MASTERCLASS: International Equities - April 2021
April 1, 2021
Jenna Dagenhart: Hello, and welcome to Asset TV's Municipal Bond Masterclass. We'll cover credit, the impact of the coronavirus pandemic, macro considerations for investors, and much more. Joining us now are three expert panelists. Dave Hammer, head of municipal bond portfolio management at PIMCO, Tony Tanner, senior vice president at Aquila Investment Management, and Grant Dewey, head of municipal capital markets at Build America Mutual. Everyone, thank you for joining us, and Dave, setting the scene here, how is the municipal market different from taxable markets both in terms of issuers as well as the investor base?
David Hammer: I think the most important difference at the outset is just the sheer size of it and the number of different types of issues and issuers. There are over 50,000 municipal issuers and they're very diverse. I think it's common to think of the muni market as state and local government finance, and while that's a big part of it, it's about a third. The other third of the market are a variety of revenue streams, the repay bondholders, those can be backed by not-for-profit healthcare systems, the biggest hospitals in America, utilities, water and sewer, public power, a variety of transportation credits, toll roads and airports, and even things that look and feel more like securitized products. Securitized sales tax bonds or property tax bonds. Ultimately, what determines the quality of those bonds is understanding the underlying commercial real estate asset or residential real estate asset, so all different types of risk.
David Hammer: Then the investor base, it's very different if you're talking about taxable munis or tax-exempt. The taxable muni market has grown over the last several years, this year in particular. It's about 20% of the market, so a little over $700 billion and that's really institutional market, but I think when most investors think of the muni market and they're thinking about tax-exempts, which are still the majority of the market, that's very much a retail-dominated investor base who are willing to take a lower yield in exchange for tax efficiency.
Jenna Dagenhart: Yeah, I'm glad that you bring up tax muni bonds. So, Grant, what impact are you seeing from the growth in taxable municipal bonds sales?
Grant Dewey: Taxable muni supply really has been the big story in our market for the past few years, particularly this year with an expected $180 billion in taxable issuance which would be a record. So, when the Tax Cuts and Jobs Act was passed in 2017, it eliminated an important lever for issuers. Namely you have the ability to continue to advance for fund debt and lower the borrowing costs on outstanding bonds with call dates beyond 90 days. So, with treasury yield levels being near zero over the past few years and the market for taxable minis maturing and growing, issuers found they were able to achieve savings by advanced refunding their tax-exempt bonds with taxable debt. So that has had the effect of reducing the amount of tax-exempt volume in the market. So, reason were having a volume this year of 450 billion or so, about 30% of that's going to be taxable. So that does crowd out some of the investors that are looking for the tax-exemption and creates a technical tailwind for tax-exempt bonds.
Grant Dewey: As Dave is very familiar, taxable market is a very high-grade market, typically AA, AAA, so that's a great alternative for high quality international buyers looking for regulatory capital relief. The other big impact that is during the meltdown in the muni market in March and April, the taxable market was provided access to the markets for a lot of muni issuers like state GOs and large universities. It's a broad deep market and it continues to deepen.
Jenna Dagenhart: Yeah, Tony with market yields across asset classes sitting near generational lows, where and how do municipal bonds fit into an investor's mix?
Anthony Tanner: Well, when I look at municipal bonds. Because of the relatively high after-tax level of cashflow that munis still throw off, and in particular in relation to the rate of inflation, they still offer a really important value within an investor's asset allocation consideration. When you throw in the bonus of a much more stable credit and principal environment, then you find across other more speculative fixed income asset classes. Munis still to me are that first building block you look towards away from equities and away from tax qualified plans which is something that you do not find with a lot of the highest quality even taxable fixed income instruments right now.
Jenna Dagenhart: Dave, what are some of the ways that you can generate alpha in the municipal market as an active manager?
David Hammer: Yeah, thanks. So PIMCO, we're firm believers in the power of active management and the muni market is very fertile ground. The three big areas that we can find in generate alpha, the first is credit. With 50,000 different issuers to underwrite and understand, what we found is that rating agencies can be very backward looking, they're working with data that's already come in. What we do is we take a forward-looking approach and really think about what might happen next that's particularly relevant right now with an economy that's been in recession and may be a bit slower to recover in our estimation than what might be priced into markets today. Then the diversity that I mentioned of the different types of credits in the market. It's not just state and local government backed bonds, it's all different types of revenue back securities. So, we'll oftentimes use our non-muni experts here in areas like commercial real estate or residential real estate to understand what might be generating a sales tax or the value of property on which property taxes are levied and that can lead us to a different conclusion.
David Hammer: So as a muni bond investor, I think first and foremost, we want to avoid draw downs and defaults. When we think about what the last two big defaults were, they're very different. The Commonwealth of Puerto Rico which was really not more of a sovereign risk type and then FirstEnergy Solutions, which was a corporate backed obligor that borrowed in the tax-exempt market to fund projects in Pennsylvania and Ohio. So, a different approach to credit can often lead to different conclusions and we've been able to consistently identify alpha opportunities there.
David Hammer: The second big one is structure. Most muni bonds are callable, very different than other markets where the standard issuance is a non-call security. About two thirds of the muni market are issued as callable bonds and those bonds have all different call dates, call prices, different coupons. So, as an active investor, what we seek to do is really understand the value of that option and look to fill a portfolio with mispriced callable bonds. That's a way to generate some structural alpha without taking additional credit risk or duration risk.
David Hammer: Then the last one that's emerged over the last 10 years or so is really liquidity. The muni market is much less liquid than it used to be, so what that means for us as active investors. We see really two ways to generate some excess return there. One is running a bit more cash in our portfolios that we can be active with and step into the market when there's not a bid or not an offer. Then the other is thinking about different ways to allocate to munis, perhaps there are strategies that don't offer daily liquidity that allow us to better harvest that illiquidity premium over time.
Jenna Dagenhart: Spending a little bit of time here on insured bonds, Grant, insured bond sales are growing about twice as fast as the overall new issue muni market this year, what's driving that?
Grant Dewey: So bond insurance has definitely made a big comeback this year. But put it in perspective, it still remains far below levels of the heyday, which was pre-financial crisis where you had seven highly rated monoline insurers rapping more than 50% of the market. So many of those firms publicly traded, battling for premium growth, and explored new riskier more leveraged business to grow profits so that as we all know, ended badly for many of them. We'd have two firms writing a new business now. We were formed and capitalized in 2012 with the benefit of 2020 hindsight and so sticking to government backed bonds and we steer pretty clear of what we feel are the much riskier sectors.
Grant Dewey: I think the growth this year certainly emanates from the pandemic and the resulting change and investor sentiment and appetite for risks. So, this was a big change from prior to March, we've really been through a long-sustained period of where municipal borrowers had enjoyed very strong financial results. So, this year the pandemic has translated to incrementally more business in the A rated and triple B sectors which is our bread and butter and a sweet spot. But the most dramatic shift has been the strong demand for insurance on higher rated AA category names. So, we've seen an 80% increase in market volumes, excuse me on names rated Aa3, AA- by S&P.
Grant Dewey: So that really municipal penetration rates have gone from about 6% to close to 9%. A lot of that growth certainly Build America Mutual has been in the higher rated names. I think it shows that it's both institutional and SMA and retail investors. I think it shows that insurance is being used more for value preservation and rating stability than it is as a hedge against default. You really find that it's being used more like a risk management tool than anything else. I think to me it's not surprising when you think of some of the difficult to measure exogenous events that the market, like a pandemic, climate change, hurricane, cyber threats, a variety of things which are very difficult over a period of 30 years for any credit analyst to forecast. So anyway, there's been a nice pickup in business and mostly in the higher rating sector.
Jenna Dagenhart: Going back to the meltdown as the result of the pandemic, Tony, what are some of the lessons you think investors can take away from the abrupt muni market sell off and then the resulting recovery in 2020?
Anthony Tanner: Jenna, that's the perfect way to characterize it. It was a very abrupt sell off and it was really amazing in terms of both its speed and magnitude. 200 basis points over a two-week period at the height of March. It had more similarities with the post 911 sell off, the taper tantrum, and the credit crisis and it was less like the Fed induced bond bear markets in the '90s. To me, one of the important lessons reminds me of something a wise man once told me, and that was it's not an opportunity if everyone sees it. One of the lessons from this is to really focus on the value that's being created.
Anthony Tanner: If you look simply at some of the basic bond math within the fixed income market, one of the things that investors and advisors can capitalize on is the fact that as interest rates are rising, the degree of risk you're taking on is going down at the exact same time simultaneously that your return prospect is going up. So, if we just take a look at that two-week period where your basic 10-year high-grade bond went from 1% to 3%, a 10-year 1% bond at par has a duration of about nine and a half years. If I go to a 2% bond at par, I have a duration of around nine years. I go to 3%, I have a duration of eight and a half years.
Anthony Tanner: So as the market is selling off and getting worse, the value proposition is increasing in magnitude. So, one of the real parameters of long run success in fixed income investing is that entry point, that yield that you're obtaining. So I really recommend to advisors and investors when things seem to be going every which way to take a step back and focus on those basic value metrics and capitalize on them when they occur because oftentimes when you get a recovery, you don't know when you're going to find that next opportunity to add a 3% yield when long run inflation has been staying at two.
Jenna Dagenhart: That's a great quote there, it's not an opportunity if everyone sees it, I like that Tony. Grant over you. I wonder anything you would add just about this shock that we felt in the muni market this year, and then the resulting recovery?
Grant Dewey: I think the only thing is it was certainly surprising, and I think if you're a market participant probably felt it was even more violent than what we saw. Previously, whether it was a Meredith Whitney period or the financial crisis, it really was an unprecedented move and it's not often where the market literally freezes up, but it snapped back very, very quickly. The third quarter had very little volatility, rates were pretty steady, I suppose had good performance even October where we saw almost 70 billions of supply. Muni's performed well, they're up 3.5% year to date, taxable munis twice that, almost 8%. So, I think that there would have been some of the credit fears I think partly due to the Fed and also just partly due to the structural nature of munis which are quite safe to have a lot of build-in liquidity and reserve funds.
Grant Dewey: Again, I think this crisis has been more liquidity driven than it is a solvency issue. So, there's been a lot of access in the market for issuers, even some of the issuers in transportation and tourism related sectors, things that would be right in the cross hairs, and the Feds MLF for any issuer that cannot access the capital markets very efficiently can fall back on that. So, I'd say the big surprise is not only how quickly and violently the market came apart, but also how quickly things got back where fund flows were positive, and volatility was very low.
Jenna Dagenhart: Yeah and we really saw the importance of liquidity. That being said, Dave, how has liquidity in the municipal market evolved over the last couple of decades?
David Hammer: It's interesting to hear Tony and Grant cite a number of muni market sell off. So, I would add to that that the sharp outflow cycle after the presidential election in 2016, some outflows just due to the rates rising in the back half of 2017 into 2018. What these all have in common is that they're stressing the liquidity of the system. When I say the liquidity of the system, what I mean is the amount of capital that broker dealers commit to buy and sell muni bonds every day. If you go back a decade, that averaged somewhere between 50 and 60 billion, today that's closer to 10 to 15 billion. So, a fraction of what it once was. However, over the same time period, daily liquid vehicles, mutual funds, ETFs have more than doubled in size from 400 billion to almost 900. So, there is twice as many investors that might look for a bit on any given day and about 20% of the capital there to provide it.
David Hammer: So what that means is we get these big valuation overshoots when traditional retail investors are all redeeming and institutional investors, oftentimes from other markets, those that buy corporate bonds, don't necessarily care about the tax-exemption, have to step in and stabilize prices. These are times that we see exceptional value creation for traditional muni investors, but it's quite important that you're in a position to capitalize on it. So, we think that the takeaways for investors are you should be in strategies that aren't necessarily fully invested all the time with enough dry powder to both avoid selling but also turn around and be opportunistic and be aggressive during these outflows’ cycles.
David Hammer: The cause of this lack of liquidity it's due to regulation, it's the cost of capital, it's in response to the great financial crisis and trying to strengthen the US banking system. This isn't going away, this is here to stay, so investors should expect liquidity driven pockets of volatility over the next 10 years much like what we've probably seen over the last 10.
Jenna Dagenhart: Yeah, and big picture here, Tony, what economic factors can muni investors pay attention to in helping guide their investment considerations?
Anthony Tanner: When I think about fixed income investing in general, compared to the equity markets, fixed income is like the single engine Cessna compared to the equity markets, Boeing 747 because the main drivers in fixed income are simply the income and that income accumulating over time. So, for investors, a focus on GDP and inflation can really provide good guideposts and signposts. When I look back to the fall of 2018, when we were nearing the end of the last Fed tightening, we had a period where long-term muni bond yields were approaching 4% at a time where the Fed still wasn't obtaining its 2% inflation objective. So, you had the opportunity to net two percentage points of real after-tax purchasing power, and within several of our funds, we took the opportunity to lock in some of those longer yields. It wasn't a market timing or a duration or an interest rate call, it was simply a recognition of value.
Anthony Tanner: Now, value has manifested itself in the last three years with rates having dropped. So, it's really difficult to achieve a steady state increase in the general level of interest rates unless you're getting solid GDP growth of 3% or higher and inflation well firmed above 2%, and we haven't seen that in a decade. Average annual GDP growth from about 1800 to 2000 average close to 4% irrespective of who is in the white house. Since 2000, it's been down in the low twos. Some of the reasons of that are around just the structural differences in the economy of being in the information age and less inflation. So again, if you can step back and look at just the value metrics of the level of income you're generating, if you're looking at the macro economy and where inflation and GDP is going, those can be really good instruments to guide your fixed income portfolio.
Jenna Dagenhart: Going back to MLF, which I know was mentioned earlier, Dave is the municipal liquidity facility likely to be extended and does that matter?
David Hammer: Confidence is a funny thing in markets and the Fed's intervention in muni markets was truly unprecedented. I recall back in 2008, looking through all the various facilities that the Fed had rolled out and munis were not mentioned in any of them. Very, very different this time around, the PDCF at the very front end, the commercial paper facility that we were proud to be hired to run here at PIMCO on behalf of the Federal Reserve Bank of New York, all of these were expanded to include muni bonds. Then of course, the MLF was added with $500 billions of direct purchasing power. Now the actual take-up rate's been pretty small, only a handful of issuers for less than $2 billion have actually access to the NLF but it's done quite a bit to restore investor confidence knowing that the Fed is there if there is a liquidity problem in markets where to seize up.
David Hammer: So we do think it's important. Will it be extended? I think with a Biden presidency, that becomes more likely that there'll be a recommendation to extend it. We certainly see it as a free policy option for the Fed, particularly as COVID cases rise here headed into the winter months. There are a few stress credits that are more acutely stressed, but by the nature of the COVID outbreak, that have big operating deficits, big public transportation agencies would be a good example. So we'd like to see it extended, but in terms of confidence, I think what we should all feel good about as muni investors is the Fed has added a number of new tools to their toolkit, they are there if they're needed again, and we think they'd be likely to use them.
David Hammer: Now, of course, none of this is a substitute for fiscal policy and I think that's where we'll be acutely focused here over the next few months is really learning what the new Congress will do in terms of phase four stimulus and not just extending loans to municipalities, which are great, but actually dedicate hard dollars they can use to backfill revenues that may reduce the need for budget cuts that will be a headwind to the broader economy.
Jenna Dagenhart: You make a good point about monetary and fiscal policies going hand in hand. Tony, what type of policies do you anticipate, or would you like to see take place?
Anthony Tanner: In terms of policies that have to meet the greatest impact and the greatest multiplier effect, going back to the PPP program, that was probably the one tool in the CARES Act that had the greatest degree of shoring up the economy beyond what I think people might have expected. Here in Arizona, close to 90% of the PPP loans that were made in the state were for $150,000 or less. Those are obviously going to small businesses and that's really critical because keeping people on the payrolls translates to payroll taxes, it translates to being able to spend that income and generate sales taxes, it translates to those businesses staying open and maintaining those tax bases. So, I'm hopeful that we're going to continue to see that trend towards policies that keep people working and keep businesses running rather than one-time distributions of money.
Anthony Tanner: If you take a look at how well Arizona has weathered the pandemic, Arizona has maintained 97% of its employment base since the pandemic started compared to last year compared to an average of about 93% nationwide. A lot of that has to do with keeping those small businesses open, so I'm hopeful we're going to see more of that. On the Fed side, they don't have a lot of maneuverability left with rates as low as they are. Programs like the Municipal Liquidity Facility, they're really helpful in times of stress, but they're somewhat limited in terms of how municipalities can leverage them. Most municipal borrowing is done long-term to finance long-term capital projects and at today's rates, there are still very attractive.
Anthony Tanner: We had the case a few months ago here in Arizona where Phoenix Children's Hospital, which at the time of the credit crisis 12 years ago was only BBB rated, it's now A1 rated and they received $5 billion in orders for their bonds with a maximum borrowing cost of 2.5%. So, the strength of the muni market outside of those very narrow windows of volatility is something that I think is helpful to investors and I think that the government recognizes the places where it's tools can have the maximum impact.
Jenna Dagenhart: As a muni investor, you have to be plugged into politics and the government. Grant, how is the election going to impact the muni market? And what's your post-election outlook for US infrastructure investment?
Grant Dewey: I think if you look at the election, there's three things that I look at in terms of having the biggest impact. One is we've talked about the additional federal aid and the probability of additional aid going to state and local governments. Number two, probably have higher tax rates obviously is a big driver of municipal performance. The third is an infrastructure bill, it's been talked about for a few administrations and is there a higher potential for a meaningful bill? So, I think as far as the state and local governments, the expectation is that a divided government did little to raise optimism for more stimulus dollars. I'd say however, vaccine news has likely provided a little bit of a tailwind for continued upward surprises for economic growth, I think all the way through here the reports that I see, they all tend to surprise on the upside and I think the vaccine could contribute to more of that and I think that could help mitigate the bearish impact on government sales tax revenues and transportation related credits.
Grant Dewey: As far as taxes, I think the results of the Georgia runoff may provide more clarity. But I think the chances are relatively remote, a meaningful tax reform bill passing. I'm sure they can pass but political temperatures have to come way down. But I think the sense is that there will be gridlock. The infrastructure bill, I'm always a little bit surprised because it does seem to be a bipartisan issue getting bi-partisan support, but I think a Biden administration will likely prioritize the passing of an infrastructure bill which we didn't see in the previous administration. So, who knows, I still think it will meet plenty of resistance in Congress given the large federal deficit and the price tag that would come along with it for state governments that are scrambling for revenues. So, I think the election outcome was probably the least bullish for munis, but I will say since the election, munis have performed very well.
Jenna Dagenhart: Tony and turning to you, what are your thoughts on COVID-19 and the election? How do you think muni investors should be thinking about the election?
Anthony Tanner: We saw some interesting results from the election. Here in Arizona, we just passed a proposition that's going to add a 3.5% income tax surcharge, which for some Arizona taxpayers will take their state tax rate almost to 8%. One of the real takeaways to me from the election was the mood towards taxing and what I would call confiscation and reserve distribution has really changed quickly in the last couple of years, it appears that investors want relief from tax relief. With Aquila where we're managing a variety of single state municipal bond funds with tax implications, some as high as 10% and 11%, it's very important from a muni investor standpoint to be aware that the mood around state taxes can change quickly and that what I'm seeing is that overall the direction of taxes certainly isn't lower and that this should be very supportive of the muni market and I think again goes back to, for investors and advisors, looking at the purpose of munis and where do they fit into your portfolio.
Anthony Tanner: I think coming out of the election, it enhances the importance of looking at generating tax-free income. But more importantly I think we're going to continue to see the government recognizing the inherent essentiality of municipal issuers and small and local issuers and conducting fiscal policy in a way that ensures that the moneys get to the places where they're going to be needed the most.
Jenna Dagenhart: Dave, what are the prospects for aid to state and local governments as we've been discussing under the new political alignment?
David Hammer: It's interesting. Sorry, I think I'm probably a bit more constructive on the takeaways for the muni market, maybe Grant is in terms of the outcome here. A narrowly divided Senate I think we do have to scale back our expectations around the size of fiscal stimulus and the size of an infrastructure bill. But my takeaway on the infrastructure bill will be something slightly smaller actually could be generally good for muni bonds. It may mean less upward pressure on interest rates, it also may mean a lower probability of a supply shock and tax-exempt advance refunding’s being reinstated, and a bunch of tax-exempt muni supply coming online. So, I think that's one area that we would be maybe a bit more constructive here.
David Hammer: However, when we think about the macro economy and the size of stimulus, I guess the first question is what do state, and local governments need? Tony made a great point that tax collections have come in better than expected as a result of so much fiscal stimulus, whether it's the PPP or the CARES money directly to state and local governments. So, there are many states that immediately after the COVID shock we're forecasting a 20% budget deficit, those were revised to 10% deficits mid-year and year over year, we're now seeing state and local tax collections come in many places down 5%. So, it's really much less bad than feared. However, as we see cases going up again and the risks of a smaller stimulus bill persist, I think our concern would be that less stimulus may have a different effect this time around.
David Hammer: If state and local governments do encounter bigger than expected deficits without additional stimulus, I think the real concern is not necessarily for municipal credit, state and local governments are forced to balance their budgets but in doing so, they cut jobs, they cut healthcare spending, education spending, all of these things have an impact on the economy. If we look at the current chairman of the Fed or previous chair people that have author op-eds, I think they've all pointed to the fact that after the great financial crisis the US economy was slower to recover. One of the reasons was the drag of state and local government employment. So, there's a risk that we repeat some of those mistakes, it's one of the reasons that our economic forecast is a bit more conservative.
David Hammer: We don't have the US economy returning to pre COVID levels until the middle of 2022, the Fed likely on hold until the end of 2022 if not 2023. So, it's generally supportive of the muni market and keeping rates low, but we think it's more important than ever to really understand the credits that you're investing in the muni market. There are so many, they're so different in risk type and in short, they have enough liquidity to survive the potential slower economic recovery with a little bit less support than expected.
Jenna Dagenhart: Taking a closer look at credit, how are munis withstanding COVID and the credit crisis, Grant?
Grant Dewey: As I touched on earlier, surprisingly well. I think performance-wise very well, positive returns across the board. I think from a credit standpoint, I think there's been a lot of liquidity and access to liquidity in the market, so I think investors are getting a lot of comfort from that. Dave's touched on the Fed's is quick response and really having that support there has a very big impact. From a credit rating standpoint which is not forward looking, I think Moody's they just recently said it's the first time since 2014 where they've had two consecutive quarters of more downgrades and upgrades. To put it in perspective, in the third quarter of 2020, downgrades exceeded upgrades by 72 borrowers and a total of 43 billion worth of debt just a year earlier, that was reversed where upgrades exceeded downgrades by 73 borrowers.
Grant Dewey: So we're certainly seeing rating changes, but again, investors PIMCO and Tony I think can see ahead. Before MTA gets downgraded those bonds are trading more in line with BBB paper long before it gets downgraded. So, the market has worked through that and I think that it's a very diverse market, investors need to understand what they're buying. It does seem like there's a very narrow part of the market where small segments like senior living centers or charter schools or project finance that are running into the most trouble. I think the large recognizable issuers have reserve funds and that liquidity is not what it's designed to do and that is whether the storm
Jenna Dagenhart: Tony, has the coronavirus pandemic changed the way municipal credit quality is evaluated or considered?
Anthony Tanner: I think what the pandemic has been able to do is to really help credit analysis Communities to evolve. Grant pointed out, we've drawn a greater distinction between project finance and what I consider to be the authentic traditional muni market. In the corporate market, you have venture capital, in the muni market, you have what I call adventure capital that buy or fuels project or that theme park fashioned after the local blast furnace industry. There are a lot of unique ideas in the muni market that often don't pan out but get lumped in with the rest of the muni market. I think what the credit crisis and the pandemic have really helped to illuminate is the inherent essential nature of the muni market which you don't see the same degree in the corporate bond market.
Anthony Tanner: Municipal bonds are the primary tool with which municipal governments and towns and cities implement public infrastructure policy. You can't build hospitals and sewers and roads and airports without them. Whereas corporate bonds are a tool of risk capital, we borrow the money, we build the project, we're going to see if it makes money. The two are very, very different. What that leads to is you have to look at a lot of intangibles within the muni market when you're evaluating credit that sometimes traditional economic analysis doesn't make or doesn't see. Here in Arizona, we're viewed as a tourism state and people often look at our airport through that lens. What people don't realize is that for the 5 million people that live in Maricopa County, for the most part, you can't get there from here without the airport. Whereas if I lived in the tri-state area and I drive six hours, I'll pretty much get to see most of my relatives, and if I'm on a college tour, I'll drive by 50 elite, 100-year-old colleges.
Anthony Tanner: If I drive six hours from Phoenix, that gets me to Nevada and Southern California, which for some high school kids isn't much of a college search. So, the airport here is incredibly essential to the state whereas if I look at the tri-state area, I look at JFK and LaGuardia and Newark it's likely that the area could do without one of those airports, it'd be inconvenient, but compare that to the New York City subway system. Long run, New York City is not New York City without the subway system and that form of transportation. A long run solution is not taking half of the MTAs form of ridership and putting them in cars in Midtown. So, if the jury events essentiality is really important and it varies by geography. I'd much rather own a combination of the Phoenix Airport and the New York City subway than the JFK airport and a toll road in Southern California or the Las Vegas monorail. The pandemic I think is going to help investors and credit analysts alike really make that important discernment and I think that leads to better investment decisions.
Jenna Dagenhart: David, do we expect to see a significant spike in muni default rates resulting from COVID and the recession?
David Hammer: What we've spent a lot of time here at PIMCO doing over the last six or nine months is really stress testing individual muni credits for our macro-economic outlook, which is a bit more conservative than what we've seen priced into markets. As much as default rates historically for munis have been very low, I think it's very reasonable for investors to ask is this time different? Is it different for airports? Is it different for toll roads? I'd say by and large we think the answer is no, we think default rates in the high-quality portion of the muni market remain quite low versus other asset classes. I would draw a bright line between downgrade risk and default risk. Even though we may think defaults remain quite low, we see many bonds, airports are a great example, where there may be a multi notched downgrade from an A rating to a BBB rating. That can come as a result of an economy that's a bit slower to recover, business travel that's slower to come back. Now, that doesn't mean a default, that does mean that there's a market to market adjustment in your bond price.
David Hammer: So if you look back to the financial crisis, there were more downgrades than upgrades for the following four or five years. I think it's reasonable that we should expect something somewhat similar in nature over the next two to three years. So steering investor capital clear of some of those big downgrades, even if they're not defaults, can have a really big impact on performance. When we look at default as a whole, there are some more severely impacted portions of the market and Grant touched on a few tourism related bonds, hotel and occupancy taxes, senior living. Some of these riskier project deals we've seen a lot of frankly bad risks sold into the muni market over the last three or four years. Very weak covenants and dependent as Tony mentioned on very aspirational project projections. So, we do think there's a day of reckoning for many of those bonds and we could see high yield muni default rates reach a level that we haven't seen in previous cycles.
David Hammer: But what does that mean? That means default rates for the muni market as a whole could go from a 0.1% or 0.25% perhaps to 0.75% or in a worst-case scenario, 1% relative to corporate bond markets or sovereign bond markets, which have long run default rates of 5% to 7%. These are still exceptionally low. So, when we think about default adjusted returns, we still see the muni market having a really big edge versus other credit markets.
Jenna Dagenhart: Tony, are there any regional or geographic trends you've observed taking shape during the coronavirus pandemic?
Anthony Tanner: We've seen a lot of differences in economic trends. A lot of really good recent articles have pointed out how in a lot of cases, the states and the areas with the strongest response to the pandemic are having the most difficult time recovering whereas states in the Sunbelt area that were perceived to have had maybe less than optimal responses to the pandemic have seen their unemployment rates drop and remain well below the national average. Some of that just has to do with the regional geographic nature of those economies. In economies where they're dependent on more person to person services, larger clusters of people in meetings, that's just difficult to navigate the pandemic right now. Whereas in the Sunbelt states where a lot of the business activity is outside, it's tied to manufacturing and construction, I think about here in Arizona it's a lot easier for a restaurant to open up a patio to 50 people when it's adjacent to a golf course than maybe a restaurant on 3rd Avenue in midtown that has to take out two lanes of 3rd Avenue.
Anthony Tanner: Here in Arizona, there just aren't a lot of places where 100,000 people congregate at a moment’s notice the way that they do on the beaches on the coast. The other thing that we're seeing is in areas like in the Southwest where you're seeing population growth continue, sectors like healthcare I think have a little less inherent risk than populations that have been stagnant or declining. So I think the pandemic has magnified that and I think it's created a great opportunity, as David pointed out, to really discern credit and to add value through finding those things, especially in the investment grade sector where the rating may not really encompass the actual inherent risk of the security and you can find an attractive yield.
Jenna Dagenhart: Final question on credit here Dave, which sectors and states are you most cautious on right now and why?
David Hammer: I think we've touched on all the major sectors in our conversations here, I would put senior living at the top of the list. That's a relatively large portion of the high yield muni index. It's an area that was already struggling a bit, a lot of capacity has been added over the last decade with the assumption that demographics would begin to move into these facilities, but Americans have been aging in place longer, staying at home, working with home health care. So many of these were already missing projections and the nature of the COVID outbreak will really be the straw that breaks the camel's back so to speak. Hotel and occupancy tax backed bonds, sales tax bonds are a great example of really having to dig deep and understand what generates those sales tax collections. Anything that has a big concentration to a brick and mortar retail shopping activity we see taking a big hit.
David Hammer: Then from a geographical perspective, I think there's two areas that we're worried about. It's those tourism related economies, I throw the state of Hawaii in there as an example. Then in addition to that, I'd say there's a compensation issue, how much are you being paid to take risk in some of these areas? Because of the state and local tax deduction, the elimination of it as part of 2017 tax law, a lot of investors really flooded into state specific investments in high tax states, that really stretched valuations. Many of these states are also highly correlated with the US economy, they have a high beta to the S&P 500. So, as the economy slows down, their tax collections slow down, they tend to borrow more money, and we see downgrade cycles.
David Hammer: So many of these high tax states or areas that again, we don't think there are any defaults here, but investors haven't been paid a lot for riskier because valuations are rich. We think there's a big benefit to really diversify nationally and go after what's really become a target rich opportunity set with so many mis-priced bonds and mis-priced credits where you're being paid a little bit more after tax today then maybe just investing in a high tax state bond.
Jenna Dagenhart: Before we wrap up the panel discussion, I want to spend a little bit of time here on relative value. Dave, how attractive is muni relative value today versus taxable fixed income alternatives like treasuries and corporate bonds?
David Hammer: We've all touched on how fast the muni market snap back after the draw down in March and April. But since then, it's been slower to recover the market as a whole versus other fixed income credit markets like investment grade corporates or high yield corporate bonds. As you move down the credit curve, this becomes more exacerbated just by the flows in and out of these asset classes. So, I think the data point I would point to is high yield corporate bond funds year to date have seen billions of dollars in inflows about, 14% of the asset class in new investments. The high yield muni market has actually seen $7 billion in outflow still. So, as the retail investor has been slower to come back, credit spreads have stayed much wider in tax-exempt munis than other credit markets.
David Hammer: Where we see really exceptional value today is in the BBB portion of the muni market. Many of these bonds are trading at simple yields before taxes that are equal to BBB corporate bonds with much less default risks. So, for an investor in the highest tax bracket, that can mean 200 to 300 basis points of after-tax pickup with less default risks than corporate bonds. Stepping into the high yield space for those higher quality high yield muni bonds that do pass our stress tests, we see tax free yields in the 4% to 5% range, that's a 6% to 8% tax equivalent yield. In a world in which we expect rates to remain lower for longer, we see quite a bit of value in these credit spreads that have lagged in their recovery.
Jenna Dagenhart: Grant, what's your outlook for muni is in 2021? And how do you think munis will stack up against other types of fixed income instruments?
Grant Dewey: I think we've probably spent an hour listening to two very successful month managers with a great track record. The takeaways are I think it takes very, very careful selection of names to provide the outsize returns. If you look at just general sectors like the airport sector where I think generally there's quite a bit of value, but you do really need to dig into O&D traffic and the recovery of the business traveler and things like that and liquidity as we talked about earlier. So, I think the alpha is in some of those names because I do agree certainly with Dave, that we're going to be kind of lower for longer as an interest rate environment. So, you're going to get either through credit by... It's a very nuanced market and by selecting the right credit. Also, structure is very important in our market, there's all sorts of different coupons and call structures. So, a professional manager being able to price, and value call options are the kinds of things.
Grant Dewey: If you look at the sophisticated credit analysis and the scale that they bring all with management fees, present great value. I think professional managers are the way to go in this market. We'll continue to see a bunch of downgrades, they've said three or four years after the financial crisis, a lot more downgrades than upgrades and that is going to impact total return. Even if the bond pays, which most of them will, downgrades will impact total return. So, it's a very interesting market. I think we're going to be in a static rate environment so it's going to be a combination of credit and structure and avoiding the pitfalls which I think we've talked about those, the narrow revenue streams, or the project finance where recoveries can be anywhere from zero to 20 cents versus recoveries on essential service are much, much higher. So, I think that we've had two strong years of performance in munis and I think it can happen again but it's going to be trickier this year or next year.
Jenna Dagenhart: Tony, in conclusion, where are you finding value in today's market?
Anthony Tanner: Jenna, the easiest way I think to answer that question is to identify where I'm not finding value in the market. I would first avoid staying away from the longest dated maturities and leveraged products. I outlined earlier just the risk return challenges that you face in a low yield environment and you just amplify those when you're going out to the longest part of the yield curve. When you add leverage, it just simply magnifies that by multiple factors. The other place that appears to be safe but I have always never equated safety and risk lessness is staying away from the shortest just absolute highest quality bonds because going back to the notion of preserving purchasing power, if you're not getting something in aggregate that's getting it close to that inflation bogey, it's sometimes is better to be on the sidelines.
Anthony Tanner: That being said, we talked earlier about liquidity, and so looking at opportunities to buy something that gives you liquidity as well is really important. So, as David pointed out, you can capitalize on that next opportunity. Only about 2% of the muni market trades on a daily basis, it's really a trade by appointment market. The liquidity challenge the market faces is in times like the pandemic, no one's around to make a trade, no one's there for that appointment. So, sticking to quality that has liquidity I think is a really good thing. It's really important to have real genuine economic diversification not just appearance diversification that's why sliding down into those A and AA rated revenue issuers that have solid recurring revenues is a really good way to go at the margin.
Anthony Tanner: For those in what I consider high state tax rate state, a meaningful state tax rate, looking at state specific funds I think is a really good idea, especially in economies that are really very well diversified. Getting away from the traditional New York’s and California’s, there are a lot of states out there with tax rates that are meaningful, whose economies are actually rather quite diverse. If you can tap into a local manager that understands the nuances of those markets, I think there's a lot of value there. Last thing I would point out is one of the sweet spots I think that are out in the market now is if you're in that intermediate space and you're capturing 90% of the lion's share of income that's out there, with only taking about two thirds or half the risk of owning a long bond. So, I keep coming back to that value proposition because munis aren't going to make you rich, they are going to help you stay rich, but you want them to be an effective tool in your asset allocation decisions.
Jenna Dagenhart: Finally, Dave, where are you allocating capital moving forward and where do you see the most attractive opportunities right now?
David Hammer: Well, I've already touched on the dislocation in BBB munis and some high-quality BBs. When it comes to the very high-quality part of the market, I think we might have a slightly different view than Tony would be duration extension. Because most muni bonds are callable, you can actually extend maturities with slightly shorter call dates and when you option adjust that duration, there's not a lot of additional interest rate risk, but what there is due to the Fed's participation in the very front end of the curve versus a muni market that has an average maturity of 12 years, you can take advantage of a curve that's very steep in terms of roll-down and carry. When we look at a five to seven-year bond versus a call it a 15-year bond with a slightly shorter call date, you can earn a lot of excess return as that bond rolls down the curve so to speak, again, without taking a lot of excess interest rate risks. So that's an area that I think we see some structural alpha in addition to credit selection and some of these mis-priced bonds over the next year.
David Hammer: The last thing I would say is we're in very uncertain times, we don't know what the future looks like, so for muni investors, it really pays to do your homework. Stress tests individual holdings for an economic outcome that is both uncertain, has the potential to be worse than investors might expect and really ensure that your bond is secure, and you have liquidity to get through the next couple of years, whatever they may look like.
Anthony Tanner: David, I would concur with you on that bond structuring and current proposition that you just talked about because there is a great deal of value there. There was an interesting study before the pandemic hit that looked at who was buying the longest dated 2% and 3% coupons due out 20 years and longer and it was decidedly skewed towards retail rather than institutional. I think when I talk about the long data, that's the area that I want advisors, investors to tread with caution because as you pointed out, if you're on the 15, your part of the curve, you're rolling down pretty fast. Five years later, there's a big difference between 10 and 15 years, not a lot of difference between 25 and 30 years.
David Hammer: Yeah, I definitely agree with you there particularly on the low coupon component, that's a much bigger risk as investors thinking about duration extension if rates were to go up in the future.
Jenna Dagenhart: Grant anything you would add there?
Grant Dewey: Certainly some coupon protection, the long pars type structures are very negatively convened and you have to be nimble in terms of when you're buying those for excess yield and selling them in a period where if the market is selling off, that's a very difficult bond to sell and becomes quite illiquid. So those are all like the nuanced parts of the market that are important to operate with.
Jenna Dagenhart: Well, everyone, thank you so much for joining us. Great to have you.
Anthony Tanner: Thanks, Jenna.
David Hammer: Thanks so much.
Jenna Dagenhart: Thank you for watching this Muni Bond Masterclass. I was joined by Dave Hammer, head of municipal bond portfolio management at PIMCO, Tony Tanner, senior vice president at Aquila Investment Management, and Grant Dewey, head of municipal capital markets at Build America Mutual. I'm Jenna Dagenhart with Asset TV.