ANY GAS LEFT IN THE HIGH-YIELD MUNICIPAL TANK?

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1 May 9, 2016 ANY GAS LEFT IN THE HIGH-YIELD MUNICIPAL TANK? A favorable credit environment and technical factors have contributed to strong high-yield municipal performance. We see limited room for further appreciation with yields near historical lows, tighter credit spreads and a municipal curve as flat as it was pre-financial crisis. Weaker relative value and the late stages of economic expansion argue for conservative high-yield muni positioning. Chad Farrington Head of Municipal Bond Credit Research and Senior Portfolio Manager The average gross return for open-ended high-yield municipal bond funds was 5.15% in 2015 and 2.31% in Q Some of this strong performance can be explained by a favorable credit environment. After peaking in 2010, defaults in the municipal market have declined in every year since. When you combine a favorable fundamental backdrop with strong investor demand and limited new issue supply, it is easy to see why high-yield municipals have done so well. Strong flows have brought total high-yield muni fund net assets to an all-time high and the longest streak of positive inflows since The limited number of high-yield deals that price every week are routinely oversubscribed and repriced to lower yields. These dynamics have resulted in tighter credit spreads and a flatter yield curve as the search for yield takes investors down in credit quality and longer in maturity. Exhibit 1: High-yield muni mutual funds reach all-time AUM high IN THIS ISSUE Any gas left in the high-yield municipal tank? Global asset allocation update Weekly Market Summary Source: Morgan Stanley Research, EPFR, April 11, 2016 Investors are rewarded less for high-yield credit risk Credit spreads have tightened to where they were just before the credit crisis in The spread reported below is likely skewed higher due to Chicago and Illinois more recent deals in most sectors reflect even tighter conditions than what the chart suggests. Generally speaking, the overwhelming majority of BBB credits are approaching the narrow end of the 25-year historical spread range.

2 Exhibit 2: Credit spreads have tightened to pre-financial crisis levels Source: Barclays Risk Analytics and Index Solutions, April 5, 2016 Using high-yield for longer maturity has become less attractive High-yield bonds are typically issued at the long end of the maturity spectrum. The spread between the 1-year and 30-year AAA municipal bond has narrowed dramatically since 2013 (Exhibit 3). The municipal yield curve is now as flat as it has been since the 2008 crisis. Somewhat tepid economic conditions and the lack of any signs of inflation may not necessarily cause the curve to steepen anytime soon, but the value of going long to pick up incremental spread has lessened. Exhibit 3: Spreads between 1-yr and 30-yr AAA munis have narrowed dramatically since 2013 Source: Columbia Management Investment Advisers, LLC, Thomson Reuters, April 8, 2016 The tax-equivalent yield advantage of munis is diminished A year ago, municipal high yields were equivalent, if not higher, than taxable high yields on an absolute basis. Since then, however, the markets have since disconnected, with energy wreaking havoc on the taxable high-yield market and shifting value toward taxable high yield. As such, municipal high yield is no longer flashing the strong buy signal relative to taxable alternatives (Exhibit 4).

3 Exhibit 4: Yields on high-yield munis have tightened considerably vs. high-yield corporates Source: Barclays Risk Analytics and Index Solutions, April 5, 2016 Time for a more conservative high-yield muni strategy Entering the seventh year of recovery from the great financial crisis, we think it may be time to consider a more conservative exposure to high-yield municipals. An improving economy tends to be good for high-yield credits as underlying revenues and fundamentals of much more economically sensitive projects improve. However, the opposite is also true. As the economy slows or enters a recession, economically sensitive municipal bonds such as toll roads, housing-related sectors and other project finances can come under pressure and cause credit spreads to widen. We still believe high-yield municipals are an attractive diversifier that can add yield in today s low-rate environment. While the next recession or major disruption in interest rate markets may not be imminent, several indicators lead us to believe that we are in the later stages of the current cycle. How long this stage lasts is up for debate, but it is probably time to consider dialing back the risk. A more conservative high-yield muni strategy (less interest rate exposure or leverage, ample liquidity and the flexibility to adjust the portfolio s credit quality) may be a better choice when it is unclear how close we are to running on empty. 1 Morgan Stanley Research, April 11, 2016

4 GLOBAL ASSET ALLOCATION UPDATE Get timely market insights and portfolio strategy ideas from our Global Asset Allocation Team. Please see our latest asset allocation positioning below and click here to subscribe to our Investment Strategy Outlook. Global Asset Allocation Outlook Global Asset Allocation Team

5 Equities: We continue to support a neutral weighting for equities. Our global equity scorecard argues that any expansion of risk should occur in non-u.s. equity markets, which remain well below last year s highs. We view the dynamic of a weaker U.S. dollar, recovering commodity prices and easing pressures on energy-related borrowers as a key reflationary factor, while the longevity of this virtuous circle remains the central issue for expanding equity risk more generally. Within equity allocation: We remain moderately overweight emerging market equities and moderately underweight U.S. equities. While the S&P 500 is near its all-time high, emerging market equities have been hurt over the last several years by a strong U.S. dollar, plunging commodity prices and fear of a slowing global economy. More recently, the dollar has stabilized and commodities have begun to recover, presenting a tactical entry point for emerging market equities. Recent outperformance due to the reflation dynamic referenced above has been trivial compared with trailing underperformance. This would suggest that scope remains for the gap to close further. While we do not emphasize regional preferences, we have upgraded small cap to neutral following prolonged underperformance, model upgrades and the possibility of an economic and earnings trough. Finally, a country-specific dislike of Canada has emerged from our analysis. Fixed income: Overall fixed income remains neutral. Recession risks in the U.S. have abated somewhat in recent months, while negative or very low yields are all we see across the globe. The overall duration framework remains negative, with duration performing poorly in the context of the reflation dynamic. To the extent that the weak dollar/strong commodity dynamic remains in place, we believe that easing duration might make sense. Within fixed-income allocation: With our high-yield model suggesting a positive carry environment, we remain modestly overweight high yield. Other spread sectors are similarly attractive, with investment grade offering better risk-adjusted return opportunities. We have moved investment grade to modest overweight and Treasuries to modest underweight. TIPS remain at modest overweight. Alternatives: We maintain our overall overweight for alternative investments based on the need for diversification to help ease the impact of volatile markets. Alternatives can also serve as a hedge against a renewed loss of diversification efficacy from bonds. Recent weakness in alternative beta performance is something that we are monitoring, but overall, expanding our diversifying components within portfolios remains one of our biggest priorities.

6 Source: Columbia Management Investment Advisers, LLC Past performance does not guarantee future results. It is not possible to invest directly in an index. DESCRIPTION OF INDICES The Barclays U.S. Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity. The Barclays U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued U.S. Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding. To qualify, bonds must be SECregistered. The BofA Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks. The Russell 1000 Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index measures the performance of those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index tracks the performance of those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. The MSCI EAFE Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed-market countries within Europe, Australia and the Far East. The MSCI EM Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value. Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Distributors, Inc., 225 Franklin Street, Boston, MA Columbia Management Investment Advisers, LLC. All rights reserved. columbiathreadneedle.com/us