MASTERCLASS: Midyear Outlook - July 2020
June 26, 2020
Jenna Dagenhart: Welcome to Asset TV. This is your municipal bond masterclass. The coronavirus pandemic sparked historic volatility, and economic shutdown, and selloffs across the board. In response, the Fed has launched aggressive bond buying programs injecting some much-needed liquidity into markets. Joining us today to discuss the impact on muni bonds, credit quality and more, we have three expert panelists. Chris Johns, a Portfolio Manager with Aquila Group of Funds, and Senior Vice President, Managing Director with Davidson Fixed Income Management. Grant Dewey, Head of Municipal Capital Markets at Build America Mutual, and JR Rieger, Owner of the Rieger Report. Everyone, thanks for being with us.
Grant Dewey: Thank you, Jenna.
JR Rieger: Good to be here.
Jenna Dagenhart: Yeah. Great to have everyone joining us remotely for this timely panel. Chris, starting with you, how did we get here, and how does this volatility compare to other black swan events that have impacted munis?
Chris Johns: Well, over the last 10 or 12 years or so, we've seen a couple of these dramatic events like this where we've seen some volatility in the muni market. I would say this one is a little bit different this time around. As people became concerned and investors became concerned about the coronavirus, there was a pretty strong move for people, investors' desires to move to cash, and so we saw many people selling shares of mutual funds, and that created a need for those mutual funds to sell bonds to raise cash.
Chris Johns: That happened in a fairly dramatic fashion, an unprecedented fashion for a couple of days, or three or four days there. That's what really made this one different, was the amount of movement. Obviously, since then, it's rebounded very sharply. I can't say for sure that this would never happen again, but the market's definitely stronger now.
Jenna Dagenhart: Yeah. JR, what do you think makes this market environment unique for munis?
JR Rieger: The world of unknowns. We've never encountered this before, and we're dealing with potential distress from the state government, all the way down to the tiniest municipality. It's not as simple as saying we've got an economic recession in the East Coast or in the Rust Belt of the U.S. We've got to figure out the impact of COVID-19 on almost the entire municipal bond marketplace, and it's most evident, the early days, it's showing its most evident in the areas where you think it would be. Like in the entertainment type bonds that were issued for museums, and aquariums, and convention centers.
JR Rieger: Then you look at the airline type of debt that's out there. Municipal bonds to finance corporate entities like American Airlines and Delta. Those got crushed, and the airport bonds got crushed. This is early days, and this scenario that we're in, and the unknowns are still very much unknown, as we look at the portfolio, what makes up the municipal bond market.
Jenna Dagenhart: I've heard some people say, "It's not the unknowns. It's the unknown, unknowns that will get you."
JR Rieger: It appears that way in this market. Now, who would have said that we would have had a pandemic that would shut down travel or the population that travels on the New York subway? That's really science fiction becoming reality in this market.
Jenna Dagenhart: Yeah. Not that you can predict what it will be, but this is definitely the definition of a black swan kind of event. Grant, how is the credit quality of insured bonds faring in this kind of market?
Grant Dewey: Just to get back a little bit to the black swan event, I think that we saw even more volatility this time around than we saw during the Financial Crisis or during the Meredith Whitney, or some of the other events, cycles that we've been through. I think the dealer balance sheets were stressed in a huge way. Right away, we had a lot of the 21% buyers of munis were not there, kind of as incremental buyers, until it was, we had already seen a lot of the damage. There was a lot of high yield selling. You had AMT spreads widen out. We're such a technical market that when you get selling like that, a lot of it coming out of the high yield funds, a lot of it being AMT paper, that you saw a lot of distortions.
Grant Dewey: It was, in talking to people on the street, they felt that this was uniformly, absolutely the biggest shock they had seen. That has, as Chris and JR said, that's mostly stabilized with the exception, the credit spreads have still remained wide. Certainly, some sectors performing better than others, but the rates have mostly recovered, the real high-grade side of things. In terms of being a bond insurer, there's been ... We're rated AA by S&P; we have quarterly meetings with them. They stress the portfolio a number of different ways, assuming a downgrade of one notch and one whole rating category on certain percent of the entire portfolio.
Grant Dewey: We have 60 billion that we've wrapped, but we've come through an extended period where most municipal governments were able to put some money aside, in terms of rainy-day funds. I think there was, prior to the COVID crisis, a lot of the credits that we had insured were actually in very good shape. In terms of payments, we have followed very closely. There's been the April 1st, April 15th payment. All issuers have made their payments. Again, most of that debt service is pre-funded almost prior to when the crisis hit.
Grant Dewey: Above it all, S&P recently put out a piece on the U.S., on the municipal bond insurers reaffirming their assessment that there are a bulk of insurers that are actively writing policies, are well-capitalized and able to withstand this based on all the stress tests, and I believe we are too. We have a fairly conservative, or very conservative portfolio. We don't underwrite any of the territory debt. We don't underwrite a lot of the bonds, frankly, that kind of blew out, whether it's tobacco or corporate backed airline bonds. We're kind of muni only, and in the 50 states, so I think that has served us well.
Jenna Dagenhart: Chris, how would you describe the nature of muni credit? What are you experiencing right now in your portfolios?
Chris Johns: Well, for us, we traffic exclusively in the investment grade stakes. There, how I would describe it is, issuers, generally speaking, over the last 12 years or so with all the volatility events we've had, tend to be very resilient. The reason for that is the nature of the revenue streams that repay municipal bonds. If you think about kind of essential service type issuers like water and sewer districts, electric utilities. Then on the other side, you have general obligation bonds that are backed by property taxes. Those aren't necessarily real volatile revenue streams and can recover from whether it's a recession or some of these black swan events, so they're a little bit more stable revenue source.
Chris Johns: Then the other thing I think that's important to know is that with many of these, and almost all of these municipal issues, they have a little bit stronger legal protection than what you might see in the corporate bond market. For instance, there's debt service coverage, ratios that they have to meet. Sometimes, there's covenants or what type of reserve funds that they have to keep for a bond issue. Many times, the reserve fund can be a year or more worth of debt service payments. Those legal protections tend to help municipal issuers and investors get through periods like this because of that underlying credit strength.
Jenna Dagenhart: JR, any thoughts on your end about general obligation bonds versus revenue bonds?
JR Rieger: Yeah, so the way I'm thinking about it, Jenna, is in three different buckets. If I were sitting down with one of my retirement clients today, and I'd look at their portfolio, I'd say, "What do you need near-term?" That's the area that I want to protect. What are they going to need long-term? What are their long-term needs? When you start breaking up needs up into buckets, you know how to begin to look at the different credits. To me, essential purpose municipal bonds, Chris mentioned it, is utility, electric and water type of credits that are out there. They're probably not going to go away.
JR Rieger: If you're going to buy a smaller municipality, debt up in a smaller municipality, well, think about maybe having that insured. That gives you that extra layer of protection on that. It doesn't eliminate all the risk, liquidity risk, for example, but it helps cover you a little bit. Avoiding the areas that are getting crushed right now, unless you have the ability to take on losses. Nursing home bonds, CCRCs, assisted living. The hotel financing that's been done by municipal bonds. Those cycles are going to be potentially volatile as we're going through the rest of 2020 and has a lot more of that unknown risk that we were just talking about.
JR Rieger: I look at bonds as essential purpose, the GOs, the counties and the local municipalities more than the states. Then I look at the essential purpose revenue bonds as being the muni bonds that mom and pop know and understand. Staying away from the gaming, the lodging, the entertainment, the zoos, the aquariums, the stadium bonds, for the time being, unless you're a gambler.
Jenna Dagenhart: Grant, where do investors feel the most secure right now within the muni market? Is there a safe haven, per se, within munis?
Grant Dewey: I think there is. Right now, there's a relative safe haven. If you look at the market in April, there's been really only about eight or nine deals that have come to market over 250 million. If you look at those, the State of California did a ... That's actually the only deal that's over a billion for the month. You also had a Harvard University deal. You had double ... You had Los Angeles Department of Water and Power, which is a double A essential service credit. I think the deals that are getting priced are probably giving us a little bit of a snapshot into what the market thinks are as close to the less risky bonds.
Grant Dewey: Clearly, the issuers that JR was referring to that rely on a narrow, like a hotel tax bond. Convention centers, obviously, are under a lot of pressure, but you do have to look under the hood there, because there are some convention centers that will continue to wrap in this environment, just because the taxes associated with a bond aren't related to convention center revenues, or just hotels in the convention center area. Some of them have very broad tax revenues, and so we're comfortable with those. It's really, the devil's in the details. You really need to do the credit work and especially in this environment.
Grant Dewey: March reminded everybody that it is sort of a credit driven market now. When everyone was reaching for yield, the credit spreads were very narrow. There was almost complacency about credit, and even from the issuers' side, about covenants. I think we're now in a period where people are picking through the winners and the losers. I think the winners are those essential service, water and sewer deals. Frankly, those are a lot of what we insure against.
Grant Dewey: You're saying, "Why would somebody buy insurance in the safest sector?" I would say that people are rarely buying our insurance because they think the bond is going to default or even has a likelihood of defaulting. You would probably just sell that bond. I'm sure that Jenna would give that advice. There's downgrade protection. When you do fundamental credit analysis, it's really hard to quantify the risks of a pandemic, or a cyber security attack, or a variety of things like that. That's why we actually have seen a big tick up in insurance.
Jenna Dagenhart: Yeah. People still buy insurance on their home, even if they don't think it's likely it will burn down.
Grant Dewey: Really, look at it almost as a little bit of a downgrade protection and a belt and suspenders against unforeseen events.
Jenna Dagenhart: Yeah. Chris, you touched on this a little bit earlier, but anything you'd like to add on how different muni sectors are being impacted differently by this pandemic, given the nature of their service?
Chris Johns: Sure. I would agree with what Grant said here about the different sectors. I think from ones that we're looking at a little bit closer, are some obvious sectors where there's immediate pain being felt. Some of those would be in any kind of transportation-backed, or any kind of transportation issuers. Things like airports. Mass transit is a big one. Light rail, trains, things like that. Bonds that are exclusively backed by sales tax, and even healthcare bonds too. Those more enterprise type sectors that depend on these revenues. Those we have to look very closely at.
Chris Johns: As far as airport and mass transit, which are very large issuers of municipal bonds, one thing we can't overlook is the fact that they will be the beneficiary of large sums of money from the federal government that are put directly to the major airports. The interesting thing to note, and I'm sure that JR has research on this that shows that a lot of the big, major metropolitan airports have, many times, over a year's worth of cash. Sometimes, as much as two- or three-years’ worth of cash on the balance sheet, so they can be shut down for a while and still be able to service their debt payments. When you add that to the fact that they'll be getting direct stimulus funds from the government ... For the bigger airports, they're probably going to be okay in the short run here.
Chris Johns: There's a variety of things that are happening here, and I think you really have to look closely at the revenue streams combined with any kind of federal support that these particular sectors maybe get.
Grant Dewey: Yeah. We agree that the challenges are more around near-term liquidity than they are any sort of longer-term solvency within LAX or anything else. It's just, you want to be looking more than ever at what type of reserve funds, and what's the cash on hand? A lot of these security features that ... The airport sectors, if you were operating, we think, in the correct kind of larger type airports, that's a pretty good value right now because, obviously, there's been sort of a general cheapening of the sector and we think some for a better reason than others.
Jenna Dagenhart: JR, anything that you would like to share based on your research with the transportation sector and how that's holding up?
JR Rieger: Well, I think the issues that I look for are, "Can I buy the bond that's going to fit in my client's portfolio or in my portfolio, and meet the objective I'm looking to meet, and get incremental yield in the process?" Not so easy for a mom and pop to define those bonds and actually understand the credit provisions, and even just download the official statement or prospectus from EMA. I'm not expecting a mom and pop to take all these steps and be able to look underneath the covers to the extent that the professional muni folks can do in this market.
JR Rieger: It's looking for the names you know and understand, and identifying where there could be some opportunity, if you can find the bonds. Remember that there are still algos in the muni market like there are algos in the corporate bond market, who can buy odd lot or retail positions at a much faster pace than an individual can, so you're competing against other individuals, mutual funds and technology that's looking for bonds that have a little bit more spread when they, historically, haven't had that spread before, and trying to scoop them up. It's not so easy.
Jenna Dagenhart: What do you think the COVID-19 impact has been on local and state issuers?
JR Rieger: I'm not worried about the states like New York, for example. I would think you should see more spread in states like Illinois. More spread in states like New Jersey, Connecticut, where deficit financing has been seen, pension deficits are prevalent and quite large. That could cause some real risk at the state level. Remember, most income that the states get are from us, you and I as taxpayers. They get other revenue from sales tax and that kind of thing, but the majority of income that comes in is from you and I earning a paycheck.
JR Rieger: If those economies are seeing population trends that are negative, they're seeing stress in their fiscal budgeting process, they've got pension shortfalls, there's bigger clouds out there than just the COVID environment, but the COVID environment isn't helping them at all. I'm more worried about those, but I'm also looking at it opportunistically. If there's an Illinois GO bond that's out for a bid, and I can get that bond at a couple hundred basis point spread than where I could have bought it three or four months ago, I'm going to pay some attention to that, because I, like many other investors, are still yield starved, and they're still looking for any bond with that additional yield on it. Unfortunately, that means we put some blinders on. Sometimes, we close our eyes and hold our nose, and have to buy a bond because it's got some yield to it.
Grant Dewey: It's interesting. If you look back a year, there's only four states ... The market will tell you that the states are generally in quite good shape. There are only four states, according to Credit Sights, that are trading at wider credit spreads than they were a year ago. Those are the states that obviously have been working through their problems. Some of them have been recently upgraded as coffers were filling, but Illinois, Pennsylvania and Connecticut are the three that are trading wider.
Grant Dewey: California had widened out about 20 basis points, but I think that was largely related to a $1.4 billion deal that had just been priced. Again, the market will tell you that it's the states that were under some stress going into this that are going to widen out. The others are all in pretty good shape to weather the storm.
Chris Johns: I would add that for us, we represent two states, Colorado and Oregon, that are on the opposite end of that spectrum. The economies in both Colorado and Oregon have been exceptionally strong in the last few years, and so going into this event, most, not only the state, I mean big cities, but even local issuers were in pretty good shape. We had seen ratings upgrades over the last several years, and so for us, for Colorado and Oregon, it's nice to start from a position of strength instead of one that has been struggling. I think that will help us in the long run.
JR Rieger: I think there's so little Oregon paper available for the other national muni investors to divide, help them diversify. It becomes kind of a premier asset, an asset that's in higher demand, just has a diversifying effect.
Chris Johns: Yeah. That's really been true over the last several years. Because Colorado ... I'm sorry. Because Oregon is such a high quality, credit quality state, the demand nationally for Oregon issuers is still quite high, so it makes our job tough sometimes to try and fight with some of the big guys out there that are after our bonds, so that's a very good observation. For us, that's both the good news and the bad news.
Jenna Dagenhart: Kind of a good problem to have there, Chris.
Chris Johns: Yeah, I guess. The prettiest girl at the dance, so to speak.
Jenna Dagenhart: What kind of questions are you hearing from your clients right now, Chris?
Chris Johns: Most people are really, from a quantitative perspective, are trying to understand why this has happened in the muni market, why we've seen this volatility. Historically, the municipal bond asset class has been a little less volatile of an asset class for all these reasons that we've been talking about. We've seen two or three events now where that wasn't true for a period of time. We try and walk them through why that's happening. Part of it is fewer participants in the muni market, where mutual funds are kind of the 600-pound gorilla right now. Banks and insurance companies had stepped away for a bit because of the lower tax rates that the Tax Cuts and Jobs Act created a few years ago, so there wasn't as many participants, which makes it a little bit more volatile.
Chris Johns: The good news is, is that what we're seeing is, what we refer to as crossover buyers. Buyers that are typically taxable investors that come into the muni market because the yields are still attractive, and the fact that the credit characteristics in the municipal bond market are generally stronger than what you see in the corporate bond market, and arguably, in the U.S. Treasury market these days. Our clients really want to get an understanding of why we've seen the volatility and just like all the questions that we have today talking about this stuff. They want to know what's going on.
Jenna Dagenhart: Grant, what kind of questions do you think investors should be asking about the credit strength of their muni bond portfolios?
Grant Dewey: I think they should have already asked some questions. In terms of what they're buying, I think that these guys have stated very well what they should be looking at, what are the fundamental drivers of credit analysis? Again, as I said, even if you do that perfectly, you're still going to be open to unforeseen events. I think that depending on whether ... It's hard to put everybody in the same bucket, but there are some people that are willing to take that businessperson’s risk, and at a time like this, venture into the credits that have been hit the hardest.
Grant Dewey: Then there are others that really want to just treat the muni asset class as a very safe haven, high grade, ladder portfolio or whatever. Not anything that they want to be thinking about of loss of principal, so I think those investors staying in higher grade paper, and also, I really do think insurance. Not only for the protections it gives you, but also understanding that we have dug into, pretty deeply, pension issues and a lot of things that I think that it would be extremely difficult for an investor to begin to get their arms around. We like to think of it also as a bit of an advocate for that issuer.
Jenna Dagenhart: In this kind of market environment, dystopia if you will, is secondary trading, you think, JR, providing enough liquidity?
JR Rieger: There are times where it has failed, and that's one of the reasons why the Fed has stepped in. I think that we had a very unique, dramatic event that occurred a couple weeks ago, where there was a significant outflow, share, price disconnected from the NAV, the net asset value of a fund. To some cases, it was 20%. A significant shift of ETF share price versus its NAV, 20% lower of the share price. It created an opportunity, but it also showed that the market has never enjoyed liquidity of its counterparts in the corporate bond market.
JR Rieger: The reality is there are tens of thousands of different issuers. I live in a summer community that has 400 homes. We borrow in the municipal bond market without a problem to build our infrastructure, long-term capital projects. It ranges to very large borrowers like the State of California, State of New York. That's a lot off disparity in the municipal bond market. Just to a point that Grant mentioned about municipal bond insurance. When I was growing up in the business, 50 to 60% of all the bonds in the secondary market were insured by an insurer.
JR Rieger: It was rare to really worry about an individual underlying credit, because all the other bonds were very high quality credit, AAs and AAAs, so to have the insurance there for a retail investor or an individual investor like me, and get the same yield or in some cases, even higher yield than I would on a comparable bond, I'm going to look at that insurance very carefully. I want that bond that has the insurance.
JR Rieger: I have a mix in my portfolio now. It's not half and half, but wherever I can find a bond that's got insurance on it, I'm giving it a good look, and making sure it fits my portfolio from all the other requirements I have. It gives me that comfort level that I don't have to look into the Village of whoever and try to get into their financial statements and do a deeper dive or risk assessment when, as a retailer investor, that's really not practical.
Jenna Dagenhart: Grant, anything you'd like to add about secondary market insurance and how demands changed since the start of COVID?
Grant Dewey: Yeah, so part of my responsibility at BAM is that I run the secondary market insurance business. Just to describe that, we have, issuers will come to market with insurance, and they're actually buying the insurance. They're buying insurance because the market ... To save money. The market will spread, insured to uninsured bond at a higher level than the cost of the insurance, so net net.
Grant Dewey: Now, if a bond comes to market as uninsured, there's 3.8 trillion or something of outstanding munis. A lot of investors, at some point, whether it's a change of circumstances, a change of rating, a change of heart, whatever, will look to ensure a bond once it's been issued. We do quite a bit of that. Obviously, it's picked up quite a bit here in March and April, and so that's a good business for us. In that situation, the investor is buying the insurance, not the issuer.
Grant Dewey: Again, I think that it really is, we've been seeing a lot more interest in higher grade paper. One of the reasons the penetration rate was so high, that JR was referring to, is that the insurers were rated AAA. I think that what got those insurers in trouble was not their municipal underwritings, but venturing into other kind of higher premium areas, structured products, mortgage related stuff, so it really wasn't municipal default rates that got those in trouble. As an AA insurer, less of the universe is going to be insurable. Presumably, you're not going to insure an AA-plus rated bond with AA insurer. What we have seen is a huge pickup in the amount of, what we would consider in the AA category, insurance. It's relatively inexpensive and it gives some extra security, liquidity in a market which is obviously very disrupted.
Chris Johns: Yeah, I would agree with that. As an investor, we have used insured bonds from time-to-time. I would really encourage you, Grant, to look at Colorado and Oregon. We're fans. If you want to allocate some of your precious capital into those two states, we'll take it. It's interesting because in Colorado, we have a very broad spectrum of credit there, I mean very broad. Oregon is a higher credit rated state, but there are opportunities in both states, so we would welcome your participation in those two states.
Grant Dewey: We certainly love to diversify our exposures. In states like that, I would say the biggest, other than the generally high credit quality, I would say one of the big impediments is that those names tend to trade pretty well, pretty tight, and so it's hard to get kind of ... It's much more difficult, especially with all the bonds priced at, for the last year or two, essentially as premium bonds. The cost of insurance actually gets amortized to the first call, so eight, nine, ten-year call. Because of the dollar value of the 01 is smaller, it's a little harder to make a compelling case for insurance. When we, briefly in March, a lot of premium bonds, there were virtually no premium bonds in the market in January and February.
Grant Dewey: A lot of 3% coupon bonds had been issued. We have a way of scouring the secondary market, and there were virtually no bonds at a premium. That changed in a matter of just a few weeks. As a bond goes to a discount, it really does create more compelling opportunities in the high tech, in the states like Oregon and Colorado because of the ability to amortize the cost of maturity.
Jenna Dagenhart: JR, you kind of already touched on this, but do you think now is the time to be looking at insured muni bonds?
JR Rieger: Yeah, I do. If you can find the individual bond that fits your portfolio objective and you can find it as insured, that's a win-win from my perspective. It takes one of the risks off the table. Every client I talk to, and even in my own investing, they always tell me that they're going to buy a bond and hold it until maturity. Yeah, I'd love to do that too, but life happens and then we have to sell it. If I have to sell a bond, I'd rather it was insured than just a standalone credit. I think it's going to be easier to sell in the long-term. I think that you got to take liquidity into consideration here.
JR Rieger: Remember, there are tens of thousands of different issuers. If you're selling an issuer that's not well-known that doesn't frequently come to the market, that could pose a liquidity challenge for you right away. Don't forget, retail positions like what I buy, they get penalized in the market when they go to sell it. Those are marked down. Then the dealer buys it and marks it up and sells it to somebody else. That markdown, plus the drop-in liquidity really makes a difference, so every piece of tool, every tool in your toolbox is good, and having bonds that are insured help in that process.
Jenna Dagenhart: Grant, what kind of structural protections are in place for muni markets?
Grant Dewey: You're getting back a little bit of [inaudible 00:35:39] there, Jenna, so the question to get back a little bit to, I think that there has been a pickup in demand for revenue bonds that have dedicated revenue streams, whether they're securitizations or dedicated tax bonds. Because I think the feeling is if you look at a bankruptcy situation, at those cashflows, if that's structured properly with the right legal protections, can be considered bankruptcy remote.
Grant Dewey: There should be times where you could have a default on a GO and the water and sewer bond in that city continues to pay. I think those protections have become more and more appreciated. It used to be GOs were the gold standard. I think the tricky part is, it needs to be structured in a way, everybody thinks that they have a bankruptcy remote, true sale situation, but in bankruptcy, you just never know. We've been through it in Puerto Rico with the sales tax bonds. It gets very complicated. I do think that more and more issuers are turning to these dedicated revenue streams. New York City uses it for a lot of their issuance.
Jenna Dagenhart: Chris, a lot of people are drawn to munis because of their tax benefits, but do you think that people's motivations are changing, looking at the risk-free rate right now?
Chris Johns: Well, yeah. There's been just a remarkable dislocation in the interest rates on tax exempt bonds and the those on Treasury securities. That's driven primarily by just massive amounts of buying of U.S. Treasury securities by the Federal Reserve. To quantify that, towards the end of the quantitative easing period of a year and a half or so ago, the Fed was buying roughly $50 billion a month in Treasury and mortgage backed securities. Well, since this virus situation, they were buying that much every day. The reason for that is they're trying to drive down interest rates to generate economic activity. Probably more importantly, to offer liquidity to the financial system.
Chris Johns: The problem with that is, is that in the municipal bond market, we don't exactly have a rich uncle. We haven't really been buying bonds in the municipal bond space yet. We have talked about that, but it hasn't actually happened yet, so you see this divergence in yields to the point where, today in the market, right now you can get yields that are four or five times higher in the short end of the curve in the tax exempt space than you can get in U.S. Treasuries, so it becomes an asset class that attracts what I talked about before, the crossover buyer or taxable buyer, where they can get higher yields, nominal yields in the tax exempt market, and the credit structures are usually much better than the corporate bond market.
Chris Johns: We've attracted a lot of new investors, even foreign investors, to the tax-exempt market that really don't care about the tax exemption. They just like the nominal yields plus the credit protections that are in the market, so we broaden our investor base for the time being.
Grant Dewey: I think the danger is that the muni ratio or the ratio of muni yields, Treasury yields, have really decoupled. In the first quarter we saw 10-year ratios at 70%. Then they got to 350% just because of the flight to quality was unique to Treasuries. I do agree that we're extremely cheap on that pace that's relative to Treasuries, but it seems like any risk asset in that comparison is going to look very attractive just because there's nothing like the old U.S. government Treasury bonds, 20 basis ... Or, I guess, the 10 year now is at 60 basis points.
JR Rieger: Chris and Grant, what I've been doing is looking at the AAA muni curve versus the curve for Microsoft Corporation bonds or Apple Inc. bonds. It still shows that on the short end, munis are relatively attractive AAA to those credits, particularly from a taxable equivalent yield perspective. Then it doesn't come back into favor for munis until a little bit longer out in the curve. Perhaps in that 12, 15, 20-year range it becomes again attractive for muni investors in regard to your higher tax bracket type of individuals. The opportunity seems to be a little bit on the short end, for sure. Then you got to pick and choose kind of carefully as you go out in the curve.
Grant Dewey: Right. We all know that an A-rated municipal is much less likely to default than an A-rated corporate, so if those yields are somewhat equivalent, I would argue all day that, obviously, the muni would be better, more compelling value.
JR Rieger: But you're giving up liquidity with the muni.
Grant Dewey: Yeah, and with corporate, but yes.
JR Rieger: Relative to corporate, munis are generally-
Grant Dewey: Because you can't-
JR Rieger:... less liquid, yeah.
Grant Dewey: It's easier to hedge a corporate, certainly.
JR Rieger: Yup.
Jenna Dagenhart: Chris, going back to your point and looking at the relationship between muni yields and Treasuries, why do you think there's such a disconnect there?
Chris Johns: Well, it's largely because of Federal Reserve interaction. I mean, with the fact they're coming in and pushing Treasury ratios down so much. That's the main reason why that is. It's attracted other investors to the muni market, which is reducing that difference. It's still there in a very significant way, so until the Fed either stops doing that, which isn't going to happen any time soon, or they participate in the muni market in some kind of meaningful way, which will be very difficult, I think that that relationship's going to last for a little bit, for a little while.
Jenna Dagenhart: I'm glad that you bring up the Fed. The federal government has made strong interventions to support municipals through the CARES Act. Then looking at the Fed, the Fed, its municipal liquidity facility. What kind of impacts do you think that they've had in stabilizing municipal credit and market liquidity, Grant?
Grant Dewey: Well, they've had a big impact. There are some unintended consequences, I think. The first thing that they did was, as dealer balance sheets were overwhelmed with short-term money market variable rate securities, to the point where very high-grade variable rate munis were trading at 5, and 6 and 7%, which, it shouldn't happen. There was, obviously, this flight to quality. Weekly floaters weren't good enough. People wanted to be in cash. The Fed came in and purchased those from dealers to help alleviate the balance sheet problems, and so that did a lot to stabilizing the short-term market. That was first and foremost.
Grant Dewey: Then more recently, the problems extend well beyond just market liquidity. The $500 billion CARES Act, and I think anytime you put legislation like this together that quick ... There are 500 billion for the muni market, not in total. There's going to be, it's going to have to evolve over time. I think the first iteration was one that benefited the states, not in a grant but offering to purchase their debt at, presumably, kind of a market rate, but It only applied to the largest of issuers. It applied to the states and to the large counties. I think, in total, it was 25 or 30 issuers that were eligible.
Grant Dewey: Frankly, I think it's the smaller localities that are probably, that have more issues coming to market than the State of Oregon would. They're trying to figure out how to get the money, push it down to these smaller municipalities. I mean, to have a state borrow from the Fed, in many cases, it might put that state in a position where they're put on negative credit watch or even downgraded because of additional debt. Really just to pass it down and take on credit risk from the local municipalities, I just don't think that that was going to do the trick to get the money where it's needed.
Grant Dewey: Just quickly, I think one of the unintended consequences is that people are trying to predict where the money's going to ... You're getting artificial credit spreads based on probabilities. If you look at New York MTA, sometimes spreads aren't based on the fundamental credit quality anymore. It's based on who's going to be able to access the funds? Who's going to get the grants? Certainly, I would put airports in that category, so it does create a bit of an artificial market, so that is problematic.
Chris Johns: I think it's been, I think, a positive development with the municipal liquidity facility. I think, from a sentiment standpoint, it's really helped the muni market but as you said earlier, the devil really is in the details with these short-term, two-year notes that the Fed has agreed to purchase from these largest issuers. Then it becomes incumbent upon the state or the large city to determine if and how to distribute those funds down the path, whether to smaller local issuers or not.
Chris Johns: Then furthermore, with those notes themselves, what happens when they come due? Will they be refinanced at a market rate? Will the Fed just buy them again? There is a lot of things to still work out there. Yes, it's a good development but how it actually shakes out in the end is yet to be seen. It's something to keep a very close eye on.
Jenna Dagenhart: JR, I see you nodding. Anything you'd like to add about the Fed's response?
JR Rieger: Well, there's two ways to look at this. When you're looking at an individual bond, I'm advocating doing the fundamental work before you buy that bond. Understanding that credit, without any federal intervention, or a guess as to how the Fed's intervention is going to impact that particular issuer, comes into play. Do the fundamental homework. Now's the time to do it. If you are not going to do it and you're going to gamble, well, that's gambling, and that's not investing, and that's not what I'm advocating. I'm advocating doing the homework, and if the issuer does get federal intervention of some sort down the line, win-win, but at least you didn't put your foot in the bucket and buy something that never got what you hoped for, which was the federal intervention.
Chris Johns: We would totally agree with that. Doing the fundamental homework is critical in this market and going to become increasingly so. For some of the big transit agencies, and you mentioned MTA and even some of the airports, we do know they're going to get direct funds, but to be an investor, to buy those securities, that's not why you do it. That's more of a, if that happens and we see over the next year or two how that impacts their finances, then it's a different story, but to bet on the come about, "Jeez, they're going to get this huge federal infusion, I'm getting in now," definitely not the way to pursue that.
Grant Dewey: The political will seems to be there, and it had a big impact on market psychology.
Jenna Dagenhart: Grant, what changes in investor behavior did you see when interest rates backed up in the first few weeks of the COVID outbreak?
Grant Dewey: We saw a pretty big pickup in direct retail demand, so we're not a broker-dealer but we're dealing with a lot of broker-dealers. They're, especially the ones with strong retail distribution networks, their business picked up quite a bit during that period, I think, for a couple of reasons. One is nominal rates were higher than they had been for a while. It was a little bit more fleeting than we thought, but so you had higher nominal rates. Also, yields on individual munis will tend to lag the yields in mutual funds so you could pretty quickly own a 4% coupon bond at par, if your timing was very good, which is more than a 100-basis drop in the value of that bond. Whereas, the yields in mutual funds, because a lot of different bonds purchased, a lot of different prices, they don't tend to react as quickly.
Grant Dewey: Same is true when the market's rallying. The individual bond yields tend to drop faster. I think that was another big driver of that. Also, you had, as I mentioned earlier, the structure. There were a lot more kind of par-ish type coupon bonds in the market, which is a favored retail structure. In some of the kind of money centered banks we were talking to, they said direct retail was running four, five, six times the average from January and February.
Jenna Dagenhart: Chris, moving forward, if spreads widen, how will you take advantage of that?
Chris Johns: Well, for our shop, for our Colorado and Oregon funds, our whole process is very credit driven. Over the last couple of years, what we've seen, I think we mentioned earlier, is that with this slow decline in interest rates and continual narrowing of credit spreads, we felt that risk was kind of becoming mis-priced, where the lower rated municipal bonds were trading at a very small difference in yield to the highest rated ones. We became, I guess to use a word, defensive. 90% of our securities are rated AA or higher. We were defensive on the duration side, with four and a half, roughly, duration. Then on the liquidity side, we had 5 to 10% of our portfolio invested in pre-refunded bonds.
Chris Johns: Moving forward with these spreads, we think now we're making this transition into a credit market, as both JR and Grant said, and that's going to change how we operate. We think we'll get more opportunities to buy, perhaps, some of these lower rated securities that offer higher yields in a credit sensitive market. These are names that, in the two states that we manage, that we've used for years and years. We know them very, very well. If we finally start to see some reward for buying some of the lower rated securities, we'll make that switch, so that could offer an opportunity.
Jenna Dagenhart: JR, what will you be watching moving forward?
JR Rieger: I'm looking for that yield spread to maintain or grow. Jenna, these are the yields we've been hoping for, for the last several years but we're getting them for all the wrong reason. It just kind of popped wider, and it wasn't one credit driving this. It was just a whole market reaction to it. Going back to the fundamental research and looking for bonds that are the right term structure, the right state, the right issuer for me or my client is really, really important. Then, is it at the right price? That question, "Is it at the right price?" actually comes at the end of the thought process, if you will, as opposed to just looking for bonds just because they're cheap.
JR Rieger: Remember, from my perspective, I'm not a fund, so to sell a bond, that punishment I'm going to get, there'll be a markdown, and that just erodes that yield. When we have yields as low as they are, every dollar of that markdown does count in that erosion, so it is something that I'm looking for. The insurance discussion, to me, is very interesting because we're beginning to see some municipalities in energy impacted states come to the market, in the secondary market. I kind of like that. It creates an opportunity to understand the credit and maybe join it with insurance. I've seen it in both Texas and Louisiana. It's something I'm watching. If the bonds do come and I can see that they're eligible for insurance, and energy is just being a broad brush to impact that bond, I'm going to take a look.
Jenna Dagenhart: Grant, any final thoughts on your end?
Grant Dewey: Again, I think this is a shorter-term problem. I think you need honest selection of credits that you think can withstand not the duration of this, but that you want some ratings, durability, and you want larger issuers, I think, can access the market. We tend to insure a little bit smaller deals, and so I think insurance particularly makes sense there. We're literally calling our issuers prior to an interest payment and making sure, especially in this environment, that the administrator, the person that's responsible for transferring the money to the trustee does that.
Grant Dewey: That person might be working from home, or might not have their kind of normal, procedural steps in place. Occasionally, and we wouldn't be surprised if we saw it here, having an issuer be a week, or a day, or two weeks late on a payment. Not because they don't have the money, but because of an oversight or something. Again, we'll make that payment on the payment date. We'll guarantee principal and interest. I think the smaller issuers, you have to keep sort of a close eye on, we certainly do, but we'll get through this.
Jenna Dagenhart: Chris, any final thoughts on your end? Any other opportunities on the horizon that you'd like to highlight?
Chris Johns: Well, I guess as a stable state fund, we have very specialized, highly focused research analysts that do the work in both Oregon and Colorado. I think those types of analysis will uncover some of these credit stories that we could possibly take advantage of, so we're working that really closely. I think the other thing is, is that within our range, we're an intermediate maturity mutual fund, both of these funds.
Chris Johns: If we also see a little bit of a steepening of the yield curve in the muni space, which we've kind of seen in the last few days, that could present some opportunities as well. We could extend a little bit to pick up some yield. Not a dramatic extension by any means, but if that opportunity is there, we'll take advantage of that as well. Between the credit research and the constant analysis of the shape of the curve, we're looking for more opportunities to add some yield to the portfolio, so the more we've had the opportunity to do in the last two or three years where rates have been very low and spreads have been very low.
Jenna Dagenhart: Well, thanks so much for joining us everyone. It's been a great masterclass.
JR Rieger: Thank you.
Grant Dewey: Thank you, Jenna.
Chris Johns: Yeah, it was great.
Grant Dewey: Appreciate it. Thank you, gentlemen.
Jenna Dagenhart: Thank you for watching this municipal bond masterclass. I was joined by Chris Johns, a Portfolio Manager with Aquila Group of Funds, and Senior Vice President, Managing Director with Davidson Fixed Income Management. Grant Dewey, Head of Municipal Capital Markets at Build America Mutual, and JR Rieger, Owner of the Rieger Report. I'm Jenna Dagenhart with Asset TV.