MASTERCLASS: Municipal Bonds
- 50 mins 05 secs
This year the Muni Market hit an 8-year-low, dipping below $4 trillion for the first time since 2014 according to Fed data and the Wall Street Journal. Four experts cover flows and performance, how rising rates and the increasing odds of a recession are impacting credit, and much more.Channel: MASTERCLASS
- Morgan Fahy, Vice President, Capital Markets - Build America Mutual
- Greg A. Gizzi , Head of US Fixed Income and Head of Municipal Bonds - Macquarie Asset Management
- Catherine Stienstra Head of Municipal Bond Investments, Senior Portfolio Manager Columbia Threadneedle Investments
- Brian Barney, CFA®, Managing Director, Institutional Portfolio Management and Trading - Parametric
People: Brian Barney, Morgan Fahy, Greg Gizzi, Catherine Stienstra
Companies: Build America Mutual, Columbia Threadneedle Investments, Macquarie Asset Management, Parametric Portfolio Associates
Topics: Municipal Bonds, Tax, Economy, Credit, Interest Rates, Federal Reserve, Akademia, CE Credit, ESG,
Companies: Build America Mutual, Columbia Threadneedle Investments, Macquarie Asset Management, Parametric Portfolio Associates
Topics: Municipal Bonds, Tax, Economy, Credit, Interest Rates, Federal Reserve, Akademia, CE Credit, ESG,
Jenna: Hello and welcome to this Asset TV Municipal Bonds Masterclass. This year, the Muni Market hit an eight year low dipping below $4 trillion for the first time since 2014 according to Fed Data and the Wall Street Journal. Joining us now to cover flows and performance, how the increasing odds of a recession are impacting credit and much more.
We have Morgan Fahy, Vice President Capital Markets at Build America Mutual. Greg Gizzi, head of US Fixed Income, and head of Municipal Bonds at Macquarie Asset Management. Catherine Stienstra, Head of Municipal Bond Investments, and Senior Portfolio Manager at Columbia Threadneedle Investments. And Brian Barney, Managing director, Institutional Portfolio Management and Trading at Parametric.
Everyone, thank you so much for being with us. And Morgan, kicking us off here. It's been quite a challenging year for all fixed income markets, but setting the scene for us, how has municipal performance been impacted?
Morgan Fahy: Thanks, Jenna. Well, it certainly seems that the word of the year has been volatility. Just using the 30 year part of the curve as an example, we've seen treasuries move from the beginning of the year at about a 190 yield to a 412 as of this morning. 30 year MMD adjusts from a 149 to a 406, and 30 year ratios increase from a 78% to right around 100%. That ratio is used to compare municipal tax exempt yields to treasury yields, and as municipal bonds underperform, that ratio increases. The muni market returns year to date or down about 13.4%, which is one of the worst years on record. New issue supply is down about 17% year to date. As we look at fund flows, according to the [inaudible 00:01:57] data from last week, we've seen about 105 billion in outflows so far this year. These are some pretty big adjustments year to date for our market.
Jenna: Some pretty big adjustments indeed, and the record outflows in 2022 have been a harsh reversal from the record inflows that we experienced in 2021. Catherine, when do you think outflows will slow or turn positive, and what impact do outflows have on the market?
Catherine Stienstra: Absolutely. Thank you, Jenna, for having me. Certainly, it's been a historic selloff. As Morgan just mentioned, municipal bond indices have actually rolled back 14 years of positive priced gains in just 10 months. So obviously worst on record as mentioned. And certainly at the end of October, as Morgan mentioned, down 13% long bonds are down over 20%. BBB, lower investment grade is down 16%. High yield down 18%. The last three months have really been negative performance months for us. September was the worst on record for the year, down 3.8. Treasury yields rose roughly to a peak of 425 in October, up 170 basis points during this quarter. Munis have been pulled along with this. One thing I wanted to underscore though is that this really has been an interest rate selloff and not a credit related selloff. So really with the selloff in rates that's pulling muni yields higher, that's causing negative performance, and therefore we're getting these outflows at record levels. Depending upon what source you're looking at, we're seeing ICI just recorded negative outflows of 119 billion. So again, just a massive amount of outflows and records that we're breaking this year in the municipal market. Again, yields are higher by 265 basis points.
So the million dollar question that you're asking me, everybody wants to know when will outflows reverse? We saw two periods this year in May and July where we saw rates rally, and therefore following that, muni yields fell and started to rally. We started seeing a little bit of inflows in our market and positive returns during those two periods. However, rates started to sell off again and munis followed that. We know in the municipal market, if you're a seasoned investor, that once that outflow cycle slows and reverses, the snapback in the municipal market can be really, really quick. We've looked at the returns of the Bloomberg Municipal Index over the last 40 years, and every negative year has been followed by positive returns.
So really, we need rates stability as we're in the Fed tightening cycle. We're getting closer, we feel, to the end with this aggressive focus on inflation and the 75 basis points increases that we've seen. Perhaps we're getting closer to the end. The Fed needs to see, of course, a slow down in inflation and then slow down in the employment. But it does feel like we're getting closer there. Maybe in the first half of 2023, we'll start to see the inflows coming back into our market. And typically when you see a peak in a 10 year treasury, the muni yields or the muni rally will ensue after that roughly anytime from seven to nine weeks after that. So again, feeling more optimistic that we're closer to the end and that the inflows will head back into our market at the end of the tightening cycle and rally in treasuries.
Jenna: With the municipal market down substantially, Greg, what's been the catalyst for the sell off in the market, and when will the muni market experience positive performance again?
Greg Gizzi: So I've been fortunate to follow Catherine and Morgan. I think they've done an excellent job explaining really what precipitates selloffs or outflow cycles in our market is, in fact, a significant rises in treasury rates. Think of us as the tail of the dog. We are not the dog, so we will be correlated to what treasuries do. I think for listeners, it's important to understand why we get such significant either inflow or outflow cycles, and it has to do with the unique ownership structure of our product.
If you look at the... And I encourage you all on a quarterly basis, go to the Federal Reserve Z1 report where it breaks down the ownership structure of each asset class in the marketplace. And we know as veterans in the market that roughly 70% plus minus of our municipal assets are held by individuals in some way, shape, or form. What tends to happen is when that mass of ownership decides that it's time to either enter or exit the marketplace, this tends to create a vicious feedback loop where selling begets more selling because NAVs fall and encourage that cycle. And as Catherine said, normally that does not abate until we get stabilization in treasury rates.
The one thing I'll add, and it's significant, it's not enough just to look for flows to turn because what you'll find historically is the inefficiency that's created in our market is often exploited by non-traditional muni buyers, meaning muni buyers that are not buying the product for tax exempt income, just total return. And that'll typically happen, as Morgan noted, when ratios get north of 100%. Now, we've been there a few times, we've added to some of our core fixed income accounts when ratios have approached 110% believing that eventually the historical relationships will revert back. So in the long end, that would be roughly in the low to mid nineties as opposed to over a hundred percent.
But I think investors have to understand that the market will in fact put a bottom in before flows. Because typically somewhere between the second to last rate hike and the last rate hike is when we see a powerful recovery. And as Catherine said, you have to think in terms of not only how liquid markets are when you want to get out of product, but also when you want to get in it. And I think you have the propensity here with the type of price degradation we've seen in the marketplace for a significant snap back.
Jenna: Turning to you, Brian, could you describe some of the inefficiencies in the muni market that managers seek to take advantage of?
Brian Barney: Sure. Thanks, Jenna. Yeah, I'll just speak briefly about just the opportunity and just kind of hammer home a little bit what Greg, Catherine and Morgan have talked about is we're in a market today where interest rates are so attractive to individual investors who are paying high marginal tax rates. We're pretty close to levels that we'll probably see more and more demand from the retail buyer. And just to put that in into numbers, you can invest in a short duration, two year duration portfolio that yields anywhere from three to three and a half percent tax rate. So finally some yield cushion, and we're starting to see investors really step out of cash into those types of opportunities. We're also seeing longer term investors look out the curve speaking to some of those attractive ratios on the long end. You can invest in a 15 to 20 year AA portfolio of high quality munis and yield somewhere around a four and a half percent. So on a taxable equivalent basis, we're looking at 8 or 9% returns that are very equity and certainly more attractive than some taxable counterparts of some more quality.
So we feel given these yields, we're close to some support from retail, and I absolutely agree with Greg that we'll see a snap back before flows meaningfully pick up or turn positive. And just to kind of answer the question on inefficiencies, I think all four of us are very well aware of the fragmented nature of the muni market, how many issuers there are over 50,000, how many CUSIPs there are, over a million, and how this is an over the counter traded market without real live quotes. What this market has done this year with all the volatility, it's really increased the liquidity premium to sell bonds. So being an active manager, being able to exploit some of those inefficiencies, that [inaudible 00:11:08] that we've seen, and be a provider of liquidity, is really an attractive deal to partner with a investment management firm to manage your portfolios.
Jenna: And I want to ask you more about liquidity in a moment, but first, as rates increase, Morgan, a large number of the bonds sold in the past few years are now trading at discount prices. How does that impact the market?
Morgan Fahy: Sure. We've been in a pretty benign rate environment for years except for a brief spike that we saw in Q2 of '20, kind of at the beginning of the pandemic. But during this low rate environment, we've seen hundreds of billions of 3s, 4s, 5% coupons being produced, all of whose prices have been significantly impacted by this rate selloff. So as the Fed raised rates this year, we did see an uptick in secondary market trading. So whether that was redemption driven or tax law swapping or rebooking higher yields, both on the retail and institutional sides on these discounted structures. So this is particularly interesting, I think, in the insurance space as the bonds are now priced to the final maturity as opposed to the call date. And now that the cost of insurance can be spread to that final maturity, it presents a pretty interesting opportunity to improve quality at attractive levels.
Jenna: Yeah, After this year's broad selloff, much of the municipal market looks much more attractive than just months ago. Catherine, where do you see the best value?
Catherine Stienstra: Yeah. Absolutely. Obviously with rates being up 265 yields, I should say up 265 basis points, from when we entered this year, we certainly have a lot of value out there. You look at taxable equivalent yields as mentioned-
Catherine Stienstra: Look at taxable equivalent yields as mentioned, extremely attractive, obviously in especially tax states as well. You can get a 5% muni bond and earn close to 8% on a taxable equivalent level. So I feel that there's a lot of value out there. As Morgan mentioned, the makeup of the market over the last few years has been in that lower coupon structure just to get additional yield over the 5% structure. So these bonds are trading at extremely deep discounts the further you go out the curve. So we like those that have underperformed the most. You can find .$75 on the dollar, $.80 on the dollar on certain issues that you have in portfolios because of the duration, the longer duration that's underperformed this year with this large selloff. And we feel that the recovery value in those bonds are going to be one of the greatest total return recovery opportunities out there.
As far as the curve positioning, longer bonds are down over 20% through the end of October. Certainly have underperformed shorter quality maturity. So we like the longer end of the curve. We think that you're going to get the greater potential for total return out of those longer bonds that underperformed the most, and certainly in a Fed tightening period and ones at recession, if we believe that the economic growth is going to slow down where we end up in a recession, Muni typically outperform in a recessionary environment and that 10 years out to 30 years will actually flatten. And that's where we're expecting the greatest price performance, again, is in that longer end of the curve.
I would also say that certain sectors that have underperformed the most lower investment grade and high yield sectors during this sell off, will also recover the fastest when we do see that snap back because as everyone has indicated here, typically that will happen. And then also we think up in quality as we start to see slower economic growth ahead, that it's prudent with that higher yield environment with triple As and double A's that you can actually book in a portfolio move up in quality as the economy starts to slow down.
Jenna: Now, Brian, you mentioned liquidity earlier, and Greg, I want to get your take on that as well. How's liquidity in the market and has liquidity had an impact on how investors should think about the municipal market?
Greg Gizzi: So I'll answer the question from two different vantage points. One, liquidity is fine. As portfolio managers, we may not like prices on given days. And I think we have to recognize, which is the second point I like to make, that we are in a different municipal market post great financial crisis. We go back to 2008, 2009, our marketplace was transformed by really consolidation number one and number two, capital lines being cut. So it's not the same universe that Katherine, myself, and Brian have to go out and get liquidity on bonds. However, there are, I would say a half dozen, eight firms that are consistently quoting markets and providing liquidity.
But again, it goes back, liquidity creates or illiquidity creates an efficiency, creates opportunity. And I think that's if I want advisors to take anything away from this marketplace is that we are, I think at a historical opportunity in the marketplace for Muni investors. You just need to have some conviction that we're not getting to a new interest rate regime where we're going to see significantly higher rates for a long period of time.
And it's not the topic of this particular session, I understand, but our view is very similar to Catherine's. We think that the parts that have underperformed the most will outperform. I'm concerned about liquidity because a very interesting stat that came out from one of the analysts this week, if you look at by the end of 2022, look at redemptions and coupon interest, $580 billion will be returned to investors in calendar year '22 against that $ 115 billion in outflows. There is plenty of cash around. It's a question of when investors are going to be willing to reinvest their cash in the market. And as Catherine and Brian have elaborated, it's a very good opportunity at this point.
Brian Barney: Great. Yeah, I'll just add on top of that, Greg, I agree with you. But I think the technology aspect, which I'll speak to here in a moment, it's also improved liquidity for small lot sizes. Certainly liquidity has been challenging this year across the board, but just the increase of algorithmic trading that exists at large dealers and even small boutique dealers is really adding to liquidity for a certain segment of the market and certainly those lot sizes below a million dollars. So we're excited by the growth of technology and the business as a whole. And certainly we're seeing better bid-ask spreads on odd lots than we have just as recently as three years ago. So, that's been something really noticeable from our perspective.
Jenna: So technology has played a big role here, Brian?
Brian Barney: Yeah, the only other thing I'll say there is that from the investment side, we've really had to invest in technology and we've been at this for over a decade to help really customize the experience for each and every client and partner with those advisors to manage something that is particular to a client's state or credit concerns or risk or return profiles or maybe certain liquidity needs. So there is that challenge of scaling your business and addressing all the customization requests. And so without technology you're not able to manage thousands of portfolios in different matters. So that's been certainly important in our business.
Jenna: Catherine, anything you'd like to add about the direction and level of interest rates and the coming months and you're ahead and what's your broad macro outlook for the rest of 2022 and into 2023?
Catherine Stienstra: Sure. So obviously a challenging year. Fed Funds are up by 375 basis points. A Fed meeting coming up here, expecting another 75 basis points in November market per cap. Perhaps the thinking of another 75 in December certainly economic data and financial conditions have not really deteriorated sufficiently since the September FOMC for the Fed to signal any major shift in strategy, we feel. Certainly need to see weaker growth in the labor market. Inflation is going to take time to slow down. We are seeing it turn over in certain areas. We're seeing parts of the economy where the inflation is starting to roll over and certainly weaker. But then in other parts inflation's remaining stubbornly high. And then also on the job side of the equation, the Fed really needs to see weaker labor demand and wage inflation there. So the key again is on wage inflation, which we'll see in the employment number coming up.
But again, it's really feels like we're at an inflection point where we've seen other central banks lower what was expected into the market and rally ensuing as a result of that. Whether we get that kind of language out of the Fed in the November meeting here will be interesting. If so, then I think you're going to have a focus on slower growth. You could see the stock market sell off as a result of that because earnings then have been slower but concern on an economic slowdown.
We feel, because of the uncertainty, still an inflection point where we need to see more inflation turning lower. We need to see the wage sites certainly slow down as well, that you're going to get another 75 basis points in November, potentially another 75 in December. But then we're closer obviously to the end of this tightening cycle. And then perhaps in the first quarter of '23, you may see the Fed easing or not easing, excuse me, out of its Fed tightening cycle and on hold to make sure that, again, that economic data and the financial tightening conditions are actually coming through.
One concern that Fed Powell has to watch is tightening conditions too much where it causes financial crisis or a pretty severe recession. So he has to balance that and we feel that we're closer to the end of that and perhaps the 10 year rates or the peak is around the corner here.
Jenna: And we're hearing more and more about that growing chance that the US economy could go into a recession as a result of the Fed's aggressive rate hikes to try to control inflation. Morgan, how is that likely to impact municipal credit?
Morgan Fahy: So it would be a pretty significant change. Currently, Muni credit is very strong with S&P upgrades outpacing downgrades about 571 to 219 so far in 2022. And for the most part, credit spreads have been pretty resilient during this rate move. I mean, there's been slightly more widening in the revenue sector, and unsurprisingly we've seen a pickup in insurance demand in those sectors such as utilities, airports. But I think in the event of a recession, you'd expect more negative pressure on local government revenues. But county, cities and states would be entering any potential recession at this point with a tremendous amount of fiscal reserves on the back of the Federal support during the pandemic. So I think that this should help local officials manage through any potential recession if it comes.
Jenna: Do you believe that we're heading into a recession, Greg, and if so, what does that mean for municipal credit?
Greg Gizzi: I think it's inevitable, given the fact that the Fed has a very difficult task with the toolkit it has controlling what essentially I believe was a supply side driven inflation that was exacerbated by additional factors. The only thing the Fed can do is actually destroy demand. And we're, as Catherine noted, we're starting to see that in some of the data series, particularly the housing side, which is a big multiplier through the economy. And Morgan's got it correct. I think state and local governments with the amount of unprecedented aid they've received from the Federal Government over the last couple years enter into this recessionary period, hypothetically if we have one in very strong fundamental shape.
I'll also say that this fiscal construct is not done yet. We've done a study recently internally here where about 70% of those funds have actually been appropriated. It's difficult to know if they've actually been spent. We don't think that all of that's been spent, but there's still about 30% of those funds available that will have to be spent by the end of fiscal year 24. So there is still a tailwind from the fiscal aid that state and local governments have received.
Jenna: Brian, are you concerned about Muni credit fundamentals as the economy slows?
Brian Barney: Yeah, we agree with what's been said, for sure. Yeah, they're in great shape heading into what is likely a slow down period and starts at the state level with a lot of the aid that they've received direct from the Fed post-COVID. So they will be able to weather what's upcoming. But certainly diligence is needed for some pockets of the market. If you look at the nonprofit healthcare sector, you've seen some significant deterioration in operating margins this year. They've been faced with the challenge of labor market that's very constrained, and so wages are rising, even having trouble sourcing labor, certainly. And also their utilization rates are not what they expect for them to be. So there's going to be some pockets of the market that require some diligence and likely will lead to opportunity, I think we would all attest. So you do have to navigate carefully but-
Brian Barney:... I think we would all attest. So you do have to navigate carefully, but on the whole, we feel like their municipal credit is in relatively great shape, heading into an economic slowdown.
Jenna: Catherine, what concerns, if any, do you see with the credit environment or specific sectors?
Catherine Stienstra: Yes. I certainly agree with everything that's been said, just Brian, Greg, and Morgan. Obviously municipal market is in great shape, solid fundamentals as we enter into '23. In fact, we haven't seen such great fundamentals for a long time. Flush with tax revenue. Year to date, receipts are up. Credit ratings upgrade, as Morgan said. Saving downgrades. Low defaults. So very comfortable with the fundamental backdrop heading into 2023. Obviously, overall revenues will slow but remain at very solid levels, given all the fiscal stimulus that has been stated already.
Certainly areas of concern, I agree with what Brian just mentioned. There will be some areas. I think it's early right now to call this, but there are high yield sectors, specifically special project finance deals that will slow down in an economic downturn. So those are areas where we would want to watch and potentially avoid, but overall the high yield municipal sector will lag. What you see in the corporate sector when you start seeing spreads widen out in the high yield corporate land. Typically there's a 6 month to a 12 month lag within the municipal market, so again, I think it's early, but it's an area that we should be watching.
Jenna: And credit segments triple B, and B investment grade, Greg, have underperformed. What's causing credit to underperform, and do you think that there's value for investors? When does credit start performing again?
Greg Gizzi: Great question. There are two reasons why I think advisors should be aware of the catalysts for the underperformance. The first is structural. If you divide any of the indices up into their individual credit segments, the triple B, the lowest investment grade category, has about a two and a half year longer duration than, say, triple A. So with curve underperforming, certainly most of that credit segment being in the long dated buckets, it's going to underperform when curve is underperforming.
The other aspect has to do with the fact that, as I mentioned earlier, with the unique ownership structure, the other thing that's unique about the muni bond market, we will in fact get non-traditional, total return type players in our market often when these inefficiencies avail themselves. However, the categories that they don't traffic in are the triple B and below investment grade categories. So Catherine is right. Typically you will see the higher grade categories recover quicker, and that has to do with the fact that well before the outflow cycle ends, we've got typically non-traditional buyers or fund managers like ourselves that are more aggressive in thinking that we're coming to the end of the cycle, starting to rally the market, quite frankly, ahead of that point until we get mutual funds en masse back in the market, and that's really not going to occur until the flows revert back to inflows. That credit segment, triple B and below investment grade, doesn't have an audience, right? It's the mutual funds that typically buy that. So I think those are the two factors why they've underperformed.
I'll agree with Brian. I think there's value in the market, but obviously there are parts of the market that you've got to rely on credit expertise, and not all segments of the market. If we're talking specifically about high yield, certainly everything was thrown out during the COVID market back in March of '20, April of '20, but the recovery hasn't been unilateral, right? So you need to actively manage that credit risk in the portfolios, and certainly I do think there are currently values in the marketplace, assuming you're doing that work.
Jenna: Another type of risk to keep in mind is ESG and ESG risks. Brian, what are your thoughts on ESG and muni investing?
Brian Barney: Yeah. Sure. I think you have to acknowledge, in this market, when you think of muni bonds, most muni bonds and credits have positive ESG characteristics, just by their nature. Nonprofit entities in governments, they exist to provide social benefits and services. So that's kind of certainly worth stating.
The second is, we are seeing a growth in labeled bonds, both green and social. You have to go back about almost 10 years now for the first green labeled bond in our market, and now we're seeing issuance of label bonds, about 10% of annual issuance, and that's slowly growing from there. So it's a portion of the market that's growing. You have to acknowledge that there are projects and issuance out there that is impactful to the environment, socially, and so this is not something new, whether it's labeled or not, and so we just find that our investors who are investing along the ESG in other parts of their portfolio are coming to muni bonds as a ripe area to say, "Hey, how can I be a little bit more intentional or impactful with my muni investments?" And so that's sort what we're seeing, and it's early innings, but certainly a high growth trajectory, we feel.
Jenna: And we're going to let you weigh in on ESG and assessing green bonds as well.
Morgan Fahy:So I would definitely agree with what Brian was saying, that the labeled green bond market continues to be strong. It just seems like municipal capital plans are getting greener. It seems like more projects are being designed kind of with environmental impact in mind, and more investors are showing a preference for green bonds. So it kind of seemed like investor preference started internationally, but now we're seeing more US mutual funds and SMA strategies kind of focused on green bonds as well.
And just looking to BAM for a minute, BAM's GreenStar program provides an independent verification. It's done about 4.4 billion across 296 series since the program started in 2018, and we think that there's still a lot of room for growth. BAM's GreenStar programs particularly focused on smaller or medium size issuers, and we have found that a lot of the time these issuers are not aware of the opportunities to sell green bonds until they hear about the program, so we're hopeful that as the word continues to get out, that'll see more issuance in the space.
Jenna: Turning to pensions, Catherine, pensions in the UK have come under enormous pressure in recent weeks. Is it likely or possible that US state and city pensions will come under similar pressure, or are there differences that make such a scenario unlikely?
Catherine Stienstra: Sure. So we have certainly been receiving a lot of questions on this since the UK debacle. State and local pensions in the US are generally in good shape for all the reasons that we've discussed. Very strong investment returns over the year, and of course with the fiscal stimulus. That has really bolstered the positions of the states. Negative market performance is obviously going to weigh on the funded ratios in '22 and '23. However, usually US public pensions will smooth out their annual investment performance over a five-year period, so that really kind of reduces the volatility that you will see on the funded ratios. And by extension, just the pension contribution requirements.
A year of poor equity performance, we do not feel is really a major concern for the majority of US public pensions. And certainly there are areas like Kentucky, Illinois, Chicago, that are going to experience more pain in this downturn from a single bad year of performance. However, there are others, as I mentioned, that are going to be in very good shape. And really what it comes down to, we feel, is how much budget flexibility or discipline does the state or local government have to respond to the negative market returns of 2022?
Jenna: Yeah. There's been a sharp decline in pension fund returns, negative 10.4% on average for the fiscal year ending June 30, resulting in decreased pension funding levels. So almost automatically, actuarial required contribution levels have gone up, which creates budgetary pressures on municipal issuers. Greg, do you think that this will have an impact on municipal credit? And have we reached peak credit?
Greg Gizzi: So I agree with Catherine. One year is not going to make a difference. I think pension liabilities are just one factor, when credit analysts look at entities that have pension liabilities, amongst many different factors. So I don't think one year makes a difference. I think the reality is, part of the problem, we existed in such a lower for longer environment that what's really changed is the composition of those portfolios. So if you go back to the early 2000s, the typical pension fund had about 31% of its assets in fixed income. By 2020, that had dwindled down to about 21%, as they were looking for alternative higher yielding investments. As Catherine alluded to, there's been pension reform. There's been a lowering of discount assumptions. All those things are great. And in particular, these state and local governments have done a much better job at making their actuarially required contributions on an annual basis, which I think is the most important thing.
Just to put it bluntly, Illinois and New Jersey, both poster children for the pension issue, going back to the Meredith Whitney days, those were both upgraded this year. So again, I don't think one year is going to make a difference. And are we at peak credit? I don't know if we're at peak credit, but certainly I don't think we're on the precipice of a significant credit weakening in the market, a fundamental weakness in credit. So I think as long as we're not in some deep, retracted recession, I think that we can weather the storm, and muni credit can continue to be fundamentally solid.
Jenna: Brian, how has the growth in separately managed accounts changed the ability for advisors to scale their business?
Brian Barney: I think in many ways the growth of SMAs has helped advisors, and I think one I touched on earlier, just the ability to customize the experience to each client and their certain situation has been big. To more thoughtfully navigate credit in some of those lower ends of the investment grade spectrum certainly is also a big factor.
We didn't touch on this, but I think one of the largest factors this year is certainly tax loss harvesting. And going into 2023, the ability to harvest losses, avoid wash-sale rules, and do that systematically on an ongoing, year round basis is some value add for advisors as well, and their clients. If you look at, your average portfolio is down close to double digits in the SMA world, and if you look at realizing about four, about half of those losses in a calendar year, about 4% in realized, you're looking at tax benefit of close to 200 basis points. So on your average portfolio, or if you take an example of a million dollar portfolio, you could be saving the client about $20,000 in taxes to offset against future gains. So that's been pretty powerful this year.
And then lastly, just to have a dedicated PM or investment professional, to help service existing clients, speak to prospectives, has been also pretty huge. So just freeing up the advisor's time as they go to professional management, and allow them to focus on their core competencies, whether that be growing their practice, asset allocation, or financial planning.
Jenna: So I have to ask, with the election just days away, Catherine, what do you see as the potential-
Jenna:... election just days away. Catherine, what do you see as the potential impact on the municipal market?
Catherine Stienstra: Yes. The polls are changing daily, so we'll have to wait till the election actually comes out to find the results. But at this point, we think that midterm likely divided government resulting in a gridlock until 2024. It looks like the GOP is likely to take the House, which would cause that gridlock. Historically, the president has been in their favor as a party of the sitting president tends to lose seats in the Senate, I'm sorry, in the House. But the battle for the Senate is certainly tighter right now. Key issue for voters right now is inflation, abortion access, and healthcare. So we'll see how the votes come out.
I guess a couple potential impacts to the municipal market would be, if there's a blue wave, you would expect a tax reform eventually, which would increase individual and corporate income rates higher, which would be positive for munis. You could see perhaps the SALT deduction cap being revisited and perhaps revised there where those potentially higher EMT could expire. That was put into place during the tax reform. That could impact more individuals again. You could see some version of the Build Back Better, if you remember, that did not get through. So that, if we see that, would be inflationary again in our market, which would not necessarily be good.
Another interesting aspect of this could be, there's 36 governor seats up for election that could impact supply. We haven't really talked about technicals here yet. The supply side has been down this year. Expectations heading into the new year after election could be lower, as usually new governors that are elected in the first three months of their election, when they're in office, supply is down by over 50%, which is pretty incredible. It's just as they are getting set up and getting their teams in place, generally new issue supply in the municipal market could be down. Even if there's an incumbent that comes back, supply can be down roughly 20 some percent. So that could impact technicals in a positive way in our market and especially if we start to see those inflows coming back in. We think that municipal market is set up for positive returns in 2023, and technicals will be a driving factor of that.
Jenna: Looking ahead to next year, Morgan, some analysts think that the bipartisan infrastructure law will have important impacts on the municipal market. Would you agree with that?
Morgan Fahy: Yes, I would. So by design, about 90% of the funding in the infrastructure law will be spent by states and other municipal issuers since they're the closest to it and will have a pretty good sense of which projects should have top priority. The law also requires municipalities to share the costs with the federal government, and this is where I think we'll see the municipal market come into play with many of the matching funds to be raised by new money bond sales. In addition, I think it's pretty likely that we see other projects that are going to get done by municipal issuers kind of investing away from, but alongside, government funded projects. I think overall it's going to create a higher profile for our market, which could potentially attract new investors. And I think it's going to be an exciting next few years for the muni market.
Jenna: What's your outlook for supply next year, Greg? Because supply has, once again, underwhelmed.
Greg Gizzi: So I share the hope that Morgan just went through. I'm not sure that's going to be the case. In fact, I think the biggest dealt on supply has been the lack of refunding. With significantly higher rates, we've seen much, much less refunding. There are a fair amount of currently callable bonds, which if we start to rally back may be taken out of the market, so we could see a slight pickup in refunding deals. But I think probably one of the most frequent questions I get when I market or wholesale is, when are we going to get into a market where there's significant supply around in really good opportunity? I think for that to occur, we need a lot of stars to align, and I don't think that's in the immediate future. I think it's going to take a commitment from both sides of the aisle to make that happen. And we all know what's really transpired.
My two cents on the election, I think we're going to wind up with a split government. And I'm not upset about that because historically that has led to good market performance, so it keeps Washington in check quite frankly. So I think we're looking at... We've seen supply lowered just for this year alone, three separate times. We're going to wind up somewhere between 380 billion and 415 billion, let's say. I start with 400 billion next year. I think we're 400 billion to 450 billion depending on whether or not we get any kind of refunding activity back in the marketplace. But certainly I don't look for this, what some investment banks are calling the golden year of supply where we're going to see significant amount of infrastructure financing that we all know is in desperate need in this country to see that actually materialize.
Jenna: So Greg, sticking with you here, when is it safe for investors to buy or add to their municipal allocations?
Greg Gizzi: Well, those kind listeners that have been with us through this presentation, I think they've heard there's opportunity right now, and Brian alluded to it and so did Catherine. Forget about being in a high tax state like New York or California, you just take federal taxes and gross up where some of the yields are now and you're seeing equity like returns with a lot lower volatility and much safer credit metrics. So I think the opportunity is, now the most difficult thing is to really standalone and get away from the crowd. I think that when you have the ability to do that in a convicted way is when your best performing opportunities avail themselves. So I think the market is very attractive. There are scenarios that we think are less likely, which you could see this inflationary period extend, which would just create, I think, even more opportunity for investors.
But if you've been a wise investor or you've never invested in munis, I feel that a number of calls recently from people that have never bought the muni market and have had liquidity events that are saying, "Hey, I'm in New York City and I'm hearing about some of these yields. Explain this to me." So I do think we're at levels that, as Catherine alluded to very early in the conversation, we've seen almost a decade and a half's worth of price gains just eradicated in 10 months, just gone. So I think investors that have the fortitude have a very real opportunity to have some very good performance going forward here.
Jenna: Well, before I let all of you go, I would love to go around the room and have you share your final thoughts with our viewers. Catherine, why don't you kick us off?
Catherine Stienstra: Sure. I just want to piggyback off of what Greg just said. We obviously think that the market is poised to outperform next year. And really historically, if you look back at the Bloomberg Muni Bond Index over the last 40 years, you'll see that following negative years, there've only been five, by the way, following those have been strong returns in the market. In fact, double digit returns as a result of the negative performance the prior year. And as we've mentioned, this has been a record selloff, the worst in over 40 years. When you see these types of numbers, that Greg was just talking about, and the need for tax exempt income, we feel that, again, the market is really poised to outperform. Higher yields are available that we haven't seen for many years, and the credit fundamentals are so strong. We're very optimistic and constructive on the market for 2023.
Brian Barney: Yeah, I'll be short and sweet here because I think along the same lines here. Very constructive on the marketplace next year. One maybe different perspective being close to that SMA buyer, we're already seeing largely positive flows, and that transpired much in the third quarter and we're seeing that in the fourth quarter, just seeing how busy we all are in front of clients on a daily basis and they're interested. So again, hard to time, but if you can have a long-term view, we think now is a great time, given the backdrop. If you wait for a piece of data to come out, which changed the narrative for the Fed, or if you wait for muni fund flows to become positive, you're going to miss out on some likely appreciation from spread tightening and just rate moves. So we're contractive, for sure.
Jenna: Morgan, anything you'd like to leave with our viewers?
Morgan Fahy: Sure. I mean, I think we've said it, but to tell you, we're saying again, while we've seen a lot of volatility and losses thus far this year, muni bond credit quality has not been the issue. In fact, it's been very strong throughout the selloff. But looking forward, I think there's a slight potential to see some more volatility in ratings, and bond insurance can help investors manage that risk. But overall, I think the risk of default remains pretty low.
Jenna: Greg, I'll give you the final word here.
Greg Gizzi: Courage will be rewarded.
Jenna: Well, on that note, it's been a pleasure hosting all of you and really appreciate you being with us. Thank you to everyone watching this Municipal Bonds Masterclass. Once again, I was joined by Morgan Fahy, vice president, Capital Markets at Build America Mutual; Greg Gizzi, head of US Fixed Income and head of Municipal Bonds at Macquarie Asset Management; Catherine Stienstra, head of Municipal Bond Investments and senior portfolio manager at Columbia Threadneedle Investments; and Brian Barney, managing director, Institutional Portfolio Management and Trading at Parametric. And I'm your host, Jenna Dagenhart with Asset TV.