Why high-yield municipal bonds may be attractive in today s market environment

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1 Spread Why high-yield municipal bonds may be attractive in today s market environment February 2014 High-yield municipal bonds may be attractive given their: Historically wide spreads Attractive prices Compelling tax-free income stream Potentially lower correlation to interest rates than other fixed-income alternatives 1) Spreads and prices in the high-yield municipal asset class remain attractive Municipal bonds, relative to corporate bonds, continue to be compelling. As the following chart illustrates, high-yield municipal bonds currently offer greater value on an absolute basis than similarly rated high-yield corporate bonds. Insights from: We believe that credit selection, spread tightening, and structural characteristics will most likely be the determining factors of municipal performance throughout 2014 and into % 120% 100% Barclays Municipal High Yield Index to High Yield Corporate Index Avg: 74.3% Min: 44.3% Max: 120.0% Std Dev: 15.6% 80% 60% 40% 20% 0% 1/31/2014 Spread = 116.1% Source: Barclays, January 31, An investment cannot be made directly into an index. Past performance is no guarantee of future results. See page 5 for definitions. By several metrics, the economies of municipalities are improving. For example, last year S&P upgraded municipal issuers on a 2 to 1 ratio compared to downgrades (Source: S&P RatingsDirect, July 30, 2013). In August, Moody s revised its U.S. State Sector outlook to Stable after more than five years at Negative (Source: Moody s, August 20, 2013). In addition, the Rockefeller Institute recently noted that total state tax collections showed growth for the 14 th consecutive quarter and state tax revenues increased by 6.1% in the third quarter of 2013, compared to the same quarter of the previous year (Rockefeller Institute, January 2014). As the economy improves, bonds with corresponding revenue streams that are tied to economic drivers will typically experience improved cash flow, debt/service coverage ratios, and may be positioned for a rise in bond price and/or a ratings upgrade. One hypothetical example to consider is a bond that finances the major sports complexes of a large city. In this example, bonds are issued to finance the facility, and the corresponding revenue stream is tied largely to excise taxes on local hotels and car rental facilities. Given the relationship to tourism, one might conclude that the revenues and debt/service coverage ratio on these bonds are likely to improve with a stronger economy. 1

2 Spread (bps) Spread (bps) For many investors, compelling opportunities to capitalize on the cheapness of the lower investment-grade and high-yield municipal market are becoming more apparent. Spreads continue to be wider than their historic averages as illustrated in the charts below. Barclays Municipal BBB Index to Municipal AAA Index Barclays High Yield Index to Municipal IG Index Avg: 161 bps Min: 36 bps Max: 413 bps Std Dev: 96 bps 1/31/14 Spread = 318 bps Avg: 299 bps Min: 113 bps Max: 636 bps Std Dev: 108 bps 1/31/14 Spread = 367 bps Source: Barclays, January Municipal IG Index represented by the Barclays Municipal Bond Index. An investment cannot be made directly into an index. Past performance is no guarantee of future results. 2) Demand is picking up The significant outflows primarily in the second half of 2013 have abated, and high-yield mutual funds have experienced inflows in 2014 (Sources: Lipper U.S. Fund Flows and JPMorgan). In our view, this has resulted in a buying opportunity at attractive lower pricing levels. We believe total return can be a significant component to high-yield municipal bond fund performance. As you can see below, the average dollar price of high-yield municipal bonds is significantly lower than other comparable indices, making high-yield municipal bonds attractive. Barclays High Yield Municipal Index average dollar price: $49.51 Barclays High Yield Municipal Index (after excluding zero coupon bonds): $89.87 Barclays Municipal BBB Index: $90.04 Barclays Municipal Bond Index: $ Barclays U.S. Corporate Bond Index: $ Barclays U.S. High Yield Index: $ Source: Barclays, January 31, Additionally, on a tax-equivalent basis, many investors are finding municipal bond yields compelling. For example, a municipal bond yielding 5.50% would represent a tax-equivalent yield of 8.46% for investors in the 35 th percentile federal tax bracket and 9.11% for investors in the highest federal tax bracket of 39.6%. These yields are higher than many long-term equity returns. We believe this is another indicator of the current attractiveness of high-yield municipals. Tax-exempt investments appear attractive, particularly in higher tax brackets 2013 Federal Income Tax Rate Tax-exempt 5.50% Yield Tax-Equivalent Yields Tax-exempt 6.00% Yield 25.00% 7.33% 8.00% 28.00% 7.64% 8.33% 33.00% 8.21% 8.96% 35.00% 8.46% 9.23% 39.60% 9.11% 9.93% Rates are hypothetical and not representative of any specific investment. The table above does not reflect performance of MainStay High Yield Municipal Bond Fund. Performance for MainStay High Yield Municipal Bond Fund may be obtained from mainstayinvestments.com. The federal income tax rates are based on published rates in effect as of January Actual tax rates will vary depending on the investor s income, investments, and deductions. 2

3 3) Duration in high-yield municipals: Points to consider There is a perception that duration is the sole driver of interest-rate sensitivity and that a portfolio with less duration will always be more insulated from a rate move than a portfolio with higher duration. We believe that fixed income is painted with a broad brush in this context and that there are nuances to consider as it relates to interest rate sensitivity in the municipal bond space. Duration, as a measure of interest-rate sensitivity, in a high-yield municipal bond portfolio may not be as important a factor and warrants additional consideration. In a municipal bond portfolio, we believe duration is a better gauge in the highest quality segment of the credit spectrum (AA and higher) at the 3-12 year part of the yield curve. The further one goes down the credit spectrum toward A, BBB, and high-yield credits, the less sensitivity, we believe, there is to rates, and thus, less application for duration as a measure. Within the high-yield space in particular, these are bonds with less correlation to pure rates, are more "credit-centric" and we believe they can perform well during an improving economic environment. As illustrated in the chart below, the Barclays High Yield Municipal Index has low correlations to the 10-year U.S. Treasury Index. Assets that have low or negative correlation may be well-positioned to take advantage of market opportunities in a rising interestrate environment. Correlation as of January 31, Year 5 Year 10 Year Citi Treasury Benchmark 10 Yr USD US OE Intermediate Government US OE Short Government US OE Inflation-Protected Bond US OE Intermediate-Term Bond US OE Muni National Intermediate US OE Muni National Short US OE Muni National Long US OE Short-Term Bond US OE Emerging Markets Bond US OE High Yield Muni US OE High Yield Bond US OE Bank Loan Source: Morningstar, January Correlation is a measure of how closely two variables move together over time. A -1.0 equals total negative correlation, whereas a 1.0 equals total positive correlation. Correlation is historical and does not guarantee future results. The chart above is for illustrative purposes only and does not represent any MainStay Fund. Asset classes are represented by Morningstar categories. Past performance is no guarantee of future results. 4) Historically lower default rates From the perspective of creditworthiness, high-yield municipal securities have produced much lower default rates than comparable corporate bonds, while demonstrating higher recovery rates as well. Importantly, BBB rated municipals have a lower historical default rate than AAA rated corporates. Rating Categories Moody s 1 Cumulative Historical Default Rates Standard & Poor s Municipal Corporate Municipal 2 Corporate 3 Aaa/AAA 0.00% 0.50% 0.00% 0.88% Aa/AA 0.01% 0.92% 0.02% 1.16% A/A 0.05% 2.48% 0.06% 2.12% Baa/BBB 0.30% 4.74% 0.17% 5.27% Ba/BB 2.85% 19.72% 2.75% 16.73% B/B 13.88% 42.00% 4.47% 29.91% Caa-C/CCC-C 12.66% 69.63% 38.54% 56.11% Investment Grade 0.07% 2.78% 0.11% 2.97% Non-Investment Grade 5.67% 33.88% 7.09% 25.94% 1. U.S. Municipal Bond Defaults and Recoveries, Moody s Investors Service May, 2013: Page 21, Exhibit 13, Cumulative Default Rates, Average over the Period , Municipal vs. Corporate Issuers. Note: 10-year average cumulative default rates U.S. Public Finance Defaults and Rating Transition Data. Standard & Poor s Global Credit Portal RatingsDirect, March 28, 2013: Page 36, Table 14A, U. S. Public Finance Cumulative Average Obligor Default Rates, (%). Note: 10-year average cumulative default rates Annual U.S. Corporate Default Study and Rating Transitions. Standard & Poor's Global Credit Portal, RatingsDirect, March 20, 2013: Page 26, Table 12, U.S. Corporate Average Cumulative Default Rates, (%). Note: U.S. Corporate 10-year average cumulative default rates. Past performance is no guarantee of future results. 3

4 As opposed to the corporate market, municipal high-yield managers normally invest a sizeable portion of their portfolios in BBB and higher rated municipal bonds. Supply of issues rated BB and below within the municipal marketplace is limited. As such, BBB rated municipal bonds straddle the line between investment grade and high yield and are included in both universes. While the corporate high-yield market is generally defined as BB and lower, municipal high-yield managers generally purchase issues rated BBB and below to create a larger universe. Thus, municipal high yield has a significantly higher credit quality than corporate high yield. Conclusion In our opinion, credit selection, spread tightening, and structural characteristics will most likely be the determining factors of municipal performance throughout 2014 and into The $3.7 trillion municipal market is a diverse, decentralized, and inefficient market with more than 87,000 issuers. The need for in-depth credit research in this complex market is now more crucial than ever. MacKay Municipal Managers believes that municipal bonds offer high income and strong total return potential. However, it s important to know not only which bonds to own, but prudently, which ones to avoid. The information and opinions contained herein are for general information use only. MacKay Municipal Managers TM does not guarantee their accuracy or completeness, nor does MacKay Municipal Managers TM assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report, are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Past performance is no guarantee of future results. 4

5 Before you invest Mutual funds are subject to market risk and fluctuate in value. MainStay High Yield Municipal Bond Fund A portion of the Fund s income may be subject to state and local taxes or the alternative minimum tax. High-yield securities (commonly referred to as junk bonds ) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities. The Fund may invest in derivatives, which may increase the volatility of the Fund s net asset value and may result in a loss to the Fund. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Definitions Average dollar price is the average price of the securities held in the corresponding indices shown. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Standard deviation measures how widely dispersed an investment s returns have been over a specified period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility. Barclays Municipal Bond Index is an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody's, with a maturity of at least two years. Bonds subject to the Alternative Minimum Tax or with floating or zero coupons are excluded. Barclays High Yield Municipal Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody's Investors Service with a remaining maturity of at least one year. Barclays U.S. Corporate Bond Index is an unmanaged index of fixed-rate, investment-grade and non-investment grade corporate debt issues. Barclays U.S. Corporate High Yield Index is an unmanaged index of fixed-rate, non-investment grade debt issues rated Ba1 or lower by Moody s, rated BB+ or lower by S&P, rated below investment grade by Fitch Investor s Service, or if unrated previously, held a high-yield rating or have been associated with a high-yield issuer, and must trade accordingly. Barclays Municipal AAA Index and Barclays Municipal BBB Index are subsets of the Barclays Municipal Bond Index. Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is composed of approximately 60% revenue bonds and 40% state government obligations. Citi Treasury Benchmark 10 Yr USD is an index that measures total return for the current 10-year on-the-run Treasurys that settle by the end of the calendar month. An investment cannot be made directly into an index. Credit ratings apply to the underlying debt securities and are rated by an independent rating agency such as Standard & Poor s (S&P), Moody s, and/or Fitch. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Non-investment grade is a rating that indicates that a municipal or corporate bond has a relatively low credit quality. Intermediate Government: Morningstar intermediate-government portfolios have at least 90% of their bond holdings in bonds backed by the U.S. government or by government-linked agencies. Short Government: Morningstar short-government portfolios have at least 90% of their bond holdings in bonds backed by the U.S. government or by government-linked agencies. Inflation-Protected Bond: Morningstar inflation-protected bond portfolios invest primarily in debt securities that adjust their principal values in line with the rate of inflation. These bonds can be issued by any organization, but the U.S. Treasury is currently the largest issuer for these types of securities. Intermediate-Term Bond: Morningstar intermediate-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixedincome issues and typically have durations of 3.5 to 6.0 years. Muni National Intermediate: Morningstar muni national intermediate portfolios invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These portfolios have durations of 4.5 to 7.0 years (or, if duration is unavailable, average maturities of five to 12 years). Muni National Short: Morningstar muni short portfolios invest in bonds issued by state and local governments to fund public projects. The income from these bonds is generally free from federal taxes and/or from state taxes in the issuing state. These portfolios have durations of less than 4.5 years (or, if duration is unavailable, average maturities of less than five years). Muni National Long: Morningstar muni national long portfolios invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These portfolios have durations of more than 7.0 years (or, if duration is unavailable, average maturities of more than 12 years). Short-Term Bond: Morningstar short-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years. Emerging Markets Bond: Morningstar emerging-markets bond portfolios invest more than 65% of their assets in foreign bonds from developing countries. High Yield Muni: Morningstar highyield muni portfolios invest at least 50% of assets in high-income municipal securities that are not rated or that are rated by a major agency such as Standard & Poor's or Moody's at the level of BBB (considered part of the highyield universe within the municipal industry) and below. High Yield Bond: Morningstar high-yield bond portfolios concentrate on lower-quality bonds, which are riskier than those of higher-quality companies. These portfolios primarily invest in U.S. high-income debt securities where at least 65% or more of bond assets are not rated or are rated by a major agency such as Standard & Poor's or Moody's at the level of BB (considered speculative for taxable bonds) and below. Bank Loan: Morningstar bank-loan portfolios primarily invest in floating-rate bank loans instead of bonds. For more information about MainStay Funds, call 800-MAINSTAY ( ) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. MacKay Shields LLC is a federally registered investment advisor and an affiliate of MainStay Investments. MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds are managed by New York Life Investment Management LLC and distributed through NYLIFE Distributors LLC, 169 Lackawanna Avenue, Parsippany, New Jersey 07054, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC. NYLIM MSMHY65b-02/14 5

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