High Yield Municipal Bonds Limitations of Benchmarks and Practical Applications of the Peer Group

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1 Wasmer, Schroeder & Company High Yield Municipal Bonds Limitations of Benchmarks and Practical Applications of the Peer Group The composition of the below investment grade municipal bond market poses interesting challenges for investors seeking to understand the role that high yield munis can play within an asset allocation strategy. Due to concentrated sector weightings and index inclusion criteria, the usefulness of industry standard indices like the Barclays Capital Municipal High Yield Index is compromised from a performance benchmarking standpoint. This is particularly true for investors that have a preference for passive, or indexed, exposure to an asset class within their portfolio. In this report, we discuss the characteristics of the high yield municipal market, the problems inherent with the benchmark and ways in which the mutual fund peer group can be utilized as a substitute, or supplemental benchmarking tool. JASON DIEFENTHALER Senior Vice President, High Yield Portfolio Manager Index Construction The Barclays Municipal High Yield Index (the Index ) is the most commonly used index by investors and fund managers seeking to establish a benchmark for this sector. The inclusion criteria for the Index stipulates that bonds must be non-rated or be rated Ba1 or below, they must have an outstanding par value of at least $3 million, they must have been issued as part of a transaction of at least $20 million and they must be at least one year from their maturity date. Table 1: Sector Weightings Inv. Grade Municipal Index Municipal High Yield Index General Obligation 27.8% 10.5% Pre-Refunded 4.5% 0.0% Electric 6.2% 3.4% Hospital 8.7% 18.5% Housing 1.2% 1.1% IDR/PCR 2.5% 11.5% Transportation 15.8% 3.2% Education 7.2% 4.8% Water & Sewer 8.5% 6.7% Leasing 6.5% 3.9% Special Tax 10.4% 18.1% Tobacco 0.7% 18.3% Source: BarclaysLive.com; data presented as of 8/31/2014 This inclusion criteria narrows the scope of the Index down to 3,379 individual issues with a market value of $93.7 billion, which is less than half the size of the investment grade Barclays New York Municipal Bond Index. If we consider the benchmark to be representative of the high yield municipal bond investable universe, then it would be fair to say that the market is relatively small compared with other asset classes. How does this compare with the $1.314 trillion Barclays Investment Grade Municipal Bond Index? The results, detailed in Table 1, paint a stark contrast between the sectors that comprise the Investment Grade Index and the High Yield Index. October

2 Sector & State Weighting The differences between the Investment Grade Index and the High Yield Index become quite apparent when viewed side by side. The Investment Grade Index, for example, is more populated with what are historically considered to be traditional sectors of the tax exempt bond Table 2: States/Territories Inv. Grade Municipal Index Municipal High Yield Index Puerto Rico 1 0.7% 31.9% All Others 99.3% 69.1% Source: BarclaysLive.com; data presented as of 8/31/2014 market, such as general obligation bonds, transportation issuers, electric utilities, school districts and water & sewer systems. The High Yield Index exhibits significantly higher concentrations in the riskier sectors of the market, including hospitals, project finance deals, corporate-backed bonds and tobacco securitizations. Perhaps the most glaring limitation of the High Yield Index s usefulness as a portfolio benchmark is its exposure to issuers connected with the Commonwealth of Puerto Rico. In February and March of 2014, Puerto Rico s general obligation rating, and various linked ratings of the Commonwealth s public corporations (PREPA, PRASA, PRHTA, etc.), were downgraded to below investment grade. This resulted in a significant migration of securities out of the Investment Grade Index and into the High Yield Index, and established Puerto Rico as the single largest issuer in the high yield benchmark. 80% HEALTHCARE, TOBACCO& PUERTO RICO Representation in Barclays Municipal High Yield Index Source: BarclaysLive.com 70% 60% 50% 40% Hospital% Tobacco% PuertoRico% Rating agenciesmass downgrade the Tobacco sector to below investment grade Rating agenciesdowngrade Puerto Rico General Obligation and Public Corporations to below investment grade 30% 20% 10% 0% Due to the concentration issues outlined above, investors, portfolio managers and asset allocators using the Barclays Municipal High Yield Index as a benchmark are faced with a fundamental question about the relevance of the Index. There are few, if any, separate account or mutual fund managers that offer an investment strategy allocating 70% of its assets to Puerto Rico credits, healthcare issuers 1 Puerto Rico is presented as a consolidated issuer in the table; there is a degree of overlap between the sector and Puerto Rico weightings, however, the majority is in the General Obligation, Water & Sewer, Electric and Transportation sectors. 2

3 and tobacco securitizations. From a performance standpoint, problems with tracking error versus a benchmark such as the Municipal High Yield Index are a permanent obstacle, particularly considering that the highest beta sectors have by far the largest weightings. This all boils down to a fundamental and overriding limitation associated with almost all major fixed income benchmarks: it is effectively impossible to buy a bond index. These indices represent useful constructs to understand the composition of an asset class, however they often fall short in terms of relevant performance measurements across investment vehicles such as separately managed accounts or mutual funds. High Yield Municipal Bond Funds as a Benchmark Surrogate Understanding the limitations of the Municipal High Yield Index (and fixed income indices, in general) creates an opportunity to explore other options for benchmarking performance within the asset class. One way to solve the conundrum of using a benchmark that is not practically replicable within an actual managed strategy is to use a pool of professionally managed strategies in its place. This approach eliminates the fundamental problem of not being able to buy the Index while also normalizing the sector and state/territory concentrations to reflect the market s opinion of acceptable exposure limits. Table 3: 20 Largest High Yield Municipal Bond Funds by Assets Under Management Fund AUM (Bn) 2 Tobacco Healthcare Puerto Rico MAD 3 Fund 1 $9, % 13.0% 0.0% 8.7 Fund 2 $8, % 18.5% 6.2% 8.5 Fund 3 $7, % 32.9% 1.8% 8.8 Fund 4 $5, % 11.8% 14.3% 10.1 Fund 5 $3, % 16.8% 18.1% 4.7 Fund 6 $3, % 26.9% 8.7% 9.5 Fund 7 $3, % 29.7% 0.9% 8.8 Fund 8 $3, % 28.0% 3.3% 8.1 Fund 9 $2, % 27.6% 0.8% 8.1 Fund 10 $1, % 12.8% 13.6% 9.7 Fund 11 $1, % 22.8% 0.1% 5.1 Fund 12 $1, % 24.9% 8.8% 8.3 Fund 13 $1, % 30.6% 5.0% 7.7 Fund 14 $1, % 29.2% 0.2% 9.6 Fund 15 $1, % 13.8% 10.6% 9.8 Morningstar, one of the industry s leading Fund 16 $1, % 28.0% 6.7% 8.7 investment research providers, lists 44 Fund 17 $1, % 28.2% 3.9% 9.1 individual high yield mutual funds 2 within Fund 18 their manager database. The combined Fund 19 assets under management of these funds Fund 20 is approximately $ billion, roughly 75% of the size of the Barclays Municipal High Yield Index. There is a relatively concentrated distribution of assets with $968.4 $812.7 $ % 3.8% 0.0% 29.0% 26.8% 23.8% 1.5% 2.8% 0.0% this fund sector, with the top 20 funds by size representing roughly 90% of the assets in the category. Peer Group Weighted Avg: 8.5% 23.3% 5.5% 8.4 Yrs Barclays Muni HY Index: 18.3% 18.5% 31.9% 10.4 Yrs Source: Morningstar, Bloomberg; data presented as of 8/31/2014 Using these top 20 high yield mutual funds as a control group for creating an asset-weighted benchmark yields interesting results. For example, the Big 3 sectors (Tobacco, Healthcare & Puerto Rico) that comprise approximately 70% of the Barclays Municipal High Yield Index represent just 38% of the assets held within the top 20 high yield municipal bond mutual funds. Using these funds as a performance benchmark for other managed strategies within the space limits the impact of tracking error associated with the Barclays Municipal High Yield Index. The Tobacco and Puerto Rico sectors have historically exhibited periods of significant price volatility that have 2 Includes only A shares where multiple share classes are available. 3 MAD = Modified Adjusted Duration 3

4 materially impacted the returns produced by the Barclays Municipal High Yield Index. During 2008, for example, the Tobacco component of the Municipal High Yield Index was down 69.5% for the year from a total return standpoint; during 2009, it was up 143.7%. Although not quite as extreme, Puerto Rico credits have also exhibited significant price volatility over the last 12 months. The fact that the Big 3 sectors command almost twice as much exposure within the benchmark as they do within the mutual funds that use that benchmark creates problems with both performance attribution and relevance. As Table 4 indicates, the top 20 mutual fund peer group has maintained a consistent correlation to the Municipal High Yield Index over the 10-, 5-, 3- and 1- year periods ending 8/31/2014. The peer group s beta vs. the Index, however, has fallen as the higher volatility Tobacco and Puerto Rico sectors have grown in size. This table describes the delinking of peer group and other sub-sector returns to overall Index performance due to the outsized presence of the more volatile Tobacco and Puerto Rico exposures; while correlations remain strong, the peer group will exhibit a tendency to underperform the Index during periods of strong performance, and outperform during periods of weakness. The data would suggest this is a linear, persistent relationship, which in our opinion, is another example of the limitations posed by the benchmark when used to assess the quality of managed returns. Conclusion Table 4: Sector and Peer Group Performance vs. the Barclay Muni HY Index Beta Tobacco Puerto Rico Healthcare Peer Group 4 10-Year Year Year Year Correlation Tobacco Puerto Rico Healthcare Peer Group 4 10-Year Year Year Year St. Deviation Tobacco Puerto Rico Healthcare Peer Group 4 10-Year 9.10% 3.44% 2.16% 2.35% 5-Year 6.21% 3.97% 1.51% 1.93% 3-Year 3.27% 4.22% 1.24% 1.85% 1-Year 2.93% 4.42% 0.87% 1.67% Source: Morningstar, BarclaysLive.com; data presented as of 8/31/2014 This paper is not meant to serve as a solution to the question of what is the most appropriate benchmark for a high yield municipal bond strategy. Rather, the goal is to simply highlight an often overlooked aspect of this asset class most standard performance measurement tool, and to elicit further thought about the relevance of its most widely used benchmark. Based on the results of our analysis, our conclusion is that a basket of high yield municipal bond mutual funds can be utilized to develop a relevant, investible benchmark that limits the impact of the largest and most volatile sectors of the market. For investors, fund managers and asset allocators, the use of a peer group benchmark can be an effective performance measurement tool in the high yield municipal bond market. 4 Results are calculated from monthly, net of fee s returns 4

5 Disclosure: The material provided is for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities. The statements contained herein are based upon the opinions of Wasmer, Schroeder & Company, Inc. (WSC), the data available at the time of the presentation which may be subject to change depending on current market conditions. This presentation does not purport to be a complete overview of the topic stated, nor is it intended to be a complete discussion or analysis of the topic or securities discussed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. WSC does not accept any liability for any loss or damage arising out of the use of all or any part of this presentation. This report should not be regarded by recipients as a substitute for the exercise of their own judgment and may contain numerous assumptions. Different assumptions could result in materially different outcomes. Please contact Wasmer, Schroeder & Company for more complete information, including the implications and appropriateness of the strategy or securities discussed herein for any particular portfolio or client. About the Firm: : Wasmer, Schroeder & Company is an independent and employee-owned investment advisor, specializing in fixed income separate account portfolio management for high net worth individuals, wealth management groups and institutions, including foundations, endowments and retirement plans, WSC has $4.76 billion in assets under management, as of 6/30/14. The Firm works with clients and their advisors to provide taxable and tax exempt fixed income portfolio solutions to meet their needs. Firm s corporate headquarters are in Naples, Florida, where the tax exempt Portfolio Management team, Client Services, Operations, IT, Accounting, Compliance, Marketing and Administration reside; our taxable Portfolio Management team is located in Cleveland, Ohio; Client Relationship offices are located in Exton (Philadelphia area), Pennsylvania and Portland, Oregon. 5