Pimco, a name synonymous with active fixed income management, isn’t the first you might associate with municipal bonds. But given the idiosyncratic nature of most munis, this is an area particularly suited to individual stock picking.
The Newport Beach, Calif., Company recently launched the
Pimco Municipal Income Opportunities Active
exchange-traded fund (ticker: MINO), managed by David Hammer, to complement his stable of established open and closed end funds and add to his exceptionally successful line of actively managed ETFs.
Fiscal policy – how much the federal government spends, what it spends, and how it pays it – stimulates the economy and markets more than it has in the past, forcing stock investors to pay more attention . Muni managers, however, have always followed the government’s maneuvers. It seemed like a fitting occasion to discuss the state of the sector with Hammer, the munis chief of Pimco. A modified version of our conversation follows.
Barron: Dave, what do you think of the municipal market?
David Hammer: The municipal market is a very fertile ground for active managers, and there are three major inefficiencies that we seek to exploit: credit, structure and liquidity. There has been a decline in broker / dealer liquidity over the years which has given rise to a number of opportunities. [Broker/dealers] raise 10 to 15 billion dollars [in bonds with which to make a market], rising from $ 50 billion to $ 60 billion before the financial crisis. This is compared to vehicles with daily fluids which have grown from $ 400 billion to almost $ 1,000 billion over the same period.
What are the implications?
We’re more likely to see temporary valuation overshoots on mismatch, which means when valuations are rich we’re likely to increase our cash flow more than ten years ago.
The market looks rich right now, with strong demand absorbing the available supply of bonds.
Law. It has been a year of significant influx for munis. The show modestly disappointed. And there has been a positive backdrop to improving credit.
Does this simply reflect the economic recovery? Or are they government policies?
There has been a record combination of fiscal and monetary support for state and local governments. But the nature of this recession was different, in that higher incomes were less affected. Thus, the collection of income tax and sales tax has held up better than in a typical recession. And we have seen an increase in house prices. It is important for local credits [bonds], which mainly depend on property tax collections, which are a function of housing prices.
We’ve seen more upgrades than downgrades this year. One of the biggest emitters, California, turned a forecast deficit of $ 54 billion for fiscal 2021 into a surplus of $ 76 billion by 2022.
Was it just tons of Silicon Valley capital gains taxes? Or Washington’s support?
Federal government support, better than expected sales and income tax collection and capital gains [taxes] as asset prices increased. This also includes credits that have been more in demand in recent years: the state of New Jersey, for example, announced record revenue expected for fiscal year 2022. The state of Illinois received its first increase in rating agency in 25 years.
How did they handle it?
Same themes as California: a combination of fiscal support, monetary policy support, better-than-expected sales and income tax collections and house price appreciation.
Is it as good as it is for an equipped investor?
“Infrastructure policy is an important part of our financial perspective.“
There are still areas of concern, such as large cities. It is still unclear how quickly workers and tourism will return to pre-Covid levels. One example we monitor is daily subway use in New York City. It is still down around 50% from 2019 levels.
So how does this fit into your process?
You have the choice between 50,000 credits. First of all, we do our best to avoid downgrades and faults. We see opportunities in smaller issues that may not be covered by a larger group of investors. And we often see a premium in complexity. It’s common for investors to think of state and local government debt in the municipal market, but a very large percentage of the market comes from public / private partnerships, securitized tax payments, risky types. [of bonds] that require an understanding of local real estate appraisals, or even companies that can operate tax-exempt markets. This is where we generally find value.
Another inefficiency that we seek to exploit is structure. Most of the bonded bonds are redeemable, with different call dates and call prices. This often leads to undervalued redeemable municipal bonds.
The other risk is that of interest rates; Yields on treasury bills have increased recently.
It was not so bad in the municipal market. We have seen a spike in monetary and fiscal support, as well as a spike in growth, with Federal Reserve hikes starting in 2023. The Munis have historically outperformed during Fed hike cycles for two reasons. The first is that as rates rise, the value of the tax exemption increases relative to other investments, resulting in spreads narrowing. The second is that the supply tends to decrease as the number of bonds eligible for prepayment as rates rise tends to decrease. A third reason I would add: because most munis are redeemable, their sensitivity to changes in interest rates is lower than that of a non-redeemable treasury bill of the same maturity.
Would all those callable bonds with coupons of 4.5% and 5% sold a few years ago become vulnerable to an effective lengthening of their maturities, if they are not called when yields rise?
Well, the 4.5% and 5% coupons are not; with yields provided with AA over 30 years of around 2%, they benefit from good protection. But note that over the past year there have been quite a few 2.5% to 3% long coupon bonds created in the market. These are structures that we have avoided; they face potential expansion risks and will underperform as rates rise.
What do you expect from Washington’s fiscal policy?
Infrastructure policy is an important part of our financial perspective. The bipartisan infrastructure bill, which includes $ 550 billion in new funding for traditional infrastructure (existing roads, new roads and bridges, existing water and sewer systems) will be the largest for the municipal market. These are regions that have faced an infrastructure deficit in recent years, and we should see an increase in supply in these parts of the market over the next few years. Other market segments will be less affected. Airports and ports often have their capital plans approved five to ten years in advance; these new infrastructure dollars are more likely to go to projects that were planned anyway. There could also be a return of prepayments, as well as a return of a taxable subsidized bond like the Build America Bond program which was created in 2009 and 2010.
Obviously, none of this is certain until the final infrastructure legislation is passed – if at all.
So how does this affect our outlook? With somewhat rich valuations, the potential for restitution of tax-exempt prepayments would lead to a more immediate increase in supply; this is another factor that justifies a more defensive positioning. Infrastructure considerations have a much longer timeframe, based on the local need to go through a formal approval process, including environmental reviews.
We are unlikely to see a huge impact from financing new infrastructure until the second half of 2022, at the earliest. We think that’s more likely a story for 2023 and 2024. Our baseline scenario is about a 25% increase in the annual net supply of tax-exempt bonds – a very different phenomenon from what investors do. have seen in corporate or treasury bonds, where there has been a sharp increase in issuance. Muni’s emissions over the past 10 years have been quite stagnant.
The other aspect of President Joe Biden’s program is the proposed tax increases for top earners. How does this affect the municipal market?
This is a positive wind for demand, and I would highlight both the potential for higher personal income taxes and the potential for higher corporate income taxes, which would be significant for banks and insurance companies, which hold around 30% of the tax-exempt bonds in circulation.
Looking very simply at municipal yields today, a 2% yield tax-exempt bond has a taxable equivalent yield of around 2.75%. For a high yield municipal bond with a simple yield of 3.25% to 3.5%, this is a taxable equivalent yield of 5.5% to 6%. So even at current tax rates, munis are quite attractive after tax.
Especially given the market situation for high yield companies.
This does not reflect their relative default rates. High yield bonds tend to default about 25% as often as high yield corporate bonds. It is a much higher quality asset class.
Finally, Dave, I have this closed end thing. What are the opportunities there?
Well, I manage our closed funds. They are currently taking advantage of the fact that many holdings are bonds that were bought in an environment of higher interest rates. Closed-end funds all use some form of leverage and benefit from a very strong [yield] curve; they borrow at a low rate and reinvest at a higher rate. Both are currently tailwinds. However, most closed-end funds have very long duration profiles. As rates go up, it can be a bit of a headwind.
This is true for just about all asset classes. Thanks, Dave.
Write to Randall W. Forsyth at email@example.com