Making the Case for Municipal Bonds Despite Recent Volatility

Josh Greco: To get right into it, Ben, you know, it's been a tough start to the year for fixed income and that includes munis. You know, a lot of it just has to do with the math of higher interest rates’ impact on fixed income, and also there's been an elevated risk environment, which has translated to wider spreads in many areas. So, let's start with that interest rate question. You know, the Fed [US Federal Reserve] has accelerated a pace of rate hikes here, but what are you expecting going forward and how do you anticipate the muni market handling and adjusting to this new rate environment?

Ben Barber: The rate environment is what we're all talking about and, the rate hikes have been surprisingly robust on a year-to-date basis in terms of how the Fed has been situated, how they've communicated, what they've done and what the reaction has been with the rest of the yield curve, not just in Treasuries, but in other fixed income markets as well. You know, when we talk about the rate environment and what we sort of anticipate, we always focus on a couple things. Number one is how has the Fed communicated and what does the market understand in terms of those communications by virtue of looking at the rest of the yield curve and Treasuries. And then we very quickly get onto how is the muni market situated relative to what's going on in the Treasury curve. So, you know, I mean the main themes year to date of course have been rates higher, curve flatter, spreads wider, and you know, one of the very significant things that has taken place year to date is a tremendous muni underperformance relative to Treasuries. That's really been the key to the muni market and why the muni market has gotten a lot of press over the last couple months in terms of, you know, what a rough start 2022 has been for the muni market. One of the tools that a lot of folks will use when thinking about muni valuations, you focus on the muni-to-Treasury ratio, nothing more than yield of triple A muni divided by yield of Treasury in the same part of the curve. And just, for an example, out in 30-year maturity space, that ratio started the year in 2022 around 70%, and was recently well north of a 100%, 105%, 110% type of ratio. So, a 40 ratio move on a year-to-date basis, and that means, of course, that munis were underperforming Treasuries or yields were rising at a much faster clip than what was taking place in the Treasury market. All of this is technically driven.  I'm sure we'll spend some time talking about the technical factors. In the muni market, they're very, very important. You know, I think it spells an awesome opportunity in today's world, when you think about muni valuations, as the underperformance has been very significant, but it sets up, you know, very, very compelling valuations in today's world. And I think we're starting to see investors starting to really understand that over the last week or two.

Josh Greco: Yes, and certainly there's an experience as an asset owner, but there's opportunity as an investor. And that's, I think the dichotomy here and what we've seen with this muni market year to date. But part and parcel to that yield conversation, Ben, is spreads. We've seen risk appetite be reduced this year through a tough market, and elevated risk generally means wider spreads for credit issuers. So what's going on with muni spreads specifically, and where is the new opportunity showing up in your view?

Ben Barber: Yes, it's interesting you use the word dichotomy, that's exactly what's going on with this topic of credit spreads within the municipal market. We've got two very interesting factors going on at the same time. You know, when you think about credit spreads and what should be driving credit spreads should be either an elevated credit risk, which would insinuate higher credit spreads or, you know, credit fundamentals are really improving and you'd anticipate tighter spreads with an improving credit fundamental situation, but that's clearly not happening this year. Spreads have widened in a risk-off environment overall. The interesting thing though, is that credit fundamentals are very positive in municipals across really every traditional municipal sector: transportation, utilities, nonprofit acute care hospitals, state general obligations, local city and county general obligations, transportation deals, education deals. Across the traditional municipal sectors, upgrades have been significant. In fact, that upgrade to downgrade ratio is about three to one in 2021, meaning many, many more upgrades than downgrades. And the interesting thing is that the upgrades have really been taking place around, traditionally, some of the worst actors in the municipal market, at the state level for sure. We've recently seen, you know, significant upgrades for the state of Illinois and the whole Illinois complex, which has been, bantered around in a very negative light in the media over the last couple of years, for good reason, but state finances are surprisingly good. And we're right in the middle of budget season right now, and budgets across the country are getting done very, very easily. So, we're in a really interesting spot in that credit fundamentals have been really positive. That should insinuate tighter spreads, but in fact, the opposite has been going on, what's been going on, and it’s all been technically driven. So, it's very directional in the muni market. This is a retail-driven asset class, and retail tends to be very sensitive to seeing rates increase and therefore, prices on their open-end mutual funds shares declining, of course, with a higher rate environment. The typical retail psyche will be that rates are going up, prices are falling, and they tend to sell. Quite the opposite of what probably a rational investor should be doing in a rate increasing environment in which prices are going down. As a rational investor, you should be considering increasing to that asset class, assuming that you're still comfortable on the credit fundamental side, that should be an increasing allocation to an asset class that's having that difficulty. But given the retail nature of the muni market, it doesn't work that way. Rates go up and people generally sell, they redeem out of their mutual funds, and that creates very difficult liquidity. In our market, it creates very difficult technical pressure, and it then finds its way into that muni to Treasury ratio increasing. So, in other words, munis underperforming. It also finds its way into muni credit spreads widening, not for fundamental reasons, but just purely for technical reasons. So, that tends to be a temporary type of situation. The interesting thing about year to date is it has certainly been a long slog to get here. It's been five months of increasing rates, and therefore, five months’ worth of redemptions. And the technical pressure has been significant on our market, and that's what has really driven ratios quite a bit higher. And that’s what has been really driving credit spreads wider on a year-to-date basis. Again, great opportunities from our perspective, especially given the very strong credit fundamental background of our market.

Josh Greco:  You mentioned that credit fundamental picture being in pretty good shape. Let's talk about budgets next, specifically. You're hearing increased chatter about recessions or the probability of recession here. How is that impacting the budgets and the outlooks for these different municipalities as they're setting, you know, their anticipated spends over the coming years?

Ben Barber: Yeah. Each state will, of course, handle it differently. And you see a wide dispersion in terms of how states deal with excess money, surplus money. I think the most extreme example of that would probably be the state of California where the surplus is extraordinarily large and much larger than was even anticipated even several months ago, certainly versus a year and two ago. So, each state will deal with those budget issues differently. And we can see exactly how they shake out. I think one of the key elements of the muni market and what makes, I think, the muni market such a powerful, high level of credit security for bondholders is this whole notion of states having to operate with a balanced budget. It doesn't mean that budget gaps can't get created and surpluses can't get created. Of course, they do, and they will over time, but there is a discipline here that's really, really different than, for example, sovereigns, which can obviously print more currency, if they want to. States don't have the ability to do that, and states have to operate with a balanced budget. That’s constitutional, a very, very significant difference between muni credit, sovereign credit and of course, corporate credit. And it's one of the key differences that I think a lot of people in the post 2008 world,  we were getting the questions quite often, you know, what's going to be first to default, is it Greece? Is it Spain? Is it California? And a lot of people that were not muni professionals started wading into the muni market asking these questions. And, that was one of the key differences that really shined a light on, on just how solid credit fundamentals can be at the state level for general obligations, one of the key sectors in the municipal market. And it's really due to that discipline of having to operate with a balanced budget and having to go through that. So again, as we talked about, this is budget season now, this month and next, and you're starting to see these numbers come through and that's really been the source of a lot of the upgrades that we've had in our market over the last couple months is just in, in how good a shape these states tend to be. Now, of course, there's a cautionary tale to that as well, right? If you have a large surplus, it depends on how that gets spent, is it going to be on one-time things? Is it going to be, you know, sort of a contractual need going forward that that a state can lock themselves into, which can be, you know, pretty scary from a budget perspective going forward. And so that's something that we at Franklin Templeton and the muni bond department spend a lot of time really analyzing the quality of the budgets. It's great that they're easy to get done this year. However, there is always a cautionary tale with regard to state budgeting processes. And that's something that we're keeping a very keen eye on, you know, this year and subsequently to make sure that the surpluses in this case are spent wisely and that it'll be a good, consistent use of proceeds going forward.

So that's at the state level. And then, you know, there's a lot of stuff that then trickles down to the other traditional municipal sectors in our world. There are many sectors of course at the municipal market that have nothing to do with what's going on at the state budget level in any state. And so, you know, that's sort of the other beauty of the municipal market. We love the fact that it's an inefficient, you know, retail-driven asset class, and we can be institutional investors and try to take advantage of that. That's great and it does trade in a very inefficient way, but I would say the other beauty of the municipal market is just how incredibly diverse the credit side of things can be. There are literally dozens of sectors that have to do with the municipal market. There are very high-quality sectors all the way down to high yield, you know, in junk, below investment grade, types of sectors as well and everything in between. And there are lots of sectors, for example, in the state of New York or the state of California, New Jersey, Pennsylvania, you know, very, very large issuing states that have sectors that have nothing to do with the finances at the state level, in whatever domicile you're talking about. So that's sort of an interesting thing about the municipal market is, you know, when you think about a recession timeframe, or you think about an inflationary timeframe there are lots of sectors that will act in very different ways from a credit fundamental perspective in different macroeconomic environments. And so that's, that's part of the beauty of it. And, that's why you like to use active managers that have a significant research background in this market. And I think that that's the perfect example as to why. And I think if you think about the environment over the last couple of years where, you know, things were going along great, and then COVID happens and it really sends, many sectors into, you know, questionable areas where, you know, people really had to do the analysis of, are these permanent issues with regard to credit fundamentals on hospitals, on student housing bonds, on higher education types of bonds, on transportation bonds, are they permanent issues or are these more temporary issues? And, you know, how's that really going to shake out? But I think, you know, the final point just on, on budgeting and budget seasons, you know, one of the other of course, key differences with what happens at the state level with regard to requiring a balanced budget type of process is that we know in a recessionary timeframe, revenues are going to go down. There's no question about that. And they'll go down at different stages, for different states around the country, but in general, they're all going to follow a similar type of trend. And when revenues go down, their expenses have to go down by virtue of having to have a balanced budget. They'll have to cut back somehow, some way. And so, it might not be pretty, and it could be very painful at the state levels, but we've seen this over lots of different cycles, great cycles and recessionary cycles, where there might be a lag of a year or two or three, depending on how difficult their budget process is set up and politically how states are set up, but in general, having that balanced budget process is a very critical element as to why state general obligation credits are some of the best that you can have out there.

Josh Greco: In talking about both the inefficiency and your institutional skillset here, let's talk about issuance next. This is a market that's impacted by technicals. Supply and demand are real forces in markets like municipal bonds. So what's the update there with respect to technicals, what are you watching or noticing from a technical impact standpoint on the municipal bond market right now?

Ben Barber: Put in perspective this way. You know, we've got a market cap of about $4 trillion for munis. So it's a very large market, 50,000 different issuers, over a million different CUSIPs. It's a very large market. Every year,  there's about $400 billion that comes in the primary market. The key to thinking about supply though, is thinking about the net supply because every year there are coupons paid, there are maturities that happen, bonds that are, you know, redeemed out of our market, etc. And so, the net supply is sort of the key. If we think about $400 billion a year of primary market supply, what's the net? And interestingly, over the last 10 to 12 years our market has actually been in net negative supply mode, meaning more bonds are being called out of the market and-or maturing out of the market than are coming in the primary market. So that in and of itself sets up what should be a pretty positive technical for the muni market. The fact that it's shrinking, you know, says that supply is moderate at best and is actually, you know, shrinking over time—very small amounts, right, on a $4 trillion market if we have a net negative year of, you know, 10, 20, $40 billion that that's not statistically significant. It's only significant from the perspective of, for the prior 30 to 40 years, you know, generally the muni market had grown, but it just is not growing over the last couple years, and there are lots of different reasons why. One of the critical reasons, is, you know, part of the Tax Cuts and Jobs Act from early 2017 was thinking through the ability for municipalities to advance refinance their debt. That was taken away in terms of tax-exempt munis being able to be advance refinanced with tax-exempt munis. You can't do that anymore. That was part of the tax change couple years ago. And so, a lot of the issuance that normally would've come in, the tax-exempt market actually comes in the taxable market if it's appropriate for those issuers to do so. So I would say that, you know, overall, that's one of the key elements to what's going on in the technical side of munis, and that sets up pretty positively. By far though, the most important portion of technical pressure, either good or bad, is what's going on with the retail shareholders, what's going on with the retail investors for munis, are they buying munis? Are they redeeming munis? And, as we stated at the beginning, it tends to be very directional, right? Rates are going up, people see their NAVs [net asset value] or their per share prices of mutual funds falling, and they generally tend to sell. And quite the opposite happens when rates are going down, prices are rising and people love to buy the winner and they'll generally, you know, come in and buy muni funds. We'd love to be out there educating investors to sort of do the opposite, right? When rates are rising, again, assuming that you like the credit fundamental story of munis, and you're a long-term investor, those can be great opportunities to invest more into munis, maybe get up to your proper asset allocation. You know, we hear consistently from large platforms at the very largest broker dealers across the country that their investor base is generally pretty underweight what their normal asset allocation should be to investment grade fixed income. And if they're paying taxes in the US, like most of us are, you know, that allocation to investment grade fixed income is generally going to be the muni market. But we actually do feel there's, you know, quite a bit of money on the sideline that should be a very positive technical feature, especially given where valuations are at this point of the year. So we anticipate the technical environment, which has been very challenging on a year-to-date basis to vastly improve in the second half of 2022.

Josh Greco: Ben, a lot of great insight on the municipal bond market. That's Ben Barber, Director of the Municipal Bond department with Franklin Templeton Fixed Income. Ben, thank you so much for joining us.

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