opportunistic-approach-to-munis

TAXES

EATON VANCE

Seeking tax-efficient income and equity

MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

Take an opportunistic approach to the municipal market Investors should stay flexible when considering municipal bonds.

SUMMARY ■■

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The municipal bond market is dramatically different since 2008 due to structural changes, low interest rates and higher taxes.

Adam Weigold, CFA Senior Municipal Portfolio Manager

These changes have increased the volatility in the municipal bond market, requiring skillful navigation.

We think municipal investors should consider a go-anywhere, flexible approach that embraces volatility to help generate total return.

At Eaton Vance, we value independent thinking. In our experience, clients benefit from a range of distinctive, strongly argued perspectives. That’s why we encourage our independent investment teams and strategists to share their views on pressing issues—even when they run counter to conventional wisdom or the opinions of other investment managers. Timely Thinking. Timeless Values.

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MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

Today’s municipal bond market is vastly different than a decade ago, with structural changes to the market resulting in increased volatility. Coupled with low interest rates, higher taxes and increased concern over credit issues, investors in municipal bonds now face a perfect storm. Left unchecked, these challenges could impact performance of their tax-exempt portfolios.

OPPORTUNISTIC APPROACH TO MUNIS • 2

Structural changes have increased volatility The municipal market is vast: approximately 60,000 different issuers, over one million CUSIPs and about $3.7 trillion outstanding. Navigating this disparate universe is tremendously difficult for individual investors and their advisors. Key changes to the municipal market after the 2008 financial crisis have made this task profoundly more

In light of this, we think investors should consider a goanywhere style that embraces volatility in the municipal

difficult, such as: ■■

Higher tax rates.

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The disappearance of AAA-rated monoline insurers.

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Increases in bank regulation.

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Declining broker-dealer inventories.

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An uptick in credit stresses, including Detroit, Chicago and

market. A flexible, opportunistic strategy may help address some of the challenges of a changing municipal bond market. In our view, employing a tactical style with discretion to span credit quality and duration in the municipal market to take advantage of opportunities makes sense now.

In this Insight, we explain how a flexible approach should resonate with investors after the financial crisis of 2008 fundamentally changed the municipal bond market. We also offer reasons why this type of total return approach may act as or complement a traditional exposure to the municipal market.

Exhibit A

Puerto Rico.

Looking first at municipal bond insurance, seven insurers carried AAA ratings in 2007; none of those insurers are AAA-rated today.

As a result, the number of municipal bonds carrying AAA ratings has declined sharply (Exhibit A). Without the backing of a bond

Declining numbers of AAA-rated bonds and dealer holdings have increased volatility.

Dealer holdings are shrinking.

Fewer bonds are rated AAA since the financial crisis.

2007

60

68.8

50

60%

49.1 32.7

40% 20%

Billion

80%

2014

13.4

18.7 7.4

5.2

4.8

0%

40 30 20

AA

A

BBB

38.7

35.4

40.0 30.9

26.6 18.6

18.9

10 0

AAA

50.1

2007 2008 2009 2010 2011 2012 2013 2014

Sources: Barclays and the Federal Reserve. Ratings are based on Moody’s, S&P or Fitch, as applicable. If securities are rated differently by the rating agencies, the higher rating is applied. Ratings, which are subject to change, apply to the creditworthiness of the issuers of the underlying securities and not to the Fund or its shares. Credit ratings measure the quality of a bond based on the issuer’s creditworthiness, with ratings ranging from AAA, being the highest, to D, being the lowest based on S&P’s measures. Ratings of BBB or higher by S&P or Fitch (Baa or higher by Moody’s) are considered to be investment-grade quality. Credit ratings are based largely on the ratings agency’s analysis at the time of rating. The rating assigned to any particular security is not necessarily a reflection of the issuer’s current financial condition and does not necessarily reflect its assessment of the volatility of a security’s market value or of the liquidity of an investment in the security.

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MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

OPPORTUNISTIC APPROACH TO MUNIS • 3

insurer, research and relative-value analysis have become top

Shifting leadership requires active management

concerns for municipal bond investors.

Due to increased volatility in this retail-driven market, we

Declining broker-dealer inventories have also increased the

think that investors may want to maintain a greater amount of flexibility with municipal bonds. Municipal returns can

challenges for individual investors. Due to increased

come from a number of different areas. For example,

regulations, dealers are allocating less capital to municipal

Exhibit B shows that annual returns of municipal bonds by

bond holdings (Exhibit A), leaving the market without a key

credit rating can shift remarkably from year to year.

stabilizing force during periods of stress and volatility.

Having the flexibility to move in and out of holdings based on credit rating is important in our estimation. Investors may need

Since the financial crisis, there has also been an uptick in

the ability to swap in and out of high grade and high yield

credit stresses in the municipal market, with Puerto Rico,

based on spread changes across the entire credit spectrum.

Chicago and Detroit among the most notable. The resulting

Changes in the yield curve have also historically resulted in

volatility is due to ownership composition of the municipal

leadership changes in the municipal market (Exhibit C). Just as

bond market. According to the Investment Company

they should watch credit exposure closely, investors should

Institute, individual (or retail) investors are the largest

continuously monitor a steepening or flattening of the yield

holders of municipal securities. These investors hold 35% of

curve and have the flexibility to react accordingly.

municipal bonds directly and another 36% indirectly

In other words, investors and their advisors need the ability to

through vehicles like mutual funds and exchange-traded

tactically shift positions as needed, whether that means

funds (ETFs). As the market is heavily retail-driven, negative

across the credit spectrum or yield curve. We think that it

headlines about these credit stresses tend to have a greater

depends on where an experienced municipal bond investor

influence on prices.

can find compelling value opportunities.

Exhibit B

High grade or high yield? Leadership has historically varied in municipal bonds.

Annual Returns by Credit Quality (%)

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Barclays Muni HY 10.52

Barclays Muni HY 8.58

Barclays Muni HY 10.74

Barclays Muni AAA 3.84

Barclays Muni AAA 1.61

Barclays Muni HY 32.73

Barclays Muni HY 7.80

Barclays Muni A 12.53

Barclays Muni HY 18.14

Barclays Muni AAA -1.61

Barclays Muni BAA 14.47

Barclays Muni BAA 8.48

Barclays Muni BAA 8.34

Barclays Muni BAA 7.61

Barclays Muni AA 3.52

Barclays Muni AA -0.76

Barclays Muni BAA 26.09

Barclays Muni BAA 3.75

Barclays Muni BAA 11.84

Barclays Muni BAA 9.80

Barclays Muni AA -2.12

Barclays Muni HY 13.84

Barclays Muni A 5.35

Barclays Muni A 4.02

Barclays Muni A 5.26

Barclays Muni A 2.67

Barclays Muni A -5.97

Barclays Muni A 15.87

Barclays Muni A 2.23

Barclays Muni AA 10.28

Barclays Muni A 8.16

Barclays Muni A -2.56

Barclays Muni A 10.52

Barclays Muni AAA 4.21

Barclays Muni AAA 3.13

Barclays Muni AA 4.66

Barclays Muni BAA -2.73

Barclays Muni BAA -21.33

Barclays Muni AA 11.72

Barclays Muni AA 2.05

Barclays Muni HY 9.25

Barclays Muni AA 6.23

Barclays Muni HY -5.51

Barclays Muni AA 8.22

Barclays Muni AA 3.87

Barclays Muni AA 3.09

Barclays Muni AAA 4.63

Barclays Muni HY -2.28

Barclays Muni HY -27.01

Barclays Muni AAA 9.06

Barclays Muni AAA 2.03

Barclays Muni AAA 8.75

Barclays Muni AAA 4.52

Barclays Muni BAA -7.17

Barclays Muni AAA 6.34

Source: Barclays as of 12/31/2014. It is not possible to invest directly in an index. Past performance is no guarantee of future results. The data provided are for informational use only. The AAA, AA, A and BAA municipal indexes are all subindexes of the Barclays Municipal Bond Index, an unmanaged index of municipal bonds traded in the U.S. Barclays High Yield Municipal Bond Index is an unmanaged index of noninvestment-grade municipal bonds traded in the U.S.

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MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

Exhibit C

OPPORTUNISTIC APPROACH TO MUNIS • 4

Returns by maturity have varied widely over time, requiring careful management.

Annual Returns by Maturity (%)

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Barclays Muni 20 Yr 6.56

Barclays Muni Long 7.05

Barclays Muni Long 6.82

Barclays Muni 5 Yr 5.15

Barclays Muni 5 Yr 5.78

Barclays Muni Long 23.43

Barclays Muni 10 Yr 4.04

Barclays Muni Long 14.88

Barclays Muni Long 10.01

Barclays Muni 5 Yr 0.81

Barclays Muni Long 15.39

Barclays Muni Long 6.27

Barclays Muni 20 Yr 5.08

Barclays Muni 20 Yr 5.86

Barclays Muni 10 Yr 4.29

Barclays Muni 10 Yr 1.52

Barclays Muni 20 Yr 18.52

Barclays Muni 5 Yr 3.40

Barclays Muni 20 Yr 13.98

Barclays Muni 20 Yr 8.48

Barclays Muni 10 Yr -2.17

Barclays Muni 20 Yr 13.03

Barclays Muni 10 Yr 4.15

Barclays Muni 10 Yr 2.74

Barclays Muni 10 Yr 4.71

Barclays Muni 20 Yr 2.29

Barclays Muni 20 Yr -7.65

Barclays Muni 10 Yr 9.85

Barclays Muni 20 Yr 1.32

Barclays Muni 10 Yr 12.32

Barclays Muni 10 Yr 4.20

Barclays Muni 20 Yr -4.42

Barclays Muni 10 Yr 8.72

Barclays Muni 5 Yr 2.72

Barclays Muni 5 Yr 0.95

Barclays Muni 5 Yr 3.34

Barclays Muni Long 0.46

Barclays Muni Long -14.68

Barclays Muni 5 Yr 7.40

Barclays Muni Long 1.12

Barclays Muni 5 Yr 6.93

Barclays Muni 5 Yr 1.86

Barclays Muni Long -6.01

Barclays Muni 5 Yr 3.19

Source: Barclays as of 12/31/2014. It is not possible to invest directly in an index. Past performance is no guarantee of future results. The data provided are for informational use only. The 5-year, 10-year, 20-year and Long municipal indexes are all subindexes of the Barclays Municipal Bond Index, an unmanaged index of municipal bonds traded in the U.S.

Take a total return approach to municipal bonds The absolute low level in interest rates also deserves attention. Due to their federal tax-exempt income, municipal

volatility, like those we experienced with Detroit, Chicago and Puerto Rico over the past two years.

generation. As such, the municipal bond market has

Stay flexible and opportunistic in today’s municipal bond market

historically had a buy-and-hold mentality. But in this low

Going forward, the perfect storm of rising interest rates,

rate environment, investors are looking to do more than just

higher taxes and negative credit headlines may increase

clip their coupon.

volatility in the market. Most municipal bond investment

bonds have been favored as a source of stable income

With interest rates as low as they have been over the past few years, a total return approach warrants some attention.

Due to inefficiencies created by its retail investor-driven nature, the municipal bond market can be a sensible source of alpha. A lack of transparency and dearth of readily

strategies are prospectus-constrained into specific areas of the municipal market. These constraints may include credit quality (high grade or high yield) and duration (long, intermediate or short). Investors may want the latitude to seek municipal sectors, credit tiers and maturities.

available information on the municipal bond market allows us

In our view, a flexible, total return approach is an

to find what we believe are compelling opportunities.

appropriate adaptation of a municipal bond strategy for

As part of this total return strategy, we want to be buying bonds at the time they are not appropriately valued by retail investors. For example, this may include taxable municipal bonds, short-dated corporate-backed municipal bonds, and health care and transportation issues. We also look for opportunities when negative headlines arise and generate

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what we think is a more volatile future. This type of approach can serve as a core position for investors looking for tax-advantaged investments. Due to the opportunistic nature, the strategy may be complementary to an existing core municipal bond strategy, allowing a portion of the portfolio to shift focus to where there may be opportunities.

MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

OPPORTUNISTIC APPROACH TO MUNIS • 5

At Eaton Vance, we have embraced this opportunistic,

opportunistic means conducting thorough, rigorous research

go-anywhere style that allows us to take advantage of

in order to recognize market inefficiencies, and then seeking

volatile markets. We think that in order to truly be

to capitalize on them. Investors may benefit from the credit

opportunistic, investors need to do more than simply take

research, skill and expertise of experienced professional

advantage of situations as they arise. In our view,

management to help implement this approach.

About Indexes Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance of any investment.

Income Volatility Taxes

Strategies. For times like these.

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Eaton Vance offers strategies to help meet three of today’s most important investment challenges—Income, Volatility and Taxes.

Explore our broad range of strategies to address these issues at eatonvance.com/IVT.

MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

OPPORTUNISTIC APPROACH TO MUNIS • 6

If you like the views expressed in this Insight, you might be interested in learning more about the following strategy: Eaton Vance Municipal Opportunities Fund A flexible municipal investing strategy, seeking to maximize after-tax total return through an opportunistic approach.

Key Highlights ■■

A Shares Inception I Shares Inception

05/31/2011 05/31/2011

Few constraints Unlike most municipal funds, the Fund invests across the municipal yield curve and credit spectrum. With a flexible approach, the Fund seeks to adapt to market changes, capitalize on value opportunities and exploit inefficiencies across the entire municipal bond market.

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Adam Weigold, CFA Vice President Eaton Vance Management

Opportunistic approach An active flexible municipal bond fund focused on generating after-tax total return. The Fund seeks value opportunities in the municipal market and tactically manages duration, yield curve positioning, credit quality and sector exposure.

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Portfolio Managers

Experienced credit research team

Investment Objective

Symbols and CUSIPs

Maximize after-tax total return

A Shares EMOAX 27826Y571 C Shares EMOCX 27826Y563 I Shares EMOIX 27826Y555

Credit research is central to our approach. Utilizing a bottom-up approach, our large and experienced municipal credit team identifies opportunities through careful fundamental research and analysis.

For more information about Eaton Vance Municipal Opportunities Fund and other income strategies from Eaton Vance, please visit eatonvance.com/taxes.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor.

Prospective investors should read the prospectus carefully before investing.

Not FDIC Insured | Not Bank Guaranteed | May Lose Value

MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

About Adam Weigold, CFA Senior Municipal Portfolio Manager

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Joined Eaton Vance in 1998.

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Education B.A. Dartmouth College | MBA Boston University

Not FDIC Insured | Not Bank Guaranteed | May Lose Value

OPPORTUNISTIC APPROACH TO MUNIS • 7

MAY 2015 CORNERSTONES OF TAX-SMART INVESTING

OPPORTUNISTIC APPROACH TO MUNIS • 8

About Risk An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. If a counterparty is unable to honor its commitments, the value of Fund shares may decline and/or the Fund could experience delays in the return of collateral or other assets held by the counterparty. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.

About Eaton Vance Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor.

Prospective investors should read the prospectus carefully before investing.

The views expressed in this Insight are those of the author and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views.

These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. Eaton Vance does not provide legal or tax advice.

The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Individuals should consult their own legal and tax counsel as to matters discussed. ©2015 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414 | eatonvance.com

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