery because it hasn't. There are certain parts of the country which still suffers from high unemployment and have not seen real estate markets recover fully. But generally speaking, the things that drive muni credit have been heading in the right direction. So our view generally is positive. I would caution you, particularly if you're an advisor in New York and California, where we are very positive on those states, I might add, one thing to keep an eye on is a fair amount of that income tax revenue is capital gains. So as the markets go, so do those incomes. California is a tech belt. There's a lot of IPOs coming from venture companies out there. If you see a drop-off in IPOs or venture IPOs, that certainly can cause tax revenues to diminish. But I will say, and this is true, you'll see that as you're studying muni's, there's a lag effect. It takes a while for real estate values and reassessments to go through the process. So we're going to lag coming out of recovery. We're certainly going to lag going into a recession, if you will. So generally positive on credit, and I think, all things being equal, we expect credit to continue to be strong this year.

Mei Baiocchi

Greg, high yield muni has been a real growth engine for Delaware and other fund companies that have a high yield product. Can we get more specific on your views of the high yield muni market, and do you think this segment of the muni market will continue to work?
Okay, very good question, because you're right. Certainly, in our complex and all of my peers that I talk to over the last three years, by far the way the fastest growing fund at the complex was the high yield fund. And go back to our original discussion about income, how income is the driver. With the Fed communicating very clearly that rates were on hold for a while, it was in fact certainly permission for investors to not only go out the maturity spectrum but also down the credit curve. And I think what we've seen here, we talked about some of our other webinars that we did about the role the great financial crisis played in changing our marketplace. Our rates market went from a-- our muni market went from a rates market to a credit market overnight during the crisis, in essence. Certainly, there has been a certain portion of the business that's been farmed out to farms to gain access to these higher yields and things at the marketplace.
Let's do a quick five-second education on the high yield market because I think one thing to understand the muni market and the growth of the muni markets, you have to really lift up the hood and compare us to our taxable brethren. And what this slide does that's up here is look at the Lipper peer space. It compares a national municipal high yield fund by its allocation in credit buckets to a taxable high yield fund. What you're going to see if you do the math, and the dark bars represents the municipal fund, the lighter bars the taxable high yield fund. You're going to see that the average fund in this space, in the Lipper national high yield space, has 56.4% of its investment in investment grade paper. Over half the investments and the average fund in this space, the national high yield fund, taxable high yield fund, has over 50% of its investment in the investment grade category. The same numbers, there's only 10% in the taxable sleeve that's investment grade. So when I think of high yields I think of jump. That's the connotation that I think of. But I think when you're looking at the municipal asset class, it's a different beast. From an aggregate standpoint, we use the Barclays national high yield index. It's actually got a lower rating point frankly than what the common index that's used in the taxable side, which is the Bank of America high yield index. That's B1. The Barclay's Index is B2, B3. And that's because Puerto Rico has actually slid down into the high yield index, and a lot of that is C rated and has dragged the average down.
The other thing I want to point out to you. We've taken the universe at the end of 2015 by rating category. And so when you think high yield, you're talking about ratings that are below triple B. So if you look at the double B and below, the unrated and unaccounted for, put that together, it's roughly 14% - 13%, 14%, right. And those of you that were with us in the fall, you know that the component of the non-rated paper isn't necessarily lower-quality paper. A lot of that is school district financing where a very solid municipal entity has decided to forgo rating for expense reasons. There's roughly 2% to 3% of that higher-quality non-rated paper in that non-rated category, but let's just say for argument's sake, the target amount of issuance is really 12% of the market for high yield fund managers. It's an extremely constrained opportunity set, so what happens is, you're going to find a lot of managers that are faced with a difficult choice. And typical, what will happen is, they'll introduce derivatives and add things like ten-year option bonds into their portfolios or simply over-concentrate certain sectors - something that we try not to do here. So certainly the best performing segment of high yields the last couple of years has been MSA Tobacco. You'll find some of these funds with 20%, 25% tobacco allocations in them.
Do I think they are going to continue to work for '16? I do. I do, because I think the rate picture looks fairly benign at this point. We'll get into what the Fed's forecasting, but I think that if income is the driver of return in '16, again like a coupon-less whatever the degradation might be from higher rates, I think having higher returns from the high yield product will afford you positive returns, absolutely.

Mei Baiocchi

Greg, what's your view on state-specific funds for investors in high-tax states? Are investors getting proper diversification being solely in a state-specific fund or should they diversify holdings in the national product as well?

Greg Gizzi

Yeah, this is the question when I'm in California, New York, I get asked all the time and for obvious reasons, right. The tax burden in those states for individuals is extremely high, painful. Quite frankly, it's an interesting dilemma, because you can argue that the amount of issuance-- we all know that muni issuance is really dominated by three states: Texas, New York, and California, and not in that order. But those are the three states that dominate the issuance. And you could argue, particularly in the case of New York and California - Texas doesn't have it-- state tax rate, right, so we're going to leave them out - but certainly in New York and Texas-- New York and California, sorry-- you have an example where you got a state that issues debt virtually in every single sector of our states. So you can get access to charter schools, you can get access to all kinds of health care, CCRCs, tax-increment finance deals, P3s. You name a sector and you can find it in those states, so from a "diversification" standpoint, it would seem like you wouldn't need to go national. What we've been suggesting to people, for two reasons, is to take a portion, even if you're a resident in those states, take a portion, whether it's 10%, 20%, 25%. The math is certainly compelling to stay in a state fund, but diversify away a portion of your holdings for the potential for a systemic event. Let's face it, If there was a significant earthquake in California, everything would trade off in California. I would argue not all credits would be affected the same ultimately in the long run, but that would happen. And certainly even though that I said there's access to those different sectors in those states, because they are specialty states, you're not going to get the same yield opportunities that you might get for similar sectors in other states like Texas, that doesn't have a state tax. So you can get access to higher yields, better returns, in some of those non-specialty states that have much lower tax rates.

Mei Baiocchi

Can you share with our audience what you're focusing on in 2016?

Greg Gizzi

Sure. So let's start out the first and obvious rates, right. We talk a little about rates. Our view is a fairly benign view. For those of you that have access to a Bloomberg, I suggest you follow WIRP go. WIRP is Word Interest Rate Probability, the chart we look at all the time. And what it does is show the probability of a rate hike based on Fed Funds futures trading. And I put this up because it notes-- you get to a 50-50 probability of a rate hike, you have to go out to December now. Now I want to highlight this is different than what the Fed governors are talking about. We won't go into why I think that's the case. The market is forecasting one or two rate hikes. The Fed is suggesting there could be more. What is interesting to me is April, which has a 0% chance of a Fed rate hike, has actually a 2% chance of a rate cut. I find that that's actually pretty comical. So we certainly keyed on rates, May. That's the first thing we're looking at.
The second thing would be curve dynamics, and we've discussed that a little bit. Certainly, our view - our outlook for '15 and certainly our outlook for '16 was predicated on a flattening yield curve. What I mean by that is, we were anticipating that the long end of the yield curve would outperform the front end of the yield curve. What we were looking for actually, given the fact we thought rates might actually start to rise this year, was the fair flat where short rates underperformed long rates. Very simple. Long rates go up less than the front end does. What we've seen is the exact opposite. Props to Merrill Lynch Bank of America, because they were spot on with their call. They were calling for actually a bull flattener where long rates-- we've got the flattner end of the market but long rates have actually fallen more than short rates, so that's the way the curve is flattening. But we're going to keep our eye on those curve dynamics. It's the basis of our call.
And the last thing, this plays into the technical aspect of the market we talked about with slopes. I mentioned that we're seeing strong flows, about $18 billion year-to-date. We're going to keep an eye on those flows. We don't foresee anything out there now that's disruptive enough to get that juggernaut 70% of the market heading in the opposite direction. But certainly, we're keying in on flows.
The next thing I want to address is liquidity. And liquidity is a term today quite frankly that's used in many different ways. I could tell you from a PM's perspective, liquidity in the marketplace as measured by the ease of trading-- the efficiency of trading is very good. In fact, one of the things I want to refute, because I've heard as I traveled around, "Oh, I understand that trade volume is way down." And I said, "No, actually, I don't think trade volume is down." And lo and behold, MSRB released this chart earlier this year, which actually demonstrates that overall trade volume is down, but that's inclusive of variable-rate demand notes, which has seen dramatic contractions in the supply of VRDOs, variable rate demand obligations. If you strip out VRDOs, we're actually been fairly consistent in the amount of secondary trading we're doing. We're certainly not seeing a drop-off in the secondary trading. It takes a while for retail, particularly in the long end of the curve to get accustomed to some of these low yields. But the longer we stay at this low-yield environment, I think the more money we're seeing leave the sidelines and enter the marketplace.
The next thing we're looking at is ratios. And we talked at length about this in the Fall. Ratio is simply are where we're trading versus Treasuries. There are a number of non-traditional buyers. The only real long-term participant in this trade has been property and casualty companies that have looked at munis opportunistically relative to their own P&Ls, buying them when they needed taxed exempt income and not buying them when they didn't, when they have lots of them paid out in casualty liability. But we know that since the crisis, we've seen some significant things from a ratio standpoint. And I put this chart up to bring your attention one thing. If you look at where we trade as a percentage of treasuries, it's been a consistent trend since the crisis. We peaked at about 208% back in '09 during the Maris Whitney crisis which saw $53 billion in outpost from funds. We peaked at about 133. When we got to the taper tantrum in the summer, spring of 2013, we peaked at 120. We got to about 116 last year at one point. What's happening to the ratio? It's declining. And the reason it's declining is because this trade's been discovered. Munis were very, very diligently pushed by investment banks during the Build America Bonds period. They went global trying to get non-traditional entities to look at our marketplace. Quite frankly what they thought that the BAB program would be an annual thing, that this would go on and become the new muni market. We all know what happened. That's lasted through 2010, $181 billion in issuance, and it's somewhat of an orphan market from the issuance standpoint and trades actually fairly well. But the reality is, people learned about munis, people understand that at times due to the ownership base we get some bouts of real inefficiency where rates-- tax-exempt munis, which are strong credits, trade in excess of Treasury notes. And when this happens, we see very aggressive buying by non-traditional buyers. So just to put it in perspective, from a ratio standpoint, we're only about two and a half ratio wider on the year from where we started. We're currently roughly about 97%, 98% on the long end, and we're through 90% in the 10-year segment. The point is, we were six and a half ratios wider in the ten-year, and we were fifteen ratios wider, or thirteen ratios wider in thirty years. So there was a point opportunistically during the course of this year where we were trading very cheap to Treasuries, and we were actually adding those to our non-traditional or taxable bond fleets here in Delaware.
So certainly keep your eye on ratios, because as we get into the 100+% ratio range, the chances of seeing demand come from non-traditional sources increases.
Quickly, election and tax rhetoric. Bottom line is this. You're going to hear a lot of tax stuff go on proposal platforms. Nothing happens till 17 or 18 at the earliest until we get a new administration, more importantly, a new congress in there. I'll get to that later. Puerto Rico - We're certainly keeping an eye on Puerto Rico. Will there be a resolution on Puerto Rico? The latest is this. There's a debt payment for Puerto Rico GDP coming up on 5/1. It's $422 million. They don't have the money, quite frankly. And what happened was, we had a debt moratorium bill approved by Puerto Rico, which enables them to basically not pay debt on any of their obligations. At the same time, we had Speaker Ryan, Chairman of the House, Speaker Ryan have the House and Natural Resources Committee draft the bill. That bill has been extended. The ultimate creation of that bill is that it's been extended several times. And I saw something on the tape today that there may be a draft release. Essentially, what they're trying to do is figure out a way to help Puerto Rico without bailing them out. Similar to D.C. Lucy remember when the district of Columbia was in trouble, some kind of fiscal control board is being suggested. There is a highly contentious crammed down provision which I guess some of the Republicans are fighting against in the House. The thing is this, we've been saying and continue to believe that ultimately there's massive litigation on this. Some fund companies are on different sides of the argument depending on which credit you're talking about. It is an economic problem that is not going to go away easily. And the one thing I'll say is that ultimately, I think something will be enacted, but what shape or form that ultimately comes out in, and at what point does that get enforced after a sure litigious environment arises, that remains to be seen.
Lastly, we mentioned this at length last time. We continue to look at the pension problem states. Those states and locales that have kicked the can down the road for years. We've talked in previous webinars about GASB 68/69, which essentially forced them to state very clearly their net pension positions-- municipal entities that issue debt, what their net pensions positions were, clearly. And as a result of that, what we have seen in the market efficiently occur is that states that have had problems widened out pretty significantly. I used Connecticut as an example, not to pick on Connecticut. I love the state. Connecticut's the wealthiest state in the country. It does not have a lot of debt outstanding, but if you look at debt on a debt per capita basis, it's about $5300 per person. The average state that issues debt is around 1500 per person. To put that in perspective, Puerto Rico is at 15000+ per person. Okay, just put that in perspective. Connecticut used to be a fairly consistent 15 off the triple A to 20 off the triple A trader, XO bonds offered today at 60 off. So those entities, despite being the wealthiest state, if you have not shown the initiative to address your pension problem, the market is responding, and we're seeing credits spread widening. So that's something we're going to continue to keep an eye on.

Mei Baiocchi

And finally, what else should advisors and investors keep an eye on as we move forward?

Greg Gizzi

So I have a list here, and these are some things if you don't know, you should probably jot down, because some of them could be significant in the future. Let's talk liquidity coverage ratio. You know that legislation's been passed that basically require banks to record sufficient liquidity in the event of a crisis. Certainly, trying to prevent what occurred during the great financial crisis. The LCR is called the liquidity coverage ratio-- has components that are classified as high-quality liquid assets. And the way it relates to munis is in the original legislation that was passed, munis were not included in the HQLA. The fear was that banks would become sellers of municipal bonds, banks have been actually net average of munis over the last few years and continue to add munis as of last year's data. So the House - in bill H.R.2209 - passed a piece of legislation that is going to suggest that certain munis become HQLA 2A classified assets. Now the Federal Reserve just two weeks ago did announce that munis were being included as Class 2B assets. Now let me just succinctly point out the difference. From an accounting standpoint, you have to haircut 2B assets at 50% and you can only have 15% of your LCR aggregate bond or aggregate security position in those securities. For a 2A asset, you are only haircutted at 15%, and you can have up to 40% of your asset base in 2A assets. So if it was passed in the House, the bill remains in the Senate, so that could be a law passed by Congress, and the muni market is awaiting that.
MSRB. Direct lending transparency. This is something people are really unfamiliar with as I travel around. One of the things that occurred during the crisis, and put your mind back in '09 where the new issue market was frozen, offshore rate securities were upside-down. We knew that there was a fair amount of direct lending going from some of this large money central banks to municipalities. When you think about a credit analyst job in trying to analyze financial metrics, if you really don't know what their obligations are, it's very hard to analyze. I have some numbers. In 2005-- this is a report that the Bank of America put out. In 2005, three tenths of 1% of the entire market was direct lending. In 2015, that's become 6.5%, or $27 billion of debt. So there's an initiative by the MSRB to require all entities that issue debt into the marketplace, that have direct loans, to report those loans.
The next thing-- this thing I know this one I'm really keeping an eye on - the Fundamental Review of Trading Book regulations, FRTB, that is due to go into action on January 2020. What this does is basically, it's an act that's trying to eliminate differences in regulatory capital requirements on trading books at a bank relative to the banking book. So there are different reserve requirements for trading books at banks than there are in the actual bank book itself. And what this is trying to do-- it's going to apply by the way to any trading book at a financial institution, either regulated by the Fed, the OCC, or the FDIC. And if you're an entity, you have to trade book that you are regulated by any of those three, you're going to have to comply with this regulation. It's going to higher the reserve requirements per low rated securities. So to just put some numbers on it, triple B rated securities for a bank to inventory those bonds, their reserve requirements are going to go up by three and three quarters times - 3.75 times. Double B and lower, anywhere from 15% to 50%. So logically, the concern is that liquidity might be impaired when we get into periods where volatility becomes in question. That gets exacerbated, because no one's going to want to hold their B securities if in fact those regulatory capital requirements are behind them.
Again, this is a proposal. Certainly, there will be lengthy comment periods. They'll be lobbying against it, but I just mentioned it to you because it's certainly something that could change dynamics for the secondary market. I mentioned this before, as far as the tax reform issues. I said House and Senate-- the Congress is more important. The consensus view - and we share it, quite frankly - is that you're going to need a clean sweep I think to get something done, any significant tax legislation done. So what I mean by that is that the republicans keep the House, they take the Senate, and take the White House, where the democrats do the same thing. They take the White House, keep the Senate, take the House away from the Republicans who want to really enact something. I think the odds of that are not good, but there are a tremendous amount of House seats up on the Republican side that are in question. So keep your eye on that for obvious reasons.
And lastly, this is one of my pet concerns, or issues with the marketplace. Given the fact I mentioned how close we are to historical lows in rates, three summers ago now, the American Society of Civil Engineers put a report out talking about the infrastructure needed in our country. By the year 2020, which is now less than four years away, that's at $3.6 trillion. Last Fed data statistics indicated our marketplace is $3.7 trillion. So you in essence have a shadow market that's lurking out there waiting to be financed. We did see a very, very slight uptake in what's called new money issuance. New projects, new supply. And the reason this is significant is because historically speaking, 75% of this type of finance is done through the muni markets. I want to quote a guy named Tom Clark. Tom Clark is the CEO of the Denver Economic Development Corp. And he was interviewed and asked what he thought the key to Denver's success in turning their economy around was. And emphatically, he said their investment infrastructure really was the driving factor, that when companies came in to interview them about switching locales, relocating themselves into the Denver geography, all the questions that they were concerned about, the non-financial questions, centered around infrastructure, what the airport was like, commute times, public transportation. I've been saying it now for three of these webinars. We will see a significant increase in infrastructure finance. The political environment I think is still in a hangover from the great financial crisis, and people are concerned with other things other than borrowing more money at this point, but I think that there is a fairly decent uptake in futures supply in our marketplace.

Mei Baiocchi

That concludes our session today. Greg, you definitely covered a lot, and I really want to thank you for your time today. As always, I appreciate your thoughts and inputs.

Greg Gizzi

Thank you. Thank you very much. And I wish all of you success navigating the markets here in 2016.
Mei Baiocchi

And for anyone who has any questions on the material covered in today's session, or if you want to learn more about the Delaware muni funds, please feel free to contact your regional director or internal consultant. And again, thank you for dialing in to listen to our update on the munis.

The views expressed represent the manager’s assessment of the market environment as of the date of this presentation, and should not be considered a recommendation to buy, hold or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the manager’s current views.

The performance quoted represents past performance and does not guarantee future results.

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Advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.

Charts shown throughout are for comparison purposes only. Source data are the most recent available data.

Investors should carefully consider the Delaware Investments Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
Investing involves risk, including the possible loss of principal.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Fixed Income securities may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by a Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
Past performance dos not guarantee future results. Diversification may not protect against market risk.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable. High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds. Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
Credit Ratings Definitions
Moody’s Investors Service, Inc.: Aaa - Highest quality, smallest degree of investment risk. Aa - High quality; together with Aaa - bonds, they compose the high-grade bond group. A - Upper-medium-grade obligations; many favorable investment attributes. Baa - Medium-grade obligations; neither highly protected nor poorly secured. Interest and principal appear adequate for the present, but certain protective elements may be lacking or may be unreliable over any great length of time. Ba - More uncertain with speculative elements. Protective of interest and principal payments not well safeguarded in good and bad times. B - Lack characteristics of desirable investment; potentially low assurance of timely interest and principal payments or maintenance of other contract terms over time. Caa - Poor standing, may be in default; elements of danger with respect to principal or interest payments. Ca - Speculative in high degree; could be in default or have other marked shortcomings. C - Lowest rated. Extremely poor prospects of ever attaining investment standing.
Standard & Poor’s: AAA - Highest rating; extremely strong capacity to pay principal and interest. AA - High quality; very strong capacity to pay principal and interest. A - Strong capacity to pay principal and interest; somewhat more susceptible to the adverse effects of changing circumstances and economic conditions. BBB - Adequate capacity to pay principal and interest; normally exhibit adequate protection parameters, but adverse economic conditions or changing circumstances more likely to lead to weakened capacity to pay principal and interest than for higher-rated bonds. BB, B, CCC, CC - Predominantly speculative with respect to the issuer’s capacity to meet required interest and principal payments. BB - lowest degree of speculation; CC - the highest degree of speculation. Quality and protective characteristics outweighed by large uncertainties or major risk exposure to adverse conditions. D - In default.
Federal funds rate – the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.
Index Definitions
The Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, noninvestment grade tax-exempt bond market.
The Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The Barclays 3–15 Year Blend Municipal Bond Index measures the total return performance of investment grade, U.S. tax-exempt bonds with maturities from 2 to 17 years.
The Barclays U.S. Credit Index measures the total return performance of nonconvertible, investment grade domestic corporate bonds and SEC-registered foreign issues. All bonds in the index have at least one year to maturity.

The Barclays U.S. Corporate Investment Grade Index is composed of U.S. dollar–denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least one year to maturity.

The Barclays U.S. Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
The Barclays U.S. Corporate High-Yield Index is composed of U.S. dollar–denominated, noninvestment grade corporate bonds for which the middle rating among Moody’s Investors Service, Inc., Fitch, Inc., and Standard & Poor’s is Ba1/BB+/BB+ or below.

The Barclays U.S. Treasury Index measures the performance of U.S. Treasury bonds and notes that have at least one year to maturity.
The Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency.
The Barclays 1-3 Year Credit Index is an unmanaged index considered representative of performance of short-term U.S. corporate bonds with maturities from one to three years.

The Barclays U.S. Securitized Index is a composite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible) and fixed rate mortgage-backed securities. For Rising Rate Period 1 in Exhibit III, Securitized Debt is represented by Barclays Mortgage-backed Securities Index, which is an unmanaged index of collateralized mortgage backed securities (ERISA-eligible) securities.

The BofA Merrill Lynch Preferred Stock Fixed Rate Index is designed to replicate the total return of a diversified group of investment-grade preferred securities.

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