Municipal Fixed Income

Transcription

1 Municipal Fixed Income 3Q 2016 QUARTERLY MARKET REVIEW Robert Collins Head of Municipal Fixed Income MUNICIPAL RESEARCH Stephen Winterstein Managing Director & Chief Municipal Strategist Gerard Durr Senior Research Analyst Ted Molin Senior Research Analyst Karleen Strayer Senior Research Analyst Clyde Lane Research Analyst Robert Tice Research Analyst PORTFOLIO MGMT & TRADING Rebecca Rogers Director of Trading & Portfolio Management John Malloy Senior Portfolio Manager Maureen Lawrence Senior Trader Please direct comments or questions to: Leslie Varrelman Fixed Income Product Specialist Roll, roll, roll your note Gently down the curve Stephen Winterstein, Managing Director & Chief Municipal Strategist As a result of money market reform mandated by the SEC which took effect on October 14, there has been a significant change in the interest rates offered by short-term tax-exempt variable rate demand notes (VRDNs). Now that yields on these short-term rates have spiked, investors who wish to maintain liquidity in tax-exempt instruments may want to consider retaining and rolling these notes, rather than exercising the put option. Historically, the net asset values (NAVs) for SEC-registered money market funds were set at $1.00. Beginning October 14, institutional tax-exempt municipal money market funds converted to a floating NAV. Also, retail tax-exempt municipal money market funds have become subject to the potential for gates and redemption fees. These provisions have resulted in many custodians jettisoning either the institutional or the retail municipal money market funds as cash sweep vehicles. As this shift has been occurring, significant amounts of capital have exited these funds. According to Bloomberg, year to date through September 30, over $100 billion has left municipal money market funds. This dramatic change in demand versus supply has disrupted the market for the very shortest municipal notes specifically, overnight VRDNs, which comprised a significant portion of municipal money market funds. A VRDN is a bond with floating coupon payments that are adjusted at specific intervals. The bond is payable to the bondholder upon demand following an interest rate change. Generally, the benchmark used to set the daily VRDN rate is the SIFMA Municipal Swap Index, which is reset weekly. Its yield has been under 0.20% for almost all of the last five years, and, with a few brief exceptions, has been under 0.10% since mid Wilmington Trust Corporation and its affiliates. All rights reserved. page 1 of 13

2 figure 1 SIFMA Municipal Swap Index historical yields Yield 0.9% 0.8% 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0% Sources: Wilmington Trust Investment Advisors, Inc. Municipal Fixed Income; Standard & Poor s Securities Evaluations, Inc.; Investortools, Inc Wilmington Trust Investment Advisors, Inc., SIFMA (Figure 1). Beginning in March 2016, this index started to increase (up to a 0.30% to 0.40% range) and those increases accelerated over the last several weeks. As of September 28, the index reset at 0.84%, its highest level since December For the sake of clarity, it is important to make a distinction between VRDNs and auction rate securities (ARS). Unlike ARS, VRDNs are money-market eligible (i.e., securities that money market funds are permitted to purchase and own). The difference is that the liquidity feature for VRDNs is delivered via a tender, or demand, option the fund can tender the position pursuant to the provisions within the issue documents. The liquidity is not dependent upon clearing the market in a successful auction. In , the market turmoil caused many of these auctions to fail, leaving the ARS holders without a valid liquidity feature. The yield curve High-grade tax-exempt municipal yields moved higher across the term structure over the past quarter, as the S&P AAA Municipal Yield Curve increased by 24 basis points, or bps (0.24%), at the 1-year maturity, and by 21bps at the 3-year point (Figures 2 and 3). The 5- and 7-year spots shifted higher by 11 and 8bps, respectively, while the 10-year rose by 14bps. In similar fashion, the 15-year maturity was weaker by 24bps, as the 30-year climbed 28bps to end the quarter, drawing a yield of 2.30% and steepening the curve by 4bps, front to back. Looking at Figure 3, the 4-year maturity marks the crossover point where shorter-termed yields are higher than they were one year ago, and all yields beyond the 4-year are lower. In part, the move upward at shorter maturities can be attributed to the dramatic change in money market regulations highlighted in the previous section. On the other hand, the voracious global appetite for positive yield has kept the curve materially lower in the intermediate part of the curve and out to the long end. While supply is slightly heavier year over year through the end of 3Q, investors have been able to easily absorb the amplified new issuance. As the AAA curve progressed upward over the past 90 days, the spread between the yield on the S&P High Yield Index and the Investment Grade Index narrowed to 309bps on September 30, from 391bps on June 30 (Figure 4). Upon closer examination, this tightening of yield spread of these two published S&P indices is somewhat distorted. On July 1, Puerto Rico defaulted 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 2 of 13

3 figure 2 S&P s AAA municipal yeld curve: recent trends (as of September 30, 2016) Previous Previous Previous Maturity Current quarter-end year-end 1-year Change for the period 9/30/16 6/30/16 12/31/15 9/30/15 Quarter YTD 1 year 1-year 0.79% 0.55% 0.51% 0.27% 0.24% 0.28% 0.52% 3-year 0.88% 0.67% 1.01% 0.81% 0.21% 0.13% 0.07% 5-year 1.02% 0.91% 1.26% 1.28% 0.11% 0.24% 0.26% 7-year 1.19% 1.11% 1.55% 1.68% 0.08% 0.36% 0.49% 10-year 1.51% 1.37% 1.94% 2.04% 0.14% 0.43% 0.53% 15-year 1.90% 1.66% 2.28% 2.53% 0.24% 0.38% 0.63% 30-year 2.30% 2.02% 2.81% 3.04% 0.28% 0.51% 0.74% 1yr 30-yr slope 1.51% 1.47% 2.30% 2.77% 0.04% 0.79% 1.26% Source: WTIA Municipal Fixed Income, Standard & Poor s Securities Evaluations, Inc., Investortools, Inc. figure 3 S&P AAA municipal yield curve: year-over-year comparison Yield 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Maturity (in years) 9/30/16 6/30/16 9/30/15 Source: WTIA Municipal Fixed Income, Standard & Poor s Securities Evaluations, Inc., Investortools, Inc.. on its general obligation debt, which comprised almost 6.50% of the High Yield Index. Once the commonwealth defaulted, the yields on those bonds went to zero percent. By July 31, the closing yield on the High Yield Index was 4.748%, down 64bps from the June closing yield of 5.394%. Beginning in February 2016, S&P began to publish the S&P High Yield Ex-Puerto Rico Index (not pictured). That benchmark drew a yield of 4.078% on June 30, By July s close, that same index was yielding 4.062%; a narrowing of over 1bp. Put another way, the spread between the S&P High Yield Index and the Investment Grade Index narrowed by 82bps during 3Q2016. The spread between the S&P High Yield Ex-Puerto Rico Index and the Investment Grade Index narrowed by only 15bps; the difference largely being the defaulted Puerto Rico GO bonds being reset to a 0.000% yield Wilmington Trust Corporation and its affiliates. All rights reserved. page 3 of 13

4 figure 4 High Yield vs. Investment Grade Indices: month-end historical yields and spread Yield 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Spread Investment Grade Index High Yield Index Spread (bps) right scale Sources: Wilmington Trust Investment Advisors, Inc.; S&P Dow Jones Indices, LLC.; Investortools, Inc. figure 5 S&P AAA municipal-to-u.s. Treasury ratios Most recent Previous quarter-end Previous year-end Previous 1-year Maturity 9/30/2016 6/30/ /31/2015 9/30/ % % 75.30% % % 90.28% 71.51% 93.64% % 92.44% 85.43% 99.66% % 88.09% 93.20% % Source: WTIA Municipal Fixed Income, Standard & Poor s Securities Evaluations, Inc., Investortools, Inc. Municipal yields relative to U.S. Treasury yields Tax-exempt municipal bonds mostly underperformed U.S. Treasury bonds over the past three months, as the 10-year S&P AAA-rated municipal-to-u.s. Treasury quotient moved higher by ratios to %, from % (Figures 5 and 6). In a more pronounced swing, the 30-year ratio went from % on June 30 to % by the end of 3Q. Bucking that tendency was the 5-year AAA municipal-to-u.s. Treasury relationship. The close of 2Q saw the 5-year print a % ratio, but municipal bonds outperformed their U.S. Treasury counterparts at that tenor, ending 3Q at %. We have noted in previous publications that the 1-year ratio provides less insight, as the low absolute level of yields of shorter maturites distort that relationship with only minor movements by either the municipal yield or the U.S. Treasury yield. We do, however, note that with the evolution of tax-exempt municipal money market regulation, short-termed instruments have gapped up in yield, driving that ratio to % on September 30. With rising tax-exempt municipal bond yields, the S&P Municipal Bond Index manufactured its first negative performance since June With an effective duration 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 4 of 13

5 figure 6 S&P AAA municipal-to-u.s. Treasury ratios Ratio 150% 130% 110% 90% 70%... 50% S&P 1-Year AAA municipal-to-u.s. Treasury ratios S&P 10-Year AAA municipal-to-u.s. Treasury ratios S&P 5-Year AAA municipal-to-u.s. Treasury ratios S&P 30-Year AAA municipal-to-u.s. Treasury ratios Sources: Wilmington Trust Investment Advisors, Inc.; S&P Dow Jones Indices, LLC.; Investortools, Inc. figure 7 Selected S&P municipal bond index totals and averages (as of September 30, 2016) T O T A L R E T U R N S V O L A T I L I T Y Number Market Coupon Yield Maturity Maturity Priced to Priced to Effective of holdings value ($B) to worst (in years) date date (yrs) duration 93,877 $1, /9/ /16/ Investment Grade Intermediate Short Intermediate Short High Yield California Index 88,232 $1, /1/ /27/ ,814 $ /16/ /15/ ,552 $ /26/ /23/ ,771 $ /28/ /30/ ,645 $ /13/ /29/ ,913 $ /18/ /24/ ,240 $ /15/ /16/ New York Index Index calculations by Investortools Custom Index Manager. Sources: Wilmington Trust Investment Advisors, 622 Inc. Municipal $31.04 Fixed Income; S&P Dow Jones Indices, LLC.; 1/31/2035 Investortools, Inc. 11/14/ Puerto Rico Index Past performance is no guarantee of future results. Investing involves risks and you may incur a profit or a loss. Source: Wilmington Trust Investment Advisors, Inc., Investortools, Inc., S&P Dow Jones Indices LLC Index calculations by Investortools, Inc. Custom Index Manager 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 5 of 13

6 figure 8 Selected S&P municipal bond index total returns (period ending September 30, 2016) T O T A L R E T U R N S V O L A T I L I T Y Yield Effective 3-month YTD 1-year 5-year 10-year 5-year to worst duration Investment Grade Intermediate Short Intermediate Short High Yield California Index New York Index Puerto Rico Index 0.14% 4.21% 5.84% 4.66% 4.68% 3.357% 1.90% % 3.82% 5.42% 4.43% 4.63% 3.307% 1.68% % 3.80% 5.22% 4.13% 4.89% 2.975% 1.69% % 2.05% 2.57% 2.34% 3.62% 1.621% 1.26% % 1.00% 1.00% 1.14% 2.49% 0.628% 1.07% % 9.49% 11.48% 8.19% 5.27% 5.102% 4.77% % 4.20% 6.03% 5.56% 5.05% 3.643% 1.68% % 3.94% 5.61% 4.47% 4.68% 3.115% 1.63% % 13.42% 13.22% 0.57% 1.75% % 6.62% 9.97 Investing involves risks and you may incur a profit or a loss. Past performance is no guarantee of future results. Source: Wilmington Trust Investment Advisors, Inc., Investortools, Inc., S&P Dow Jones Indices LLC Index calculations by Investortools, Inc. Custom Index Manager of years, that broad-market index generated 0.136% for the three months ending September 30 (Figures 7 and 8). Looking at rolling 3-month returns rather than calendar quarters, beginning in January 1999, the Index had 211 such period returns. Of those, only 49 3-month periods produced negative returns, the worst occuring in November 2008 directly in the eye of the credit hurricane at a 6.711%. In fact, the average negative return since inception was 1.607%, so the most recent print is rather benign. The Intermediate Index followed suit for the quarter, producing %, while the Short Intermediate Index manufactured %. Worth noting is the Short Index s 0.118% return for 3Q2016. That benchmark contains all bonds in the S&P Municipal Bond Index that mature between 6 months and years, and has an average effective duration of years. Because of the dislocation in tax-exempt municipal money market fund supply and demand, and the subsequent dramatic rise in short-term yields relative to the more moderate increase in intermediate and long-term rates, the Short Index actually underperformed the Intermediate Index. The S&P Municipal High Yield Index delivered a total return of % for 3Q, while Puerto Rico printed an outsized % for the same period. As of September 30, the Puerto Rico Index has produced % year to date Wilmington Trust Corporation and its affiliates. All rights reserved. page 6 of 13

7 Public pension debt counts, but can it be accurately counted? Robert Collins Head of Municipal Fixed Income Albert Einstein is reported to have said, Not everything that can be counted counts, and not everything that counts can be counted. Clever enough, but clearly he did not contemplate public pension accounting in the 21st century. Otherwise, we would have added that some things that count and can be counted, can be counted multiple ways. The pension debacles of some states, Illinois and New Jersey immediately come to mind, have been prime fodder for headlines and it is unlikely the focus on the underfunding practices will lessen anytime soon. Poor fiscal decisions, combined with a regulatory drive toward more realistic return expectations, will likely result in more bad news and more headlines. In this commentary, we will review some of the root causes of the problems today, and some of the regulatory changes that could make the situation even worse than it is with current reporting standards. However, we want to be clear up front while underfunding of public pensions is a credit concern, it is not universal across states and municipalities. There are many fiscally responsible municipal obligors and, through diligent research, investors can channel their investment focus toward issuers with less relative pension risk. Underfunding How did we get here in the first place? The long-term nature of the obligation is inherently a bad fit with short-term political tenures. State and local governments negotiate with unions to curb current salary costs in exchange for enhanced pension benefits to accrue over the next 40 to 50 years. Clearly, this behooves today s government officials whose term of office will be long over before the cost of those higher benefits impacts state and city coffers. This of course oversimplifies the matter, but the point is accurate. Part of what we are paying for today is the result of labor negotiations in the 1960s, 70s, and 80s. figure 9 New Jersey pension costs and contributions ($ millions) Source: State of New Jersey, Comprehensive Annual Financial Reports 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 7 of 13

8 figure 10 Percentages of total debt (public, pension, OPEB, and negative general fund balances) States.87% Cities 0% 30.51% 27.77% 25.52% 34.08% 40.85% 40.40% General fund balance Net bonded debt Unfunded pension Unfunded OPEB Source: Loop Capital Markets How did we make that situation worse? One of the primary triggers of this escalating issue is a chronic underfunding of pension liabilities. Spending needs for state and local governments vary widely, from safety, education, and healthcare to maintaining and even improving our aging infrastructure, among others. Few if any of these spending needs ever get smaller. Getting elected, and staying elected, often requires making sure these core governmental functions are properly funded. But in today s charged political environment, raising taxes to pay for these functions is rarely feasible. In fact, in efforts to generate a more vibrant economy (one that can create more jobs), several states have lowered or have proposed to lower taxes. Long on spending needs and loathe to raising taxes, states and municipalities needed a solution. Enter pension funding. A decision to not meet their annual pension contribution as calculated by their independent actuaries, known as actuarial required contribution (ARC), has been an easy way to find new revenue. These are very longterm obligations and states and municipalities determined that they could make up this funding shortfall over that interim period. Or not. This is exactly how Illinois and New Jersey have dug themselves into severe underfunded status. Figure 9 is a chart showing both the ARC and the actual contributions made by New Jersey to their staterun pensions. The percentage of contribution to ARC has ranged from a high of 28.6% in fiscal 2013 to a low of 0.00% in One of the less obvious impacts of this funding mismatch is the crowding out of public municipal debt. Ultimately, states and municipalities only have so much revenue coming in. With growing pension obligations come larger and larger funding requirements. If a greater percentage of that revenue is allocated to funding pensions, simple math tells you there is less and less available for other public purposes, such as debt service. States, municipalities, and institutional investors are all keenly aware of this crowding out. Aggressive expected returns To this day, most states and municipalities use 7% 8% return assumptions to discount future pension obligations. How is that going for them? Many public funds in the last fiscal year earned less than 2%. To the degree that actual returns fall short of expected returns, the level of underfunding increases. There are great pressures on states and municipalities to use more realistic return 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 8 of 13

9 assumptions some from the ratings agencies, some from regulators, and some from institutional investors like Wilmington Trust. Many states have started addressing this mismatch, but their efforts are woeful. For example, Washington State is reducing its expected rate of return from 7.8% all the way down to 7.7%. That beats Hawaii s planned reduction from 7.55% to 7.50%. These numbers are important and hence the reference to Einstein s purported quote. Since these figures are used to estimate return values many decades out, changes to these assumptions can have profound impacts on the funding levels. As you ratchet down the expected returns, the future pension valuations decline, matched by a commensurate increase in the unfunded liability. One recent study, by Stanford s Institute for Economic Policy Research, demonstrates just how profound that impact can be if the expected rate of return is lowered to what are generally considered more realistic levels. In the study, the total U.S. public employee pension debt in fiscal 2014, using the same actuarial return rates as the aggregated pension systems (again, averaging 7.5%), is estimated to be $1.0 trillion. However, this economic research group applied a market-based expected return rate, based upon 20-year Treasury rates in 2014 of 3%. This level would be in line with new Governmental Accounting Standards Board (GASB) standards for public pension accounting (see Governmental Accounting Standards Board (GASB) Standards Update on page 10). As a result of the lower estimated returns compounding over decades, the pension debt liability would balloon to $4.8 trillion. To put that near quintupling of pension liabilities in perspective, the entire public municipal debt market is $3.6 trillion. With or without the new GASB standards, the level of debt from pension and other post-employment benefits (OPEB) liabilities is meaningful. Figure 10 shows the total debt of states and cities, broken down among public, pension, and OPEB obligations. In both cases, the largest percentage at nearly 41% is the pension liability. Bondholder legal standing Historically, bondholders particularly for unlimited general obligation bonds have been considered to be priority lienholders, with the states and municipalities required to take all steps, which include raising taxes, to service both interest and principal payments. However, recent history has led to a questioning of this standing vis-à-vis the pension liability. Much like the political realities that helped create the pension mismatch, those same pressures seem to work against the interests of the bondholders in a workout or bankruptcy scenario. In this world of tweets and sound bites, where summary images outweigh in-depth analysis, the interests of the hardworking public employee (picture the widow of a municipal firefighter pensioner) always win out over those of the tax-exempt municipal bondholder (now picture a Wall Street investor clipping his coupon). In various California municipal bankruptcies (Stockton, Vallejo, and San Bernardino), pension obligations were left untouched while bondholders (in these cases, mostly lease-backed debt) were impaired. In Detroit, unlimited general obligation was impaired by 26% while pension obligations were only impaired by 4.5%. We note here that OPEB liabilities were severely impaired in Detroit, by 90%, which highlights that OPEB benefits are often held with less legal backing than pension contracts. The standing of Puerto Rico bonds vs. pension obligations has yet to be determined. The financial oversight board has just recently been appointed and we expect it to have at least the framework of a reorganization plan by yearend. However, in light of the above-referenced recent history, we fear the outcome will not favor the bondholders. Summary Given the political realities and the changing accounting standards, we expect this issue to continue to be a hot button and investors in this asset class can expect more 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 9 of 13

10 headlines. However, as we pointed out so briefly in the opening comments, this is not dire for all municipal bond issuers. Let s not throw out the baby with the bathwater. Many issuers from a wide range of sectors (e.g., general obligations, water revenues, higher education, not-for-profit healthcare, airport revenues) represent good solid credits, worthy of their investment-grade credit ratings. While the world in general may be more interested in tweets, we believe that good old-fashioned, roll-up-your-sleeves, in-depth credit analysis can help investors sift through the municipal market and limit their exposure to those credits most vulnerable to credit problems, including those rooted in growing pension liabilities. Governmental Accounting Standards Board (GASB) standards update Robert Tice Municipal Research Analyst Clyde Lane Municipal Research Analyst Over the last few years, this standard-setting board for state and municipal financial accounting has been implementing new standards for how these entities account for pension and other post-employment benefits (OPEB) liabilities. Here is a summary of some of those changes. GASB 67 and GASB 68 In order to improve the transparency and comparability of the pension information reported by state and local governments and pension plans, GASB introduced two new reporting rules: Statement Nos. 67 (effective 6/15/2013) and 68 (effective 6/15/2014). These rules impose the following requirements on a reporting entity: Defined benefit pension liability must be measured at the present value of future payments to active and inactive employees, less the amount of the plan s net position. Net pension liabilities must be disclosed on the balance sheets of plans and employers, as well as recognition of pension expense on the income statement. Establishes single discount rate to calculate present value of net liability. Expected returns for positive liabilities will use expected investment return, and negative balances will require the use of the 20-year municipal bond index rate; most states and local pensions currently show a negative balance. Cost-sharing plans must report a prorated share of net pension liability on their balance sheets. Under the new standard, small towns and small school districts will have to show their share of liabilities, giving greater insight into their financial conditions. GASB 74 and GASB 75 OPEB primarily consists of retiree health insurance, but may also include life insurance, disability, legal, and other services. As stated by GASB Chairman David Vaudt, These OPEB standards usher in the same fundamental improvements in accounting and financial reporting that were previously introduced for pensions. Because OPEB promises represent a very significant liability for many state and local governments, it is critical that taxpayers, policy makers, bond analysts, and others are equipped with enhanced information, which will enable them to better access the related financial obligations and annual costs of providing OPEB. Many of the new provisions are parallel and follow the same guidelines to the provisions of GASB Statement Nos. 67 and 68 for pensions in order to provide a more comprehensive picture of what state and local governments have promised and the actual associated costs. The new standards address a number of important issues, which include changes that affect how the long-term obligation and the annual costs of OPEB are measured, requirements to recognize the net OPEB liability on the face of the financial statements, and a requirement to present more extensive note disclosures and supplementary information about their liabilities. GASB Statement No. 74 addresses reporting by OPEB 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 10 of 13

11 plans that administer the benefits on behalf of the governments, and will be effective for reporting periods beginning after June 15, GASB Statement No. 75 addresses reporting by governments that provide OPEB to their employees and those that finance benefits for employees of other governments. It will be effective for reporting periods beginning after June 15, Determining OPEB liabilities under the new methods For plans that are prefunding their OPEB liabilities, GASB Statement No. 74 introduces a single equivalent discount rate (a combination of long-term assumed rate of return for years with positive net asset positions and 20-year tax-free high-quality municipal yields for years with negative net asset positions) for discounting liabilities. Under GASB Statement No. 75, net OPEB liabilities need to be recognized on their balance sheets. For plans not prefunding their OPEB liabilities, it introduces a new discounting rate, equivalent to 20-year tax-free highquality muni yields (which in essence pushes municipalities towards prefunding their OPEB liabilities). The most visible short-term effect of these changes can be seen in net asset balances at the entity level, moving from a positive to a negative balance. Moreover, entities that sought to lower the annual expense of pensions and OPEBs (particularly those who chose to fund their plans on a pay as you go basis) by raising discount rates will now face closer scrutiny from the market. By making the pension and OPEB liability readily apparent, the GASB enables users of governmental financial statements to have access to information that provides a more comprehensive, easily understandable description of a government s financial position at a given moment in time. Without it, users are left with an incomplete picture. DISCLOSURES The Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market. It tracks fixed-rate bonds exempt from federal income tax, though they may be subject to the alternative minimum tax (AMT), with par outstanding of at least $2 million. The index includes bonds of all quality ratings from AAA to non-rated, including defaulted bonds and from all sectors of the bond market. The Index constituents undergo a monthly review and rebalancing. The Investment Grade Index consists of bonds in the Index that are rated at least BBB- by Standard & Poor s, Baa3 by Moody s or BBB- by Fitch Ratings. For the avoidance of doubt, the lowest rating is used in determining if a bond is eligible for the Index. S&P Dow Jones Indices looks at the long term rating, either insured or uninsured, and the underlying rating for index inclusion. All bonds must also have a minimum maturity of three years and a maximum maturity of up to, but not including, fifteen years as measured from the rebalancing date. The Intermediate Index consists of bonds in the Index with a minimum maturity of three years and a maximum maturity of up to, but not including, 15 years as measured from the rebalancing date. The Short Intermediate Index consists of bonds in the Index with a minimum maturity of one year and a maximum maturity of up to, but not including, eight years as measured from the rebalancing date. The Short Index consists of bonds in the S&P Municipal Bond Index with a minimum maturity of six months and a maximum maturity of up to, but not including, four years as measured from the rebalancing date. The High-Yield Index consists of bonds in the Index that are not rated or whose ratings are less than or equal to BB+ by Standard & Poor s, Ba1 by Moody s or BB+ by Fitch Ratings. Bonds that are prerefunded or escrowed to maturity are not included in this index. The lowest long-term underlying rating, either insured or uninsured, is used in determining if a bond is eligible for the Index. The state level municipal bond sub-indices consists of bonds in the Index that have been issued by municipalities or municipal authorities within the respective states, the District of 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 11 of 13

12 Annualized returns and volatility (as of September 30, 2016) A N N U A L I Z E D R E T U R N S 1-year 3-year 5-year 10-year A N N U A L I Z E D S T A N D A R D D E V I A T I O N 3-year annualized standard deviation 5-year annualized standard deviation 10-year annualized standard deviation Investment Grade Intermediate Short Intermediate Short High Yield California Index New York Index Puerto Rico Index 5.84% 5.69% 4.66% 4.68% 2.33% 3.36% 4.55% 5.42% 5.45% 4.43% 4.63% 2.29% 3.31% 4.47% 5.21% 4.82% 4.13% 4.89% 2.24% 2.97% 3.87% 2.57% 2.54% 2.34% 3.62% 1.43% 1.62% 2.30% 1.00% 1.10% 1.14% 2.48% 0.66% 0.63% 1.25% 11.48% 9.01% 8.19% 5.27% 4.15% 5.10% 8.50% 6.03% 6.45% 5.56% 5.05% 2.50% 3.64% 5.08% 5.61% 5.54% 4.47% 4.67% 2.17% 3.11% 4.24% 13.22% 3.39% 0.57% 1.75% 10.65% 10.56% 9.20% Investing involves risks and you may incur a profit or a loss. Past performance is no guarantee of future results Source: S&P Dow Jones Indices, LLC Columbia, Puerto Rico, Guam and the U.S. Virgin Islands. States and municipalities may have issues across the duration and quality spectrums or may be more concentrated to certain sub-indices, such as in the S&P Investment Grade or High Yield bond indices. The Puerto Rico Index consists of bonds in the Index issued by the Commonwealth of Puerto Rico, and municipalities and municipal authorities within the Commonwealth. Individually these entities may have issues across the duration and quality spectra; however, as a general matter they have been increasingly concentrated in the S&P High Yield Bond Index. The Securities Industry and Financial Markets Association Municipal (SIFMA) Swap Index is designed to reflect activity in high-grade, weekly-reset Variable Rate Demand Notes (VRDN). It represents the average reset rate of qualifying VRDNs, subject to exclusions to ensure diversity of market participants and exclusion of outlier events that may skew an equal weighted index. In order fo r an issue to qualify for inclusion in the index a VRDN must have an outstanding amount over $10 million, reset weekly, pay interest monthly, have the highest short-term rating from S&P or Moody s, and may not be subject to the Alternative Minimum T ax. Beginning 2014, VRDNs also must be reported to the Municipal Securities Rulemaking Board. The Index excludes reset rates falling outside +/- 1 standard deviation (i.e., ignores the top 16.7% and bottom 16.7%) of reported rates and can include only one quote per issuer through a given remarketing agent, and each agent is limited to no more than 15% of the number of securities in the index. Designed and overseen by SIFMA, the Index is calculated and published by Bloomberg. Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs, which would reduce returns. Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Investment management and fiduciary services are provided by Wilmington Trust Company, operating in Delaware only; Wilmington Trust, N.A., a national bank; and Manufacturers and Traders Trust Company (M&T Bank), member FDIC. Wilmington Trust Investment Advisors, Inc., a subsidiary of M&T Bank, is a SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T affiliates and clients. Brokerage services, mutual funds services and other securities are offered by M&T Securities, Inc., a registered broker/dealer, wholly owned subsidiary of M&T Bank, 2016 Wilmington Trust Corporation and its affiliates. All rights reserved. page 12 of 13

13 and member of the FINRA and SIPC. Wilmington Funds are entities separate and apart from Wilmington Trust, M&T Bank, and M&T Securities. These materials are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports. Investment products are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by Wilmington Trust, M&T, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. The information in this commentary has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer, recommendation or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor s objectives, financial situation and particular needs. The investments or investment strategies discussed herein may not be suitable for every investor. There is no assurance that any investment strategy will be successful. Past performance is no guarantee of future results. Slope Analysis: The slope of the yield curve measures the rate gap between two points in the yield curve representing shorter- and longer-term yields. A low slope indicates a flat yield curve, where shorter- and longer-term rates are close to each other. The slope increases as the yield curve steepens, due to rising long rates and/ or falling short rates, reflecting the higher gap between the yields of shorter and longer maturity bonds. In our slope analysis, we plot the trailing 40-day moving average of the slopes of the short v. long bond (1-30 year) and the intermediate range (2-10 year). We also plot +/- 2 standard deviation of the 40 trailing daily slopes the trio are commonly referred to as Bollinger bands to offer context to the moving average in light of the overall volatility of changes in the slope. Together, this is intended to indicate current steepness of the yield curve relative to recent trends. Municipal bonds typically provide a lower yield than comparable taxable bonds in consideration of the tax-advantaged status of the interest payments from these bonds, which are exempt from federal taxes and may be exempt from applicable state and/or local taxes in the states and/or municipalities where they were issued. Capital gains do not share this tax advantaged status. Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. The Alternative Minimum Tax may negate some or all of the tax benefits available through municipal securities. Quality ratings are used to evaluate the likelihood of default by a bond issuer. Independent rating agencies, such as Standard & Poor s and Moody s Investors Service, analyze the financial strength of each bond s issuer. Moody s ratings range from Aaa (highest quality) to C (lowest quality). Bonds rated Baa3 and better are considered Investment Grade. Bonds rated Ba1 and below are Below Investment Grade (also High Yield or Speculative ). Similarly, Standard & Poor s ratings range from AAA to D. Bonds rated BBB- and better are considered Investment Grade and bonds rated BB+ and below are Below Investment Grade. All investments carry some degree of risk. This report uses return volatility, as measured by standard deviation, as a proxy for risk. Volatility serves as a collective, quantitative estimate of risks present to varying degrees in the respective asset classes (e.g., liquidity, credit and default risks). Certain types of risk may be underrepresented by this measure. Investors should develop a thorough understanding of the risks of any investment prior to committing funds. Third party trademarks and brands are the property of their respective owners Wilmington Trust Corporation and its affiliates. All rights reserved. page 13 of 13 CS