Municipal Bond Yield Ratios and Credit Market Commentary

Exhibit 83: Ratio of Municipal Bond Yields to Treasury Yields Current municipal bond yields offer a larger valuation buffer to absorb risks than in the past. Ratio (%) 100 mCurrent mAverage Since 2000 Average Since 1987 95 93 5-Year Ratio 10-Year Ratio Data as of December 31, 2016. Source: Investment Strategy Group, Bloomberg, Thomson MMD. Exhibit 84: Municipal Issuer Rating Changes Stable revenue and spending discipline have led to recent issuer rating upgrades. Share of Rating Changes (%) mUpgrades m Downgrades 100 - 90 5 80 - 49 Re) 49 5 re 56 56 54 a 60 5 50 4 40 4 30 4 ° 61 Gil = au 20 + 44 44 46 10 5 a 4 3014 4ai4 1015 2015 3015 4015 1016 2016 3016 Data as of 03 2016. Source: Investment Strategy Group, Moody’s. benchmark duration. Given their important portfolio hedging characteristics, municipal bonds should remain the bedrock of the “sleep-well” portion of a US-based client’s portfolio. The same can be said for high yield municipal bonds. Despite their almost 10-year duration, these bonds currently offer attractive spreads of close to 3%, a level that has been higher only 29% of the time since 2000. This spread provides a substantial buffer that could partially offset higher Treasury yields, enabling the high yield municipal market to deliver positive returns of around 4% in our base case. Therefore, we recommend clients stay invested at their customized strategic weight. US Corporate High Yield Credit Even for the bullish among us, last year’s 17% total return in corporate high yield was surprisingly strong. Not only was it the largest gain within US fixed income, but it also ranked among While there is clearly no shortage of risks, the silver lining to last year’s rout in municipal bonds ts that we begin 2017 with a much larger valuation buffer to help absorb them. the top annual returns of all time for the asset class. What makes this performance even more impressive is that high yield was down about 5% at its worst point in early 2016. But these sizable gains have come at a cost. Spreads—which compensate investors for the risk of default losses—now stand well below their long- term average. In fact, the level of spreads has been lower only a third of the time in the last 30 years. Moreover, yields have fallen from above 10% early last year to less than 7% now, diminishing the allure of these bonds to investors searching for high returns. Even so, we think the strong fundamentals underpinning the asset class still warrant an overweight, though returns are almost certain to be more modest going forward. At the heart of this stance is our benign view on default losses, which are the primary risk to high yield investors. Here, several factors support our below-historical- average 2.5% par-weighted default forecast for 2017. First, high yield firms stand to benefit directly from the strengthening US economy we expect this year, considering almost three-quarters of their sales originate domestically.’** Second, leading indicators of defaults—such as Moody’s liquidity and covenant stress indexes— are trending downward, suggesting fewer speculative-grade companies are Outlook | Investment Strategy Group 69 HOUSE_OVERSIGHT_014602