DWS Strategic High Yield Tax Free Fund
US > Non-Investment Grade >
Jan 19, 2010
52 Week HL
41.56 - $29.62
Dec 12, 2000
Q: What is the objective of the fund?
A : We seek to provide a high level of income exempt from regular federal income tax. The fund’s management team invests with an emphasis on value. We strategically increase or decrease our credit exposure as yield spreads change.
Q: How do you apply your strategies to achieve this objective?
A : What makes us a strategic fund rather than a typical high yield municipal fund is that we reduce, or stop adding to our risk profile when there is very little return for the imbedded risk. On the other hand, when risk premiums are historically fair value to wide, we will add to our high yield exposure.
Q: What is the size of this tax-free high yield market and how does the credit spread change between the up and the down periods?
A : We estimate the size of the high yield market to be about 8% of the total $2.7 trillion municipal market. It is a much smaller than the taxable high yield bond market and most below investment grade municipal bonds do not have ratings. Because of its size and lack of ratings, it is also prone to trade to the extremes. Our base level for high yield spreads considers the difference between BBB hospital yields over AAA rated credits. This averages about 125 basis points. When the financial markets collapsed in 2008, this number was around 400 basis points. The spread was much narrower at 50 basis points during the boom period 2006 and 2007, when tax exempt high yield funds were overflowing with cash. The current range is 200 to 225 basis points for BBB hospital credits.
Q: Who issues these high yield municipal bonds and why are they not rated?
A : They are issued by a broad spectrum of entities, not necessarily cities or states.
For example, high yield municipal bonds are issued to develop senior living centers, build airports, put in infrastructure for home, office or retail developments, build toll roads, hotels, or charter schools. Other examples would be, airlines financing improvements at airports or infrastructure projects for Native American tribes backed by casino revenue. Also, there are a number of hospital and college projects that fall into the high yield category due to their weaker credit quality. If the projects or facilities fail to earn enough money to pay debt service or repay the debt, there is no obligation for the city or state to pay the investors.
The fact that they are typically not-rated is just a convention in the market because many of the deals are never very large and investors don’t demand ratings.
Q: How do you screen your investment universe?
A : We look for markets that have the best relative value and for investments that offer the optimal credit, structure and curve position within that market.
We differentiate ourselves by comparing the value of high yield bonds versus investment grade, because there are times when these municipal markets have very narrow credit spread differentials. When those spreads are narrow, then the high yield bonds are overvalued. Even though this is a high yield municipal bond fund, we will not blindly buy high yield bonds for incremental yield if the spreads don’t justify it. This was one of the reasons that funds who pursued a yield driven investment strategy were 40% to 50% down in 2008.
Q: What has been the activity of these issuers in recent months?
A : From September 2008 through September 2009 there were only a handful of high yield deals that came to market due to lack of market access. However, during the 4th quarter of 2009, there have been a number of new deals coming to market. Investor demand is picking up, recognizing the opportunistic value of high yield municipals.
Q: What is your research process?
A : We have four research analysts who specialize in different sectors of the municipal market. Every purchase in the high yield fund is subject to our rigorous research process, including credit analysis, indenture analysis, and a discussion of liquidity and price. Credit analysis involves the review of: historical financials and operating ratios; market position; management; and disclosure. Indenture analysis incorporates: source of security; use of proceeds; redemption provisions; flow of funds; and covenants.
Q: What are some of the larger sector holdings in your fund and what is the analytical process in selecting them?
A : We have over 20% of our holdings in hospital revenue bonds. Our analyst spends a great deal of time looking at the respective service areas, the management of the hospitals, the strength of the local economy and the hospitals position vis-à-vis its competition. Given the attractive spreads and few credit problems, this sector has historically been the largest in the fund.
Tobacco and airline sectors are highly volatile, so we keep a modest weighting in those credits. These sectors swing so broadly that their returns have an outsized weighting on the high yield index returns both positive and negative.
Q: Why are development bonds and start-ups less represented in the fund?
A : These bonds are issued to finance a stand alone project that has no other backing than the project itself. These bonds have very high risk characteristics and we are very selective when buying one of these projects.
Q: What is your buy discipline?
A : As we discussed earlier, there are many factors that go into selecting a bond for purchase. From a structure perspective: when considering an investment grade purchase, we will look for a bond with a maturity that we think is attractive given the steepness/flatness of the municipal yield curve. Call protection and coupon structure are very important to us as well. Ideally, we prefer 10 year call protection and a premium price to that call for better convexity. However, for high yield issues, the bonds are typically sold as 30 year par bonds with 5 to 10 year calls. We avoid bonds priced with a call shorter than 10 years as we try to lock in the income for as long as possible. From a credit perspective: as we discussed in our research process, there are many levels of analysis we do on every credit. From a relative value selection: we compare spreads with all levels of credit quality to determine if the price/spread reflects the risk imbedded in the bond.
Q: How do you structure the portfolio?
A : Construction of the portfolio is very important. We have a well diversified broad based spectrum of securities from high yield to investment grade bonds. Each bond was selected for its’ adherence to our buy discipline process. Strategically, we add high yield bonds to the portfolio when credit spreads are fair value to wide and reduce our exposure to high yield when those spreads are historically narrow. This is an important discipline for managing overall risk in the portfolio.
Q: What is your benchmark index?
A : Our benchmark is the Barclay’s Capital Municipal Bond Index. We also track a combined benchmark, a mixture of the Barclay’s Capital Municipal Bond Index as well as the Barclay’s Capital Municipal High Yield Index.
Q: What is your risk control at the portfolio level?
A : We manage our duration to our benchmark to remain neutral. We do not place bets on duration or interest rate calls.
We select our investments based on yield curve, structure and credit. When credit spreads are narrow, we will invest in higher quality bonds. When spreads are fair value to wide we will turn our investments toward high yield, lower rated bonds.