SBH Investment Summit: Municipals

[Robin Fujimoto] Hello, thank you for joining our investment summit series. I’m Robin Fujimoto, I’m a member of our Advisor Solutions team at SBH. Today we’re going to be featuring our municipal bond expert, Nick Foley. Nick’s a Senior Portfolio Manager on our municipal bond strategies. Well, I think this is the first time in my lifetime where we have another unprecedented year. We’ve seen fixed income drop alongside of equities and so I’m really interested to hear what Nick has to say today. Nick, let’s talk about something you’ve spoken frequently about and continues to come up, and that’s concerns over the liquidity of the bond market. What’s driving these concerns and what should we be paying attention to?

[Nick Foley] Yeah, sure. And it’s great to talk to you Robin. So, the word liquidity has a lot of different meanings. It’s kind of this concept that people are fearful of, but it’s challenging to quantify. But we think in the way that we view it and the way that we think about it, it’s really important and essentially, all that it means is that at any given time are you really being paid for your ability to go out and sell whatever securities you hold? So, whether that’s in the Treasury market, corporate bonds, municipal bonds, we know it’s been in the news a lot that liquidity in the Treasury market has been somewhat strained. The corporate bond market maybe to a lesser degree. But as we know, municipal bonds are always a challenging liquidity asset class in the sense because of the structure of the underlying muni market, which is there’s 1 million CUSIPs. So, at any given time, every single day that you want to sell a bond, or you want to buy a bond, it’s truly price discovery on that day. In a normal market, it functions not nearly as liquid or as cleanly as Treasuries or corporate bonds, but it functions in finding and matching up those two parties. But what we’ve seen this year is that we’re undergoing the largest and longest outflow cycle we’ve ever seen in the municipal bond space and now part of that is the fact that inflows over the last decade have been so high into bond funds in general, but especially municipal bonds. So, what we’re seeing is some reversal of that; just for context, we had about a 100 billion dollars of inflows last year into municipal bond funds. We’re a little over a 100 billion in outflows this year. So again, just offsetting essentially last year. But the question really starts to become in those outflow cycles, there’s less and less people showing up every day to essentially set that price and make that market. And when you get these periods of big stress, like we’ve seen throughout this year, you’ll see it just turn into a one-way flow. So, everyone that is a municipal bond manager suddenly is saying, I need liquidity and going into the market and the door to walk in is wide open to enter the muni market and the door to exit can get really small. So, we think the premium that you need to be paid essentially to own illiquidity and to own longer term bonds especially, has risen. And there’s some market participants we think that understand that and are grasping that, but we’re seeing others that are somewhat recklessly just jumping back in thinking we’re going back to this 50 basis point rate environment and nothing can go wrong. And we’re seeing these swings in the pricing of liquidity essentially.

[Fujimoto] How do you think that’ll play out over the next year?

[Foley] Yeah, it’s a really good question. My crystal ball: I think what we’re going to see over the next year is continued volatility. So, one of the things we’ve seen this year is the majority of price declines that have occurred have taken place due to duration. What I mean by that is interest rate risk. The majority of price losses have been to rising interest rates. We’re entering a period now, it feels, where credit is going to come into focus. And what we think is that volatility is maybe to a lesser degree rate-driven, even though that’s certainly a higher volatility in rates, but we’re going to start to see higher volatility in credit spreads as well.

[Fujimoto] Interesting, thanks. While you’ve mentioned concerns around longer maturity bonds, you’re bullish when it comes to short-term securities. Why is that? And can you explain why elevated rates on the short end can provide an income cushion in a volatile or a rising rate environment?

[Foley] Absolutely. Something I have not really had a chance to talk about in a decade, which is that short-end maturity, short-end rates are quite interesting. You can provide, what we think is an attractive return on the front end. And the reason short maturity bonds are interesting is for a couple reasons. You know, as we talk about that volatility if investors have concerns about rates continuing to rise, credit spreads widening. When you own shorter bonds just due to the characteristic of the bond, it’s generally much less volatile. Just a basic example is that if you have a bond that yields 3%, say it’s a 1-year bond, your duration or your interest rate risk is one. In order for you to lose money over the next year with a 3% yield, interest rates would have to rise 300 basis points. And then at the end of the year even if that does happen, obviously the bond will be maturing so long as it doesn’t default. And so again, that’s why in very basic terms, we think that short-end bonds can be interesting. To take it one step further in the municipal market is where you get the tax exemption as well. And so, what we see is not just again, there’s been a lot of commentary about how attractive front-end rates in the Treasury market are. In the municipal bond market, obviously the rates that you’re able to get, that income is tax exempt. So, we’re seeing in general 4 – 5% yields across the front-end right now in high-quality municipal bonds.

[Fujimoto] Oh, that sounds like a pretty good opportunity. Nick, how are these higher rates affecting the new issue supply?

[Foley] There’s been some debate back and forth about how it’s going to affect new issues. If you think about it conceptually in the municipal market, there’s a city, state, or someone’s building a bridge or a road. And this planning takes years and years for one of these projects to come to fruition. Now again, when they’re building into their model how much debt they need, how much they can afford given the revenue streams, they’re using their best assumptions generally of what that debt is going to cost. So, over this last year the cost of that debt or the yield that they would have to issue that debt at has risen fairly dramatically. What that changes is just the dynamic of some of these projects and maybe some of the assumptions around debt issuance. But what I would say is that overall, what we’ve seen even so far this year is that a lot of these projects went from a very dramatic rate rise in terms of magnitude. Going from say 1% to 4%. But again, a lot of these projects and the revenue streams backing them, 4% is still not 8% or 10%. Some amount that would make it uneconomical to do the projects anymore. We’re thinking that it’s going to be somewhat close to average, a little bit below it, say about 10% below average issuance here for municipal entities. Some forecasts are saying it could be even lower. So, I think it’ll really come down to just what we’re seeing in the markets. Where we sit now, the markets remain very open and I think very affordable for municipal issuers.

[Fujimoto] Okay, great. Well, I think we’re wrapping it up. I think we’re running out of time. But Nick, I wanted to thank you again for taking the time to speak with us today and your insightful comments. Everyone, thank you for joining us today and if you have any additional questions, please reach out to us and have a good day.