William D. BlackManaging Director, Senior Portfolio Manager | 2019

Disciplined Research is Key to Helping Navigate the Current High Yield Municipal Market

High yield municipal bond impairments and defaults are rising YTD.

Late-cycle behavior necessitates prudent research analytics and security selection.

The CNR Municipal High Income Fund team anticipated current dynamics and we believe we are well-prepared ahead of the next downcycle.

The ongoing economic expansion improved the success of many high yield (HY) municipal bond issuers with core fundamentals supporting the prospects and performance of their associated projects. According to Municipal Market Analytics (MMA), a provider of impairment and default statistics, the year-over-year change in first-time payment disruptions reached a cyclical low during 2018 (Figure 1). However, the YTD data illustrates a noticeable uptick in issuers experiencing some level of distress that could portend a further rise in material credit events over the near-to-medium term. A recovery that has now become the longest on record, accompanied by strong market technicals, has helped to temper the underlying challenges surfacing in recently issued financings. As a result, we present a set of questions and answers to help stakeholders understand the current climate and how the CNR Municipal High Income Fund team philosophy and credit research process are deployed to potentially counter rising risks within the space and take advantage of market inefficiencies.

Why are high yield municipal bond defaults rising?

MMA reported 37 first-time issuer defaults through 3Q19, the most recorded in three years ex-Puerto Rico, and approximately a 20% increase year-over-year (Figure 1). Inclusive of defaults, the level of municipal impairments climbed 30% to 108 incidences through September 30, 2019 YTD (the most since 2015). Recent issuances (within the past three years) accounted for roughly 40% of the technical and monetary defaults. About half of impairments eventually transition into a monetary default, so the rise in impairments should mean defaults are likely to increase over the near-to-medium term, albeit from a low base of current activity.

As of September 30, 2019, HY municipal bonds offered roughly 220 bps of incremental yield over their investment-grade brethren, which hovered near the smallest spread in a decade (Figure 2). The desire for above-market income coupled with tight supply and overwhelming demand for HY municipal bonds (as measured by net capital flows) have fueled highly speculative financings with relaxed covenants and weaker security packages, which narrows the headroom an investor has to intervene when the issuer confronts challenges. Unproven technologies (e.g., a plant that converts plastic waste into fuel) or questionable real estate investments financed over the past two to three years represent some of the deal types approaching their operational phase, with numerous financings meeting the end of capitalized interest (bond proceeds used to make interest payments during project construction) and experiencing episodes of covenant violations. One cautionary observation is the time to default. In 2018, risky sectors, such as industrial development, took about eight months to transition from the initial reporting of trouble to a default, versus ten months in 2017, and 23 months more than five years ago, according to MMA.

If current trends persist, what do they mean for investors?

Avoiding credit “potholes” requires rigorous discipline consistently applied throughout a business cycle (Figure 3). Unfortunately, for those investors that failed to apply extreme care with speculative deals marketed into the tight, covenant-light environment, they will find it difficult to recover when the number of impaired credits increases (such as now) and confidence begins to erode. Thorough research and analytics are a laborious undertaking that the CNR Municipal High Income Fund team embraces as a part of its overall portfolio management and security selection framework. The research staff conducts site visits, meets with management, seeks, and in some circumstances, negotiates “bondholder friendly” protections, such as real estate collateral, and meticulously examines the economic viability of the particular project. Ongoing surveillance is a vital component of the operation that effectively reaffirms our forward-looking view of credit and suitability within the portfolio as well as performance attribution. We expect that not “relaxing our credit guard” will reward our fund’s investors over time.

How is the CNR Municipal High Income Fund team positioning its portfolio in the current environment?

The uptick in distressed credits is not a surprise to the CNR Municipal High Income Fund team. The implementation of defensive measures, such as less “risky” sector/security allocation, maintaining credit protections, and raising the overall quality of the portfolio, we believe will serve the fund’s shareholders well during periods of economic and market weakness. Recent trends also suggest opportunities could surface if investor fears lead to softened demand and destabilized liquidity, and fundamentally sound credits become available with favorable risk/return dynamics.

Key Points:

High yield municipal bond impairments and defaults are rising YTD.

Late-cycle behavior necessitates prudent research analytics and security selection.

The CNR Municipal High Income Fund team anticipated current dynamics and we believe we are well-prepared ahead of the next downcycle.

Definitions and Disclosures

Index Definitions

Bloomberg Barclays High Yield Municipal Bond Index (barhiym) is an unmanaged index considered representative of non-investment-grade bonds.

Bloomberg Barclays Municipal Bond Index (lehmunlt) is a market-value weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least 1 year from their maturity date.

MMA defines [monetary] default as a full or partial missed payment of scheduled principal and/or interest to bondholders, even when bondholders agree to, or direct, non-payment.

An impairment is a catch-all term that includes monetary default and other types of events, such as draws on reserve funds or claims under a bond insurance policy to pay debt service, and covenant violations (i.e., failure to comply with terms or conditions of a bond agreement).

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.

There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities which are usually called “high-yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

This material must be preceded or accompanied by a current summary or full prospectus. Investors should read it carefully before investing or sending money.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible.

Investing involves risk including loss of principal. Bonds and bond funds are subject to interest rate risks and will decline in value as interest rates rise. Investing in securities that are not investment grade offers a higher yield but also carries a greater degree of risk of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. No investment strategy can guarantee a profit or protect against loss in periods of declining values. There is no guarantee that the Fund’s income will be exempt from federal or state income taxes. Capital gains, if any, are subject to capital gains tax. Income from municipal bonds may be subject to the alternative minimum tax.

City National Rochdale Funds are distributed by SEI Investments Distribution Co., which is not affiliated with City National Bank or any subsidiary or affiliate.

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