Sponsored by Macquarie Investment Management
Interview with Gregory Gizzi, Head of Municipal Bonds, Senior Portfolio Manager, Macquarie Investment Management.
The municipal market has put up a strong performance thus far 2019. What are the performance drivers, and do you expect this trend to continue?
The market, as measured by the Bloomberg Barclays Municipal Bond Index (MBI), is up close to 5.00% as we speak today1. A really strong performance that has been driven by a strong technical condition in the marketplace. Supply continues to struggle, investors have been receiving a record amount of cash, in the form of bonds maturing, coupons and calls, and as a result, investors have been plowing money into tax exempt bond funds at a record pace. As of June 13th, tax-exempt bond funds which includes ETFs, have seen $41 billion in inflows, a record pace since the data series was started by Lipper back in 1992. That does not include the amount of money going into separately managed accounts (SMA) , which is likely larger.
The supply /demand technical has been a tailwind for the municipal market, and this has been exacerbated by a Federal Reserve that has become dovish based on slowing growth and a persistent inability for the economy to reach the Fed’s 2% inflation target.
The question as to whether this will continue? I believe it will for the remainder of the year barring any significant spike in US Treasury rates, which we anticipate would lead to a reversal of fund flows, a phenomenon we experienced in the fourth quarter of last year.
What role is the Tax Cut Jobs Act (TCJA) playing in the municipal market? Lower tax rates seemed to have had little impact on a tax-advantaged asset class?
The TCJA has had a significant impact on the market in several ways but let’s examine the most significant. First, supply is struggling because advanced refundings, a transaction in which issuers refinance their debt much like a homeowner refinances their mortgage, became prohibited which eliminated roughly 30% of supply from the market.
Second, corporate tax rates were lowered from 35% to 21%, making a tax advantaged investment less appealing relative to other taxable investments. Banks have been selling municipals and historically they have been the largest segment of demand coming from corporations, at roughly 15% of the market. Their positions, based on the latest Federal Reserve data, have fallen by approximately 1.5%. This means that retail, or mom and pop investors, have become a more significant source of demand for the market particularly in the long end of the curve where banks invest. In general, municipals must get significantly cheaper relative to taxable investments for corporations to find value in the asset class. Due to the strong demand from individuals, the absence of corporate demand has not been an issue for the market, but in the fourth quarter of last year when individuals were selling, the market experienced extreme volatility in a short period of time.
The individual investor has certainly taken up the slack and the demand has been supported by the State and Local Tax (SALT) provision, despite the lowering of marginal tax rates. This is because by capping state and local tax deductions in high income tax and/or high property tax states, the effective tax rate for many individuals has increased. Tax bills increased not decreased for many investors. Individuals have sought municipals to help minimize additional taxes from investment income.
Why has municipal supply been challenged? Do you see this changing in the near term?
I believe there are two forces at work. First, it’s a function of state and local governments still having an austerity mindset. Post GFC debt is still a bad word. Particularly for state and local governments that have done a poor job managing their pension plans.
Second, the empty promise of an “infrastructure program” from Washington has created a situation where state and local governments delay financing infrastructure projects for fear of missing out on a “deal” from the government. This has diminished supply because historically roughly 75% of the financed component of infrastructure spending is done through the municipal bond market. Given where rates are today, many would argue issuers may be missing out on relatively inexpensive cost of capital to do such projects.
I do not see a significant shift in supply picture in the near term. There is a bi-partisan bill in Congress to restore advanced refundings, but that will take some time if it is in fact passed. On the infrastructure front, while conceptually its easy to get both sides of the aisle to support an infrastructure deal, agreeing how to pay for one is an entirely different proposition.
What is the philosophy/process you use when constructing municipal bond portfolios? Why do you deploy this strategy?
Our investment philosophy is built around the belief that income is the most significant and consistent component of total return, over time, and that price is less significant and much more volatile. We integrate this belief into our investment process by focusing more on the credit selection process and less on predicting where interest rates will go. In general, our portfolios will have a neutral duration to the benchmark or peer group, and then we will utilize underweights in the higher investment grade categories (AAA/AA), to overweight the lower investment grade (A/BBB), with some type of allocation to the below investment grade segment in all of our strategies, except our high yield funds which have no limitation on below investment grade. The focus is on credits which provide investors with high levels of income, but we do so in a very disciplined manner which we believe assures proper diversification.
The reason we deploy this strategy is supported by the returns of the individual credit tiers in the MBI. Over 1, 3, 5, 10, and 15-year periods when you examine the actual returns of the individual credit tiers within the MBI, the lower the credit quality the higher the return over all those time frames. Investors have been rewarded with higher total returns by going down the credit spectrum.
We deploy a research staff of 7 dedicated municipal credit analysts that rate each credit we consider for investment and make our living from providing investors with returns generated from some of the most credit intensive sectors in the market. These are credits in project finance, health care, corporate backed issuers, and education, to name a few.
Our goal is to provide investors with high income coupled with consistent long-term returns.
Where do you see opportunities?
We still see opportunities in the lower investment grade and high yield markets. While credit spreads in the lower investment grade or below investment grade are tight, that’s a reflection of the strong technical in the market. There is a lot of demand for this paper. Spreads are not at all-time tights, despite the strong technical. We still find value in sectors such as Charter schools, Master Settlement Agreement (MSA) tobacco bonds, and project finance deals, to name a few. Many of these credits are in the below investment grade sector. As an investor we must do the analysis to make sure we are investing in credits that are going to perform the way the issuer believes they will for the life of that bond. Once that risk is analyzed, you then must believe you are being compensated for that risk.
There are many investors competing for the below investment grade space which comprises about 12% of the overall municipal market. We still hold steadfast to our belief in proper diversification. We are going to maintain our investment discipline at all times regardless of what the technical backdrop of the marketplace looks like.
We believe investors buy municipal bonds for two reasons. First, they want to preserve their wealth. Second, they want to maximize a tax-exempt income stream they can earn off that wealth. Our strategy is designed to do that in a thoughtful manner.
Can you tell us more about your diversification strategy?
Let’s use the charter school sector I referred to earlier. Charter schools come in many different flavors. They are issued in multiple states, some of which are charter school friendly, some are not. The curriculum can have different themes. Some projects have construction risk, some don’t. Some boards are heavily skewed toward teachers, parents, or administrators. We like well balance boards with a mix of professionals. The point is we do not invest in these school projects based on their yields alone. We also like to take very measured exposures. For instance, in our high yield fund we own 57 different charter schools in 20 different states. We maintain a steadfast discipline to make sure clients are getting diversification.
Any final thoughts for the balance of 2019?
Municipal credit fundamentals are solid, flows are at a record pace, the economy is growing at a slower pace, but I do not believe we are heading into a recession this year. Inflation continues to be muted below the Feds desired target which has shifted the markets view on rates. The market has a tailwind which we believe will remain for the rest of the year, if we don’t get some unforeseen event which causes a spike in Treasury yields that causes fund flows to significantly reverse course. Individual investors are so important to the market that if that were to happen, we would most likely give back a fair amount of the market’s 5.00% gain this year.
The municipal market should continue to perform but we foresee periods of volatility. In our view, investors should use those periods to add to municipal bond allocations. Investors should ask themselves a question, do you think the next move in tax rates will be higher or lower? Municipal returns for both IG and high yield, on a tax adjusted basis, have been the best performing asset class in fixed income for the past 5 years. By a long shot. Municipal bonds should be a key component of investment portfolios.
[1] As of June 20, 2019.
The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Fixed income investments may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
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