In this episode of Markets in Focus

With the Biden Administration aiming to raise taxes, many investors are turning to municipal bonds as a solution. Compared to recent extreme moves in equity markets, the muni market has been downright calm in comparison. Burton Mulford, CFA, Portfolio Manager and trader for Eagle Asset Management's tax-advantaged Fixed Income portfolios, joins Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers, to discuss how tax code changes — and potential inflation — may affect muni opportunities.

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Transcript

Matt Orton:
Investors have understandably been focused on the implications of rising rates, inflation expectations, and the path of the economic recovery. We've had big moves in rates this year, and they've had meaningful implications for investors. And we've discussed in this series, some of these extreme rotations that we've had between styles and factors in the equity markets, as well as where to find opportunities, but one area that we haven't discussed and where there's a lot of client attention given the likelihood of tax changes is the municipal bond market. I'm lucky to be joined by Burton Mulford, portfolio manager and trader for Eagle Asset Management's tax advantage portfolios, to dive a little bit deeper into the municipal bond market and some of the areas of opportunity going forward.

This is Markets in Focus from Carillon Tower Advisors. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

Burt, thanks for being here today.

Burt Mulford:
It's my pleasure.

Matt Orton:
Great. And I'm looking forward to hearing about how you're positioned, especially in light of some of these potential tax changes that we hear about probably on a daily basis, but before we get there, maybe it makes sense to start at a high level by discussing your thoughts on rising rates, inflation expectations and what you think that means going forward.

Burt Mulford:
Yeah, very good. So the concern of market investors for the calendar year 2021 is the rising inflation environment that we're experiencing. And we've seen a back-up, and interest rates in the taxable market more dramatically than in the tax exempt market. So the municipal market is a defensive place to invest if you're concerned about inflation in the sense that the market doesn't move in tandem with Treasury. So at the beginning of the year, the 10 year Treasury was at about 0.9%. And currently we're at 1.6%. So we've seen a back-up in interest rates of about 70 basis points in the taxable market.

The municipal market has been relatively stable. You've only seen a back-up of about 29 basis points in the tenure AAA muni scale, which is the equivalent benchmark for tax exempts. The beginning of the year, we were at 67 basis points or 0.67%. And currently we're at 0.96% on the AAA 10 year muni. So it's a defensive place to be. Munis across the board in terms of total return have been relatively positive. It's been flat in the belly of the curve. The seven year is up nine basis points, total return. Whereas, the long muni index is up 1.6%. Compare that to taxable benchmarks, the broad aggregate intermediate index is down 0.96%. And the U.S. Treasury index is down 3.30%. So it's been a safe haven for investors to put money to work.

Matt Orton:
And so I think that that's an interesting point and one that a lot of people might not appreciate that correlation relationship. This is a question that I think everyone gets asked, but I'll pose it to you nonetheless: what are your expectations going forward for, I think, both just Treasuries and for the municipal bond market broadly?

Burt Mulford:
Yes. So the U.S. economy has come roaring back from where we were mid-last year. We're seeing a V-shaped recovery in the economy. The first quarter nominal GDP increased to about 11% quarter over quarter on an annualized basis. So that is significantly higher than pre-pandemic levels. So inflation is at the tip of a lot of investors’ tongues. We're approaching the Jackson Hole congregation of Fed governors to talk about what the Fed is going to do given this inflation backdrop. And the concern is inflation expectation on the consumer side is likely to be around three and a half percent in July. So the Fed’s got to deal with that. The employment cost index is likely to be up 4% quarter over quarter in the second quarter. So there's significant pressure on the inflationary level.

So we are structuring our portfolios in defensive mechanism to preserve principle. We're keeping about 20% of the bonds in the short end of the maturity curve. So one to two year paper, and we're implementing a barbell strategy by combining that short paper with 10 to 15 year paper where we see greater valuation. So we're avoiding that belly of the maturity curve, that five to seven year part, which, on a relative basis, is more expensive.

One factor that we look at in the market is something called a capture ratio, and it's the yield on a AAA rated muni compared to the yield on an equivalent maturing Treasury. And right now, those ratios are the most attractive in the two year part of the curve and in the 10 to 15 year part of the curve. So that five, six and seven year part of the curve is what we call rich. So we're avoiding that. We see some opportunity by using that structure because when the bonds mature over the next couple of years, we'll have money to redeploy or cash to redeploy in a higher interest rate environment.

Matt Orton:
And so I want to dig in, I think it's helpful to have that context of positioning. And I know you mentioned Jackson Hole thinking about what the Fed is going to do going forward. There's been such an unprecedented amount of fiscal and monetary support that we've seen come into the market over the past 12 to 18 months. It's hard to keep track of all of the measures at this point. And I think it might be helpful for our listeners if maybe you could provide a brief summary of some of the legislation that has specifically benefited municipalities. And has that changed your views or preferences on certain credits as a result of those policies?

Burt Mulford:
Yeah, very good. So there's been massive historical monetary stimulus that started back in March of 2020. So the first stimulus package that took place, the large was called the CARES Act, and CARE stands for Coronavirus Aid Relief and Economic Security Act. And that was passed on March 27, 2020. The total package was about two trillion in size. And in terms of the municipal issuers, the money that went towards issuers in our space was pretty significant.

So $150 billion went to state and local governments, $30 billion went to school districts in higher education. $45 billion went to a disaster relief fund for the immediate needs of state and local governments to protect citizens. $25 billion went to transit systems. $500 billion went into a lending fund for businesses, cities, and states. And then finally, $150 billion of that $2 trillion package went towards hospitals and healthcare providers. So those are all issuers in our state. So there was significant aid that came from the federal government through the CARES Act.

The second act that was passed was called the Paycheck Protection Plan and Health Care Enhancement Act. That was smaller at about $483 billion, was passed in April of 2020. And of that $483 billion, $75 billion went towards hospitals. So hospitals got another stimulus in that second act. Thirdly, in December of last year, the Consolidated Appropriation Act was passed, which was about $686 billion in total size. $82 billion of that went to aid school districts and higher education systems. And then finally in March of this year, the American Rescue Plan was passed. That total dollar amount was $1.9 trillion. And inside of that, $362 billion went to state and local governments and $170 billion went to school districts in higher education.

So this stimulus significantly will strengthen the ability to cover debt service for many of the municipality issues. So it was a historical number and there could very well be additional aid down the road, but those are the four largest ones that impacted the municipal bond market most significantly.

Matt Orton:
Did any of the money that was passed change your view on any of the areas where you were allocated in your portfolio, or did it reinforce some of the views that you already held?

Burt Mulford:
It shifted our opinion. Once numerous packages were passed, we started reconsidering adding towards transportation sector and also healthcare and higher education, which were really three of the largest, most beaten up parts of our market. Within transportation, we really started focusing on airport revenue bonds, which got significant aid and we still see some value there. So it shifted. The most defensive sector during the time of the economic slowdown, in our opinion, was in the local and state geo sector. Local general obligation bonds are backed by ad valorem taxes or property taxes. And as everybody's well aware, the housing market has been on fire over the last year and a half. So property tax bases have been growing significantly. Foreclosure rates have been decreasing. So there's a lot of optimism in the housing market, which buffers the ability for local governments to cover their debt service.

Matt Orton:
Thanks, Burt. I think that's definitely interesting to get a breakdown of how all of that money has been allocated. And I think now a question is how are we going to pay for all of that? And there's been a lot of discussions lately, especially about changes to the tax code, both for individuals and corporations that could be under halt in the coming year or years. We've only seen the initial proposal and it's still being negotiated right now by the house and the Senate and Republicans versus Democrats. But what's your initial reaction to what we know about the proposal with respect to the potential impact on the municipal market?

Burt Mulford:
Yeah. Broadly speaking, higher taxes bode well for the municipal bond market because the intrinsic value increases on a tax exempt investment when tax rates are high. So on the personal side, currently the top marginal tax rate is at 37%. It was lowered in 2017 by the Tax Cut and Jobs Act that was passed. It was lowered from 39.6 to 37. So I think there's a pretty good possibility that we're going to see that top marginal rate go back up to 39.6.

The impact on the demand for municipal bonds will be marginal. It will increase, but it won't be significant because it's only going to be a smaller increase, but it could very well have an impact. But I think more importantly, on the corporate side, I think you're going to see accelerating demand make a large change or shift in our market by corporations or banks, and insurance companies would comprise part of that, which they're talking about increasing the corporate tax rate from 21% back up to 28%.

So I think it's probably going to be somewhere in the middle, maybe around 25%. You've got [U.S. Senator] Joe Manchin from West Virginia who is opposed to a big increase. So I think there's going to be some negotiation in terms of that rate. So you'll see a rate jump on the corporate side of about four percentage points. So it's going to make it more attractive for banks and insurance companies to start buying more and more municipal bonds. That part of the market on the bank and insurance side, they're about 25% of the holders of all municipal bonds. So it's fairly significant retail on the other side is about percent. So if you've got more compelling incentive for institutions to buy munis, that's going to put a squeeze on supply. And so that's what you've been seeing over the last year. And this is going to even sharpen that with a mismatch between the available product in our space and the accelerating demand.

Matt Orton:
Given that, then, how do you and your team look at potential opportunities then with that sort of backdrop, or is there anything different that you're doing, or are you really just following the news and trying to keep an open mind?

Burt Mulford:
So I would say we are a bit more bullish than our taxable counterparts because of that dynamic. If you've got a rising tax rate environment, that's going to soften the blow in our market if interest rates start to creep up, and you're already seeing that. Year to date numbers, like I said, municipal bonds are outperforming taxable bonds because of this expectation of higher taxes. And then on top of that, you've got a significantly improving credit quality in our space because of the federal stimulus package and the opening up of the economy. There is excess cash on the sidelines. There's pent up demand. So that will bode well for the credit quality in our space. So you're going to likely see more upgrades by the rating agencies than downgrades from here going forward.

Matt Orton:
Yeah, and I think something else to mention along these lines is we've been hearing more increased support, bipartisan in many cases for bringing back both Build America Bonds and advanced refundings, which are two powerful financing tools to help lower the borrowing costs for municipalities. Any revival of these tools would probably benefit municipalities, but what would the impact be for municipal bond investors?

Burt Mulford:
Yeah, that's a great question. So there is a pretty good chance that you're going to see a version of the Build America Bond or BABS program from 2009 and 2010. So back in 2009 and '10, this program was implemented. It's a direct pay subsidy bond program where the federal government gives a subsidy to the issuers. That subsidy, I believe was about 35% back in 2009 and '10, likely going to be less than that if it does get past, where that market... I wouldn't call it substantial, but it was fairly large. In 2009, you had $40 billion in issuance in the BABS program. And then in 2010, it doubled to $80 billion. So I think you could see maybe a hundred billion potential, or even larger if it in fact came back into play.

So what it would do it, would make or provide kind of a scarcity value for tax exempt bonds because issuers, instead of issuing the tax exempt structure might very well choose to go through the Build America Bond or taxable muni avenue to raise funding. So it could in fact put a squeeze, an additional squeeze, on the constrained supply of tax exempt paper. So 2020, in terms of all issuance, you saw about $319 billion in tax exempt issuance. And then on the taxable side, taxable munis had about $185 billion in issuance. So, that was a pretty big number compared to historical numbers. So we're on track for 2021 to be about 10% higher. So supply of tax exempt paper in fact will be a little bit higher than last year, but if you get this Build America Bond program in play, I believe the focus is going to be much more on the taxable side.

Matt Orton:
Gotcha. And so I know we're coming up at the end of our time, but maybe to help sum things up, you can leave us with some areas that you're most optimistic about going forward and what you consider to be some of the most important headlines or events for municipal bond investors to follow in the coming months.

Burt Mulford:
What I would like to say about the municipal market is that it's invaluable portfolio diversifier. Given that we're in a rising interest rate environment, municipal bonds provide diversification to an investors overall asset allocation. So we currently see opportunity in what we call the reopening sectors in this economy where fundamentals should sharply improve as the economy continues to reopen. So one sector that would be considered to be a reopened sector is transportation.

Our focus really has been on the airport revenue bond sector. Credit fundamentals will continue to improve as the propensity to travel increases. So you've got a lot of pent-up demand from lockdowns and the closed economy. So this is going to lead to the accelerating use of public transportation systems and air travel. The TSA travel numbers have been steadily rising. So we are relatively bullish on airport revenue bonds. We like the larger, more sophisticated airport systems that have a diversification of revenues through retail, parking and the airline travel.

The other sector that I think will benefit from the reopening more than others is the higher education sector. So we've got a high quality focus within this sector, and we believe higher eds will benefit from the broad vaccine rollout and the ongoing relaxation of social distancing requirements. We like higher ed systems that have diversity in terms of their revenue stream. So some of the higher ed systems have maybe 20% of their revs coming from med systems, and they're not solely reliant on tuition. So those are some opportunities from here going forward.

The local general obligation sector and the state general obligation sector, I think, will continue to be kind of a safe haven, but there might not be as much performance in that sector as those other reopening sectors.

Matt Orton:
Burt, thank you so much for all of your insights today. I think it's been really, really helpful to spend some time talking about this part of the market. And as you said, it's a very important diversifier for the portfolio. So thank you again for your time, and thanks to all of our listeners for tuning in.

Burt Mulford:
Thank you very much.

Matt Orton:
Take care.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisors. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time I'm Matt Orton.