Rob Almeida:

Welcome to the MFS Strategist's Corner podcast. I'm your host, Rob Almeida.

Disclosure Voice:

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida:

In this episode, I speak with municipal bond analyst, Tom Compton. Tom explains the fundamental credit strength of municipal issuers in aggregate today, why that came to be, and how he thinks about the risk moving forward. Tom, welcome to the podcast.

Tom Compton:

Thanks. Happy to be here.

Rob Almeida:

So tell us about your background, how you get started in the industry, how you got interested in finance and investing.

Tom Compton:

Sure. So I'll take it back a little bit, not all the way back, but maybe starting with my college years, which is where I sort of got my first interest in municipals. For myself, like I think a lot of other students, I had absolutely no idea what I wanted to do after college. I really just gravitated towards a coursework that I found most interesting. And for me, I really enjoyed learning about public policy and government, and it was fascinating to understand how these organizations work and how they impact everybody's day-to-day lives. And so that's the path that I set out on in terms of coursework.

Tom Compton:

I was fortunate enough to land some really great internships, both with federal government organizations as well as some local government organizations. Following graduation from graduate school, I was offered a full-time position with the City of Boston, right down the street here. When I was working with the city, I think like any other entry level hirer, I wore a lot of hats, I ran around a lot, I did a lot of different projects, but the thing that I focused on the most and the thing that interested me the most was helping the city prepare for their annual municipal bond issuance, so helping get documents together, putting the tables together in the prospectus, really learning the inside and outside of how that process worked. And that was really my first exposure to public finance in general and more generally the bond market.

Tom Compton:

I loved that experience, but I really wanted more on the finance side, more on the credit side, and so after a short time with the city, I went to work for a rating agency as an analyst covering municipals, primarily focusing on local governments as well as some essential service enterprises, so things like water and sewer districts. This is really where I built my skillset, learned how to evaluate credit worthiness, and ultimately what are the things that we look for that make a good investment. I spent five or so years at the agency, worked with some really talented people, and I loved the research that we were doing, but I knew I wanted a more active role in the marketplace. I wanted to be actually investing, and so I started to explore opportunities on the buy side at asset management firms. I was lucky enough to find this spot at MFS, and that was about seven years ago. I think looking back at all of that, perhaps my path to a role in investment management was a little bit untraditional but-

Rob Almeida:

A little bit, that's an understatement.

Tom Compton:

Yeah, absolutely, but I do think it really helped me. Understanding how a government organization works from the inside out, understanding the process that rating agencies take has really given me what I think is an advantage looking at municipals every day.

Rob Almeida:

That's a really interesting background because I'd never thought about it in these terms. As an investor, you're on the outside looking in, trying to get into as deep the company, the municipality as you can, but the early part of your career, you were on the inside looking out and perhaps gave you a very different lens or more holistic view of credits.

Tom Compton:

Yeah, absolutely, and I think I have a deeper appreciation of the work that goes into putting a financial statement together or putting an offering document together and really understanding fundamentally how those tables and financial metrics are compiled. I think it makes it a little easier for me now looking at it from the outside.

Rob Almeida:

So when you combine your early years' work in the public sector, your years since working in the private sector, are there any big, large lessons, takeaways, or constructs in how you think about going to pick good credits in muni space?

Tom Compton:

Yeah, I think some advice that was given to me a while back from a coworker is that you cannot trust information that's given to you by somebody else, right? As an analyst, we gather information from a ton of different sources, but ultimately it's up to us to evaluate that information and gut check it. So never taking anything at its face value, really digging in and coming to our own conclusions. Like anything else, municipals, there's a fire hose of information and a million different sources that we can utilize. And so, being able to sift through that and make my own decisions I think is the core of what I do.

Rob Almeida:

Yeah, so it's not information that's the advantage, but it's interpretation, research, nuance, context-

Tom Compton:

Absolutely. Yeah, exactly, exactly.

Rob Almeida:

... and bringing that all back to what matters. So maybe jumping into it, in an internal research media piece, you were highlighting the strength that you're seeing across states specifically with tax revenues. Maybe share some of that.

Tom Compton:

Yeah, absolutely. You're correct, when we look at state tax revenue trends, we have seen tremendous growth over the last few years. In fact, fiscal 2022 will mark the 12th consecutive year of state tax revenue growth.

Rob Almeida:

Wow.

Tom Compton:

I think this makes sense when we break it down and we consider that, in the aggregate, personal income taxes and sales taxes account for almost 70% of state tax revenue. And of course, both of those revenue streams tend to perform really well during good economic times. I think it is worth noting, in particular the last couple years, how remarkable that resiliency has been given the pandemic and given the possible impact of some of the economic shutdowns that we were dealing with over the last couple of years.

Tom Compton:

I think we can contribute some of that resiliency to a few different things. First, if we look at individuals, high income earners were much less impacted by pandemic-related job losses. These are people who contribute more taxes to state coffers, and these were people that were able to work remotely, as we've seen. Second thing, I do think stimulus checks and expanded unemployment benefits provided by the federal government to individuals really help support consumer spending. And even though we saw a shift away from maybe brick and mortar, people starting to shift to online shopping, states are now able to capture that share of tax revenue as well. So that helped mitigate some of that shift in consumer behavior. And then I think the most important factor was the absolutely amazing performance of the equity markets really after our brief correction in 2020 through the end of 2021. That supported really exceptional capital gains tax receipts for the states, which, again, are a big share of revenues for them.

Rob Almeida:

Yeah. Triple digit returns in financial markets will create that tax win.

Tom Compton:

Yeah. Yeah, absolutely. And so, what does that mean, right we've had this really strong revenue growth. What that has allowed states to do is not only continue providing the services that they're designed to, so funding education, building bridges and infrastructure, the things that we think of, but it's also allowed them to store away a good amount of money in their rainy day fund. One of the things we look at when we're evaluating credit at the state level is, how prepared are they for a downturn or how prepared are they for volatility in their revenue streams? And the thing we look there is reserves. And so rainy day funds in the aggregate are at all-time highs, and we think that's going to give them a really good cushion to withstand any sort of potential downturn over the next couple of years.

Rob Almeida:

So Tom, decompose some of the larger sources of revenue strength in any context you think worthwhile to add.

Tom Compton:

Yeah, sure. Internally here at MFS, we track a lot of the monthly financial data that's provided by the states. Just to give some examples, if you take the 10 largest states, total tax receipts are up roughly 30% thus far in 2022, and that's coming off a really high level in 2021. So we're seeing continued very strong growth thus far in 2022. If you break that out into income taxes and sales taxes, again, the two largest components, both of those pieces are up about 20% year over year. Again, really strong revenue growth, and we've yet to see any material weakness trickle in. But that being said, I do expect that we will see that trend slow in the second half of the year given the correction we've seen in the equity market. So we're going to see capital gains receipts sort of evaporate, I think, in the last half of the year. So that is certainly something that we're paying attention to.

Rob Almeida:

Right. Yeah, you just can't extrapolate what has happened, there's going to be a fall off.

Tom Compton:

Yeah, absolutely. You talk about other things like inflationary pressures.

Rob Almeida:

Yep.

Tom Compton:

Ironically, that can be good for tax receipts in the near term, higher prices generate more tax receipts. But over the long term, as we know, inflationary pressures will erode consumer spending and that's going to impact sales tax receipts down the road.

Rob Almeida:

Too much of anything is a bad thing.

Tom Compton:

Yeah, exactly. You reach a tipping point at some point.

Rob Almeida:

Right. This is remarkable on its own but particularly noteworthy when you consider the tax cuts in 2017 from the tax cuts in Jobs Act, because that lowered, if I remember, the tax rate from 39% to 37%, the corporate tax rate from 35 to 21. At the same time, the American Rescue Plan, they earmarked billions to the states for COVID, the pandemic. I guess maybe bring us up to speed, how much did they get, what was spent, what's left, if any?

Tom Compton:

Sure. As we know, the federal government played a really large role in providing aid to state and local governments as well as a number of different sectors in the economy. Most recently, like you mentioned, the American Rescue Plan allocated 350 billion in fiscal recovery funds. Of that amount, about 190 was allocated to states, with the remainder being sent to local governments as well as some tribal governments in US territories as well.

Tom Compton:

And with respect to how that was distributed, the bulk of it was sent out in May of 2021, about 250 billion was sent out, and the final 100 billion or so was just sent out this last month. So at this point, all of that aid has now been distributed to state and local governments. When I think about what that means or how that fits into my analysis of a credit, I do think these funds are really supportive, especially against the backdrop of the tax receipts that we just discussed and the all time high reserve funds and rainy day funds. States today are using that money to offset some pandemic-related costs. And they're also using to support spending on a number of different areas like education or support of small businesses, helping some people get back on their feet. And really what it boils down to is this is just another source of additional liquidity for state and local governments and another just resource that they can tap into over the next couple of years.

Rob Almeida:

That makes sense. If we were taking live calls, we would probably get questions on the equity market, which you touched on earlier, so let's go back to that. At the time of this taping, equities just reached a bear market, and the future has no facts, so we have no idea what's going to happen tomorrow though we have our views. So how do you think about funding ratio status in pension plans?

Tom Compton:

Yeah, that's a great question. We talked about the impact that equity markets have on tax receipts, but another very direct result of equity market volatility is the impact that it can have on pension plans. And so, pensions have and do remain an important credit driver for a lot of states and local governments as well, just given the expenditure pressure that these liabilities can create down the road. And so, what we saw last year with a very strong equity market was a significant improvement in funded ratios following what was really a once in a generation return through the end of 2021. This boosted funding ratios, which again is just the assets of a plan divided by the liability of that plan to what is the highest level I think we've seen in about 15 years.

Tom Compton:

But as you mentioned, with the equity marketing correction territory, they're almost certainly going to give back some of those returns. But I think the good thing is that we're coming off a very high level in 2021. I expect that, while we'll give it back, it's going to bring funded ratios to a more normalized level of what we've seen over the last few years. One other thing I would note, obviously, deterioration of funded ratios isn't a great thing, but markets go up and markets go down. But one structural thing that I have seen in pension plans which is favorable is the adoption of much more conservative assumptions regarding investment returns on those assets.

Tom Compton:

And so what that does is it mitigates some of the volatility or the really significant swings we'll see in a pension liability from one year to the next based on performance of the equity markets.

Rob Almeida:

So translation, maybe they're de-risking a little bit, like you're saying, corporate pension plans, public pension plans, et cetera. That lower discount rate that their assumptions are lower about future return, is that-

Tom Compton:

Yeah, I think that's absolutely right, and I think it reflects, again, the expectation that this equity strength wouldn't continue forever. It also reflects the low interest rate environment we've been operating in. We're talking about fixed income here. We've had rates go up, but prior to 2022, we were in an all-time low rate environment, and you just couldn't get those returns that you could get 15, 20 years ago.

Rob Almeida:

So almost some practicality to the portfolio.

Tom Compton:

Exactly.

Rob Almeida:

Okay, that makes sense. So let's talk about local credit where property tax matters a lot. How do you think about that?

Tom Compton:

Yeah, that's right, I think when we're looking at local government credit, we do analyze a lot of the same factors as the states, but the key difference for locals is where they get their revenue, which is property taxes for the most part. For 2022, we expect that will be the 11th consecutive year of growth in property taxes. And similar to the states, that really strong revenue growth has allowed for a rebuilding of reserves. And so, we're also seeing local government fund balances at all-time highs. I think what is noteworthy about property taxes is how resilient they are and the fact that they do not fluctuate year to year like income taxes and sales taxes, which when combined with the reserves that they have on hand we think is really going to provide some stability in that sector.

Rob Almeida:

Well, just as a homeowner, I feel like they just go up.

Tom Compton:

Yes. We don't want to say always, but, yeah, absolutely, I mean, I think property taxes go up. Of course, property taxes are based on the assessed value of your home, whether it's residential home or a business, and we have seen really good home price appreciation. As anybody who's trying to buy a house over the last few years knows very well, the appreciation in home prices has really been incredible. Moving forward, one thing we are paying attention to, and that has been in the news a lot, and anyone who's buying a house also knows this as well, is mortgage rates have spiked. I think we started the year with average 30-year fixed about three and a quarter, and I believe we're around 6% now. And so, we know and we do expect that this will erode affordability of homes and perhaps a little bit of the demand, but that being said, there is a very large structural supply imbalance here. We've seen home building pick up a little bit, but there remains a really large supply gap, which we think will support continued, although likely slowed, appreciation in home prices.

Rob Almeida:

It's funny you mentioned that. The very first podcast we did was with Jake Stone, Matt Doherty, and Annie Glancy on... If you recall that presentation, they gave the investment round table and just the structural supply shortage.

Tom Compton:

Yeah, exactly. The last couple of years, we have seen historic appreciation of home prices. We don't anticipate that will happen this year. Again, there will be some erosion, but I think in our base case should be flat or marginally positive. And again, that will translate into stability in the property tax receipts which support local government spending.

Rob Almeida:

So Tom, sum this all up for us. Recap the fundamental strength that you're seeing, but maybe highlight some of the risk too.

Tom Compton:

Yeah, no, absolutely. Like we've discussed here, state and local revenue growth has continued for now, reserves are at all-time highs, and pension funding is improved at least through 2021. And so, this sets a really favorable backdrop from a credit standpoint. In terms of rating upgrades as well, I think we expect upgrades will continue to outpace downgrades, although at a slower rate than we've seen over the last couple of years. That's a very good picture, but there are some headwinds that I do think we need to recognize. We anticipate there will be a slowdown in tax receipts, particularly capital gains related to what we're seeing in the equity markets. We expect slower home price appreciation will result in a slowdown of growth and property tax at the local level, like we mentioned. Pension funding is expected to weaken but remain adequate relative to historic figures. And then inflationary pressures are likely to erode some of the consumer spending power. I guess summing all of that up, fundamentals are very strong but perhaps near their peak given some of those headwinds that we just discussed. I think given that, security selection is going to be critical, and thankfully, that's what we do best here at MFS with the bottoms-up research.

Rob Almeida:

Yeah, it makes sense. Tom, thank you for your time.

Tom Compton:

Yeah, appreciate it. Thank you.

Rob Almeida:

And thank you to all our listeners for tuning in. If you've enjoyed this and past conversations in this series, please subscribe to the MFS Strategist's Corner podcast on Spotify, Apple, or wherever you listen to your favorite podcast. All MFS podcasts along with other market and investment commentaries from MFS can also be found at our website, mfs.com. Again, thank you.