Two veteran bond investors survey the tax-exempt market.
Our guests this week are Jim Murphy and Charlie Hill of T. Rowe Price’s Municipal Bond Investment Team. Jim leads the team and is portfolio manager for several high-yield muni strategies. Charlie, who has been at T. Rowe since 1991, manages several short and intermediate term municipal-bond funds. Morningstar’s manager research team rates T. Rowe Price’s municipal bond capability highly with several strategies carrying Gold medalist ratings.
Background
T. Rowe Price Tax-Free High Yield PRFHX
T. Rowe Price Tax-Free High-Yield Advantage PATFX
T. Rowe Price Tax-Free Short-Intermediate PRFSX
T. Rowe Price Tax-Free Short-Intermediate 1 TTSIX
Municipal Bonds
“Reasons to Fall in Love With Municipal Bonds Right Now,” by Amey Stone, barrons.com, July 28, 2023.
“It’s Been a Poor Year so far for Municipal Bonds,” by Tim Gray, nytimes.com, July 18, 2022.
“3 Tax-Free Funds That Are Gems,” by Russel Kinnel, Morningstar.com, Sept. 11, 2024.
“Muni-Bond Niche Defies Sales Slump as Banks Seize on Cheap Rates,” by Nic Querolo and Sri Taylor, fa-mag.com, Oct. 22, 2021.
“Municipal Bonds: Where to Find Opportunities in a Volatile Market,” by Elizabeth Foos, Morningstar.com, Aug. 6, 2024.
Other
“Build America Bonds (BABs): Types, Restrictions, Vs. Other Bonds,” by James Chen, Investopedia.com, June 8, 2022.
“Ed Slott: What Investors Need to Do Before the Tax Cut and Jobs Act Expires,” Interview with Christine Benz and Ed Slott, Morningstar.com, Feb. 6, 2024.
Financial Oversight and Management Board for Puerto Rico
Dan Lefkovitz: Hi and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Our guests this week are Jim Murphy and Charlie Hill of T. Rowe Price’s Municipal Bond Investment Team. Jim leads the team and is portfolio manager for several high-yield muni strategies. Charlie, who has been at T. Rowe since 1991, manages several short and intermediate term municipal-bond funds. Morningstar’s manager research team rates T. Rowe Price’s municipal bond capability highly with several strategies carrying Gold medalist ratings.
Jim, Charlie, thanks so much for joining us on The Long View.
Jim Murphy: Thank you.
Charlie Hill: Thanks for having us.
Lefkovitz: Absolutely. Jim, let’s start with you. The past few years have been something of a roller coaster for the municipal-bond market. Maybe a bit more drama than many investors looking for steady tax-free income would desire. We had the pandemic and then 2022, the rate hikes with recoveries, of course in between. But maybe you could talk us through the past few years in the muni market from your perspective.
Murphy: My old boss, Hugh McGuirk, used to say that one day in the stock market could be a year in the muni market in terms of volatility. But yeah, that really changed. When you go back, I like to think about some of the periods we went through. And I would say starting with the period of 2015 to 2020, it was a period of real calm in the muni market, kind of Groundhog Day where rates were very low, quality spreads were very uninteresting. Inflation at the time, a lot of the discussion was inflation was dead, vacillating up and around, over/under of 1% with the Fed having real concerns as much about deflation as inflation. And then, March of 2020, covid hits and it’s been quite a volatile ride since. So, covid, basically the market was run for the hills. Anything that was not cash or Treasuries got crushed. And then we moved into 2021 where we had a massive swing back, on the back of the Fed swinging a heavy axe to bolster the markets post-covid. And then 2022 and most of ’23 where we had an enormous interest-rate reset in response to inflation.
I think that transitory is a word that will probably be struck from the Fed script moving forward. But now here we are in ’24. And I think we’ve returned to maybe a period of more normalcy. And now I always look for the falling safe over my head when I use that expression. But things feel a lot more normal for the market. And I think that as we were talking about before we jumped on the value proposition for the asset class has really rarely been stronger in my time of doing this where we’re in a sweet spot. We’re past this very significant Fed-rate reset. So, rates are at 10- to 15-year highs. So we can actually in income products offer real yield for our investors. And also that dovetails nicely with credit quality in the municipal bond market being very, very strong as well. Whether you liked it or not as a taxpayer, federal support for the states through covid left the states, the byproduct of that left the states and local governments in great shape from a fiscal perspective. Balance sheets strong, pension fundedness improved a lot, even for poster children of former bad fiscal behavior like New York and Illinois. So we’ve seen significant credit upgrades. It’s pretty easy to like what we’re seeing as bond investors, certainly after living through a pretty bumpy ride.
Benz: That’s really helpful stage-setting, and we’ll follow up on some of the themes that you just referenced. But Charlie, I want to turn to you and ask about the recent rate cut. We recently had a 50-basis-point rate cut, which was the first since 2020 and potentially more rate cuts expected in 2024. So the muni yield curve has been inverted like the Treasury curve. Can you talk about what the impact of this recent rate cut has been for the muni market?
Hill: So the inversion in the muni curve was very much focused on the very front end of the curve where overnight municipal money market investments were yielding more than one-, two-, three-, four-year bonds. That inversion still exists today, although it’s not as pronounced as it was back in the summer of 2024. So some of that inverted steepness has come out of the market. The rest of the muni curve is actually fairly steep. If you start with the five-year at around a 2.4%, you go up to 30-year debt a little bit under 3.7%. So 130 basis points from five-year bonds to 30-year bonds is actually historically a pretty steep yield curve in the muni space. As far as what the impact immediately of the Fed cutting rates 50 basis points from 5.3 roughly to 4.8, the overnight municipal rate has come down from about 3.3% to 2.97%, to 3.3% to 3%. So what you’re earning on your cash is obviously coming down the front end of the muni market, the front end of the Treasury curve. A lot of this had obviously already been built into the marketplace before the FOMC met and cut the interest rates last Wednesday. And since that time, going into the unemployment report last Friday, rates had moved up anywhere from say 10 to 15 basis points moving out the Treasury curve. And then post the payroll report we’re up another 20 to 30 basis points depending on what part of the curve you’re looking at. So in the very big picture, if we step back and we’ll talk about the Treasury market, treasury yields declined from about 4.75% to 3.6% right before the Fed cut rates. And since then, rates have moved from 3.6% to roughly 4.1% in the aftermath of the Fed cut and the nonfarm payroll number.
Lefkovitz: Well, taking a step back, Jim, it might be helpful. This is a massive market. For those who aren’t familiar, it’s often referred to using terms like fragmented and opaque. How do you go about researching such a large and fragmented market?
Murphy: That’s the great fun of the market is we always say that it’s a large market of small issuers. It’s sprawling. So you mentioned, Beth Foos and when we spoke with her last week, we talked about it. It’s one of the last bastions of really inefficient bond market. So, we really view ourselves as credit investors. We invest very heavily in credit research and we’re active managers, so we’re trying to add value with that research. So when you have a large sprawling market like the muni market with varying degrees of sophistication in terms of market disclosure, we think it really lends itself to bottom-up analysis. And that includes, having boots on the ground, folks that can do timely research, folks that can absolutely navigate the heterogeneous world of municipal-bond disclosure. So if you can do that, then you can really add value in real time. And that also includes, getting out in the world and meeting management teams and marrying a quantitative approach to the qualitative work as well. So it’s a lot of fun. And the average issue size of most municipal deals is probably somewhere in the $50 million to $75 million range. So you can just add a lot by finding these little off-the-beaten track nuggets of high-quality credit at reasonable yield. So that’s kind of what makes the job a lot of fun—is the inefficiency and the ability to extract that for the benefit of your clients.
Benz: We appreciate the shout-out for our colleague, Beth Foos in manager research. She has been covering fixed-income funds for a long, long time and is really good at it. Charlie wanted to ask you about the fund versus individual bond question, which seems especially alive and well in the wake of 2022, where I think many investors just think they’re better off holding individual bonds to maturity, where they believe they’ll be made whole at the end of their holding period. Can you talk about that decision? I think even a lot of advisors put their clients in individual bonds versus muni-bond funds or, other types of products. So can you talk about that decision and maybe what you think investors are giving up if they opt for individual municipal bonds?
Hill: Well, it’s a great question. It’s an age-old question that people love to pose to a mutual fund manager. Yeah, obviously, right? Let’s support the business that you’re in. A few big-picture things are that, when you hire a professional to do it for you, they take a holistic view of your entire portfolio and look at the interest-rates exposure and credit exposure of the entire portfolio. And one thing that we try to do is make sure that we have kind of an asymmetric lean toward interest-rate exposure. If rates go down, we want the portfolio to appreciate and value, and if interest rates go up, the value of the portfolio doesn’t go down faster than it otherwise would. So you want an asymmetric payout depending on which way interest rates go. And I think if an individual populates a bond fund or a bond portfolio, they don’t necessarily know the overall risk that that portfolio has. Another item obviously is going out and doing the due diligence on individual credits and where you hire a professional manager, you do that. And, we’ve had, or I have had at least in my career, a number of times where high-quality credits have gone south. And I go back to my early years at T. Rowe price when Orange County defaulted. Bob Citron was the manager of Orange County Finance in 1994. He was managing the cash, basically buying mortgage-backed securities. And when Greenspan raised rates 300 basis points, his mortgage portfolio blew up. And here you had a double A, very high-quality, general obligation issuer that was suddenly in trouble. We’ve seen that happen with other high-quality issuers or large issuers like the state of Illinois or New Jersey, and we’ve even seen the state of California get in trouble from time to time.
So I think having somebody do the research and pay attention to the credit quality, various investments are important. Another thing that I think doesn’t get really appreciated is, as you point out, if you buy an individual bond, you know you’re going to be paid off at maturity. Well, if interest rates go up and you have a loss in many of your bond holdings, that loss is something that you can reduce your tax liability with if you realize it. And it’s an asset. At that point, it’s really an asset that if you monetize that loss and use it to offset other gains that you might have in your equity portfolio, you can make it work for you. And an individual with a portfolio of 20 securities, for instance, I doubt is going to go out and execute tax-loss swaps to realize losses on the individual bonds and then go back into other bonds. Where we do that in institutional size across a number of funds and separately managed accounts all at one time. And you really see our transaction, the amount of transactions increase dramatically when we’re in a situation of being able to realize losses for our clients and rebook into higher-yielding securities that will then pay the investor a higher stream of tax-exempt income going forward. So, I feel like between the overall professional management of the rate risk, obviously the credit research and then tax-loss recognition, those three accounts, I think are very supportive for farming it out to a mutual fund or an ETF.
Lefkovitz: Well, it’d be interesting to hear what you’ve been seeing in terms of investment flows into your products. Munis have the reputation of being a retail market and so flows can be volatile and sensitive to headlines. What have you been seeing?
Hill: Flows have recently turned positive in the ETF and mutual fund space. I think we’re at roughly $25 billion worth of inflows year to date and 13 or 14 consecutive weeks of inflows. And that follows the better part of 2.5 years of anemic growth: 2022 when the Fed started raising rates, the industry lost about $123 billion; 2023 another $16 billion, and we’ve been flat-lining into 2024, and we’ve had a recent uptick in issuance. But I think if you step back and think about what has happened, the rate move in 2022 was very quick in the first three months of the year or the other. I should say that February, March, April time frame and we saw a tremendous amount of cash leave the market. And if you think about where interest rates were when that money was leaving, rates had already moved up and people were reading headlines in The Wall Street Journal or whatever newspaper, seeing it on television that interest rates were moving higher and they started liquidating bond funds.
If you look at the prior three years, 2019, 2020, and 2021, you had inflows of about $250 billion over that three-year period coming into a market where interest rates were very low and the municipal-bond asset class was trading at a very rich level relative to Treasury bonds. So you just think about the individual investor that is choosing to chase returns when interest rates are very low and then liquidating that asset class after rates have moved up in 2022 and 2023. So it’s good to see that they are returning to fixed income, and I think that if you listen to asset allocators, you think about where the equity market is today relative to where it was at the end of 2022. Suddenly fixed income appears to be a much more interesting asset class to asset-allocation managers.
Murphy: The one thing I would add to that is just this expression moves it T-bills and chill. So when a lot of that money, rightly departed the market in 2022, they were doing exactly what we’re doing in portfolios, which was taking tax losses. We as an industry fully expected a lot of that money to roll back in to the funds, but it’s been very hard to compete with a 5.25% money market rate. I think what Charlie was just talking about the fact that inflows are starting to really pick up and the tax-exempt space has a lot to do with the fact that maybe that party is coming to an end in money market rates and adding duration makes a lot of sense in front of that.
Benz: Jim, I did want to ask you about the upcoming election. We’re taping this on Oct. 10. We have an election coming up less than a month away. So I wanted to hear about what you’re watching in terms of the election in terms of the presidential election, Congress, national, and state elections. What are the potential implications for your market?
Murphy: I think the tail risks are really what we’re looking for to try to understand. It seems a lot of our in-house research and folks that we talked to outside seem to point to more divided government. And it feels like smart money is saying that the House might flip toward the Democrats. The Senate might flip toward the Republicans. I think watching the Senate race here in Maryland is really interesting. Maryland is a pretty dark blue state, but we have a very popular centrist, former governor in Larry Hogan that really might be the linchpin of swinging the Senate back to Republicans. The presidential race is a coin flip. So I think what we are playing for is divided government, which means whoever gets elected whether it’s Trump or Harris, they’ll get maybe one bite in their first year at the policy apple. We think that if Trump gets elected he will certainly try to make permanent the Tax Cut and Job Act of 2017, maybe try his hand at lowering the corporate tax rate even more. I think this time around he will stay away from healthcare. He lost pretty convincingly last time.
Then if Vice President Harris gets elected, I think one of the things she’s campaigning on is a big change to the corporate tax rate and I think it’s fair to say if Harris gets elected, we could expect higher tax rates across the board. So that at least for the muni market means more demand for the exemption. And after the Tax Cut and Jobs Act of 2017, we saw pretty considerable downshift in demand from both banks and insurers for the tax exemption that munis offer. And so if the corporate tax rate went up to 28%, we should expect to see banks and insurers coming in and buying munis at a far more torrid pace. One other thing we’re watching as investors too is what happens to the alternative minimum tax. So that was largely fixed in the Tax Cut and Job Act. We had millions and millions of middle-income Americans in high-tax states being drawn into the AMT it was never designed for. And that was fixed with the Tax Act. If that’s allowed to expire, our math says that we might go from somewhere around 50,000 individuals to over 7 million being pulled into the AMT, which would be a pretty major headache for the government.
Lefkovitz: Charlie, did you want to weigh in on the election?
Hill: I think the AMT question for us is the biggest thing and the AMT relief sunsets at the end of 2025, unless they reach an agreement and leave it in place. And it’s interesting, even though fewer people are subject to AMT right now, AMT spreads have remained relatively wide throughout the entire period from 2017 until today. It’s one of the last places in the high-quality investment-grade market where you can actually pick up some spread. So the change didn’t really have an impact. So I don’t know if it’ll have a terrible impact if it gets reinstated. We’ll see.
Lefkovitz: Jim mentioned the exemption. Is there is there any risk that the tax-exempt status for municipal bonds could be changed?
Hill: No.
Murphy: I don’t think so.
Hill: It’s a one-word answer.
Murphy: The Build America bond program was an attempt at that during the Obama administration and it’s like a fielder’s choice. It became over complicated. And I think most people that we know down in Washington believe that the municipal-bond market as much as everybody likes to say, oh, crumbling infrastructure or failing infrastructure in this country, they fail to mention that from a bottom-up perspective, most state and local decision-makers know where to put the bridge. They know where to build the airport. They know where to build the hospital and the exemption is the grease for the wheels of all of those good infrastructure decisions that are made at the state and local level.
Benz: I wanted to ask whether the sunsetting of the TCJA potentially at the end of next year, I guess, 2025. Does that embellish prospects for munis? Does it make it more likely that people will gravitate to that tax-free income that munis offer?
Murphy: Yeah, if the highest tax brackets move upward and the corporate tax rate goes up, then yes, at the margin that should create more demand for the exemption would be my expectation.
Hill: Yeah, Christine, I was just going to say that I think the demand for tax-exempt income right now is very high. You’ve had as this act also cut corporate rates, it made municipal bonds less attractive to banks and insurance companies. So we’ve seen them liquidating municipal holdings for the past seven years. And on the other side of that, issuance has been very high. We’re going to hit a record in issuance this year. And yet, in all of this, banks, corporations liquidating, issuance being high, the demand has been insatiable, except for times of periods of very high volatility where there might be a lot of negative price action in the fund and ETF space. The rest of the time, the demand from whether it’s mutual funds, ETFs, or separately managed portfolios has been extremely high. And I think the wealthy people seeking tax exemptions understand where rates are today relative to the last 15 years. And they see it as a great opportunity to lock in to a certain amount of good high-quality income prospectively as many of us, including myself, look toward retirement. So I don’t know that the sunsetting of the act will have as big an impact as just the uptick in rates that we’ve experienced over the last two, three years, and the opportunity it has provided. I think that’s the bigger thing in the room right now.
Murphy: Yeah, I would just add that exactly to Charlie’s point. The exemption is it just feels a heck of a lot more valuable to individual investors at higher rates. Well, if you’re sitting in a money market earning zero or earning, you get $10 a year in interest, well, who cares. But all of a sudden, you have a money market rates at 5.25%, and you’re getting $500 or $600 a month in interest showing up, you’re paying taxes on that. It makes the whole dynamic more interesting for people to invest in tax-exempt income.
Lefkovitz: I know the key statistic in muni land is that M/T ratio, the muni yield versus the Treasury yield. Can you explain what drives that ratio and how you use it?
Hill: Well, it’s very simply you take a Treasury maturity of your choice, we can talk about the five-year right now. So the five-year Treasury is at 3.9%. A five-year municipal high-quality bond is around 2.4%. You divide the 2.4 into the 3.9 and you come out with about 61%, 62% of Treasury. So that’s the ratio that we quote. And I think in generally calm markets, that ratio can exist at a level that’s plus or minus one or two ratio points for a long period of time in periods of high volatility, especially negative volatility, counter parties will cheapen the municipal market, if they need to, in order to bring in other entrants. So we saw this big time in 2008 in the spring of 2008 where there were massive liquidations of leveraged mutual funds. And you started to see 30-year municipal bonds trade at levels that were 120% and 130% of 30-year Treasuries. So the ratio day in and day out, we use it to gauge where a specific maturity should be relative to what the Treasury market has done. So if the Treasury market moves a few basis points, we apply the existing ratio, today’s ratio to the new Treasury level and estimate what the new muni rate would be. But the other way that people use it is as it gets very cheap or the counter very rich, you’ll see people who don’t normally pay attention to the municipal market, poke their head up and start to get involved.
Benz: So, Jim, I want to ask you about credit spreads, which you mentioned earlier in the conversation. It’s obviously something you monitor, and you indicated that covid was actually good for municipalities in a lot of ways in terms of improving their fiscal health. But maybe you can talk about how you are assessing credit quality in the municipal-bond market, especially relative to other areas of fixed income.
Murphy: Yeah, it looks fairly healthy, Christine, it’s probably not as wide as during 2022. Quality spreads in munis tend to be positively correlated with the direction of rates. So when rates are falling, quality spreads typically tighten. And that’s the retail element of our market where individuals will reach for medium and lower quality as rates go down. Just that I need my 4% kind of mindset. So there’s a lot of technical in there and there’s also a lot of fundamental. I would say right now, based on the last five years, quality spreads are about, we would say about one standard deviation tight to where they’ve been in the recent past. That feels OK to me, especially if you overlay that mindset to, let’s say period of 2001 to 2006, where rates were a lot higher. We had a very constructive credit environment like we did now. Quality spreads look quite healthy in that regard. So it feels good when you dig under the hood and you take a look at just the fiscal health, you see that income statements and balance sheets are very healthy at the state and local level. So it justifies paying a little bit more for, let’s say an A rated credit at the wides over the last couple of years, probably has been as wide as 100 plus 120 to a AAA net, maybe now it’s 75 to 80. From a longer-term historical perspective, that’s just fine.
Lefkovitz: Well, it’d be really interesting to hear about how you’re approaching today’s market and where you’re finding opportunity from a sector perspective, from a geography perspective. Our colleagues on the manager research team say healthcare is a sector that you like.
Murphy: Yeah, healthcare has always been an area of specialization for us. I think we invest a lot in our ability to do credit research there. And I think it’s a very misunderstood part of the tax-exempt market. We always say the muni market, which implies all state and local geos, but the tax-exempt market, two thirds of which are revenue bonds and not-for-profit hospitals are a very, very big part of that. If you look at just our nation’s network of hospitals, a very, very high percentage of them are not-for-profit. So the interesting thing about that is unlike for-profit hospital systems, these systems are not forced to dividend their earnings to shareholders. So what happens is you have businesses that generally generate anywhere between a 5% to 10% Ebitda margin or a free cash flow margin. And that money, after providing the healthcare services to their constituents, those profits go right into the balance sheet of those hospitals, which is great for periods like covid or periods… We have a hospital down in Tampa right now, BayCare Health, where they’ve got, it’s a double A credit that’s got 2 times cash/debt outstanding, which means you can survive a lot of income-statement volatility in that environment, or payor mix volatility, which is exactly, really the healthcare industry took two gigantic body blows in three years, one with covid and then two with pretty rampant employee inflation for healthcare workers during 2022.
We’re on the other side of that now, and it just, most of these credits benefit from limited competition, very resilient income statement strength, and balance sheets that typically cover their debt outstanding by a multiple. So frankly, I think the rating agencies often get it wrong in healthcare. The municipal market too, like because so much demand comes from the SMA business and the retail side of the business, a lot of people will just simply say, hey, no healthcare, no transportation, no this, no that, I just want really nice, clean, safe water and sewer bonds and local, and you’re really missing out on terrific extra income and spread in these sectors that are very safe and are often misrated in our view.
Benz: So Charlie, how about the flip side of that? Are there any sectors that you are generally avoiding for whatever reason, and maybe you can expound on what the reason might be?
Hill: Well, it’s really, it’s just the opposite of what Jim just talked about, the state and local general obligations, bonds, water and sewer, prerefunded bonds, the handful of very high-quality sectors in our market that offer no additional spread or carry relative to what you can get in some of the revenue bond sectors. It’s the counter to buying healthcare, you’re not going to purchase the stuff that trades at a very rich level. So those are the areas that you end up underweighting them in order to overweight the revenue bond sectors that we do a lot of research on. And, just to further Jim’s point, another example of a healthcare bond, the largest position in one of my portfolios is Inova Health in Northern Virginia, it’s a $5 billion a year operation, and they have $7.5 billion in cash and investments on the balance sheet, and they have got 3.5 times more cash than they have debt. And we look at a hospital like that that’s giving maybe 50 basis points more than a high-quality water and sewer bond or a high-quality local general obligation bond. And you think about the professional management, the corporate-style management that you’re getting out of a hospital, the balance sheet that you’re buying, and you ask yourself, why in the world would you not pick up that incremental yield over a local general obligation bond or a water and sewer credit?
Murphy: Another one in the market, Children’s Hospital of Philadelphia, the double A hospital is one of the top children’s hospitals in the country. And they’ve got 2 plus times cash/debt. It’s just, if you’re a really careful fixed-income investor, then you pay a lot of attention to the balance sheet, and a lot of novices in this space will pay a lot more attention to the income statement and we just think you have to do both.
Lefkovitz: Your portfolios have some exposure to corporate-backed munis. Could you explain what those are, first of all, and why you like them?
Murphy: Yeah, traditionally, corporate-backed munis, the heading would be industrial revenue bonds or pollution-control bonds. So, you’d have a lot of certain types of corporate credits that could issue in this market largely, let’s say, take utilities, for example. So, a utility, maybe 30% of their base electricity generation comes from coal. As much as we want to get away from coal in this country, it’s hard to do. But maybe they can issue $100 million or $150 million of tax-exempt debt to put in a scrubber for that coal plant. So, the code will allow for corporations to often issue debt for pollution control. We’ve seen that with paper companies. We’ve seen it with steel companies, like US Steel is a big issuer. We used to see International Paper a lot. And airlines, airlines have the ability to issue on a tax-exempt basis, typically when they’re lessors at airports, at state-owned airports. So, we do get a decent amount of issuance coming from corporations, which is a really neat thing for a firm like ours that has a very robust research advantage, not only in munis, but across taxable and high-yield investments and even equity investments. So, we partner with those folks very directly. I would never ask a hospital analyst to tell me what they think of US Steel. I would go right down the hall to our US Steel analyst and talk to him about that.
So, it’s a pretty cool thing. We used to have even more, as much as 20% of tax-free high in corporate-backed debt. When rates got to that Groundhog Day environment—really, really low—the value for corporations of issuing in the exempt market versus the taxable market became less. And now we’re starting to see more corporations come back into the muni market. Because when borrowing costs are so low, what’s the difference between issuing at a 180 or a 140 to the corporation? But now, at 4% and 5%, they could probably save 100 basis points by issuing on an exempt basis. But with that, the responsibility of the corporate entity is to prove to the IRS that they are issuing this debt for bonafide tax-exempt purposes too. So, there’s a little bit of a hurdle there that they have to go through as well.
Benz: We wanted to ask about geography. We’re talking to you today from Illinois, both Dan and I are in the Chicago area. It’s obviously long been a problem child from a fiscal perspective, though you referenced that things have improved a little bit. So, maybe you can talk about how you think about state-specific regional issues as you go about putting together muni portfolios. And maybe you can weave in how you think about population shifts that we’re seeing, where people are moving away from some of these higher-tax states toward Sunbelt states. And then also, the related question about the Sunbelt states and some of the climate-change impacts that they’ve had where it seems they maybe have more of a need to do rebuilding and address some areas that have been hurt by some of these big storms that we’ve been seeing.
Hill: As far as state issues, I think you’re talking to us from Illinois, and Illinois has obviously had issues over the years. I think it’s very difficult to come in and buy a local geo or a healthcare credit or a water and sewer credit, even if the state general obligation debt is trading at a widespread or even distress level. It’s hard to give yield to go into other bonds within a state, ignoring what the general obligation debt is doing. And we saw that in the 2007 to 2010 time frame in the state of California, where Cal revenues declined precipitously during the global financial crisis, spreads widened considerably. And as such, other spreads in other California-exempt debt also widened. So I think your opinion, your outlook for the state general obligation debt does make a difference. You can’t necessarily draw a direct line to another credit being weaker, but you can definitely draw a line to the perception of other credits within a state getting a little less attention than they otherwise would.
As far as the migration question, we’ve seen out migration in California, Illinois, New Jersey, New York for a number of years now and in migration to Texas and Florida. I think specifically with Texas and the other side of it hurting the states where populations are leaving, the amount of debt that we’re seeing issued from the state of Texas just to handle the educational needs and other infrastructure needs within the state has increased issuance out of Texas tremendously. So to the extent that California may be hurt, or Illinois may be hurt from out-migration, you’re not seeing the corresponding issuance pressures that you’re seeing on some of the states that have a lot of the net in-migration. On the Sunbelt state questions and rebuilding, and I hate to throw Puerto Rico into the mix, but a couple of hurricanes really brought a tremendous amount of money into Puerto Rico, and I would imagine to the extent that we’re going to see considerable rebuilding needs in North Carolina and Florida that that will only create mini booms in those areas of the country once they get their feet back on the ground.
Lefkovitz: Jim, did you want to add anything?
Murphy: That was well said, but I think we are spending as much time as we can really looking at some of these coastal regions more carefully and understanding that maybe we’re supposed to demand a little bit of a yield premium on a place like Miami versus Atlanta. And so I think we’re doing that. I think the market is in the early stages of doing that. And I would echo some of the second, third derivative effects of the migration shift. We invest in charter schools. So you look at places like Arizona, Texas, and Florida that have all been growing. And so charter schools have been a really, really interesting, nice outlet for the public school system. And a lot of times, if you’re in a pretty static population growth environment or a declining and you drop the charter school into one of those areas, there could be some real friction because the public school system in that charter might be fighting for the same tax dollars. Well, that’s absolutely not the case in Texas. In fact, in Texas, you see that once a charter school gets to a certain critical mass of students in financial solidity, the PSF—Permanent School Fund—will actually come in and wrap that system and allow them to borrow at even lower rates. So there are some really interesting second- and third-tier nuances to this migration shift. But we watch them closely and try to take advantage of them.
Lefkovitz: Well, you mentioned Puerto Rico earlier. You also mentioned the famous Orange County, California, default. City of Detroit was another bankruptcy, high-profile bankruptcy in the muni market. Do you see any major risks like that on the horizon today? And it also might be interesting to hear how you’ve moved in and out of Puerto Rico. It looks like you’ve got some exposure to Puerto Rico now in your portfolio.
Murphy: Yeah, are there any Puerto Ricos in the offing? No. That was a $70 billion problem. And the thing about the municipal market is most of these very big thematic distressed credit problems. I’m not talking about the one-off project finance deal or trains down in Florida; these are slow-moving train wrecks. The beauty of having research is we really got the Puerto Rico question right, let’s call it, from 2010 to 2015. It was very clear to us that they were so massively overleveraged as soon as the market started to starve them from capital, they were going to have a big problem, which is exactly what happened. And what had been the case, and Charlie mentioned Orange County, prior to something like Puerto Rico and Detroit was a lot of big municipalities somehow got bailed out at the last minute and averted any type of real substantive loss to the investor. Post-GFC places like Detroit and Puerto Rico, the populace in Washington, said enough with the bailouts and allowed these places to fail, which as a credit investor, I think is very healthy. It was so disappointing to get something like that right and then just have some white knight come at the end and bail these places out.
So we think it was, we got Puerto Rico right, we had very little exposure to Puerto Rico when that happened. And if you take the blueprint of Detroit, what happened? They passed PROMESA down in Washington, which is a bill that allowed for the Commonwealth to actually reorganize under a bankruptcy-like framework and fix their problems. And with that, they imposed upon them a financial oversight board that was going to hold and has held local officials and leadership accountable to their finances. So a) when you get it right and you don’t have any, and then it defaults and it goes down, you get rewarded for not owning it from a performance perspective. And then from an opportunistic, certainly high-yield perspective, to be able to look at that distressed debt with a much more sober eye of how are they going to recover? And frankly, Puerto Rico has done a pretty good job of right sizing their debt profile. And the FOMB has imposed upon them fiscal discipline. And as Charlie mentioned, a lot of revenue has hit the island both from hurricane relief and covid relief. So you have this really nice beneficial credit tailwind happening in Puerto Rico at a time when they right size their debt profile. So yeah, we re-engaged in most of the boxes—when I say boxes, the general obligation credit, the sales tax credit, which is known as Cofina.
We had owned the water sewer system, which never defaulted. So that was a good situation. The only real disappointment that we see with Puerto Rico today is a real obstinance to face and fix the problems at their electric utility company, which is called PREPA. For some reason, they are really fighting very, very hard where the debt is really not the big problem in Puerto Rico for PREPA. It’s the cost of fuel, but they seem to be just in a very aggressive legalistic way, be taking that out on bondholders who did nothing but loan them $6 billion of money. So that’s the last part of Puerto Rico that needs to get fixed. And we’re hoping for a good resolution there as well.
Benz: Jim, I wanted to ask you about high-yield munis in particular. This is a specialty area or your main specialty area there. Obviously, it’s attractive from an income perspective, but the trade-off is low credit quality and the potential for problems like some of the ones we’ve been discussing. How should investors think about risk and reward in the high-yield muni space? And then a related question is how to think about the role such a fund or such an investment might play in a portfolio? Do you think it’s best used to augment higher-quality exposure? Maybe you can discuss that too.
Murphy: Yeah, well, thank you. There are some really interesting nuances to muni. We always start with the fact that the municipal market is a very, very high-quality market with a very low default rate. So the use of the words high yield is very different than true junk in the corporate market. Only about 5% of the municipal market is actually below investment-grade. So when we use the term high yield, it’s really more higher yielding. If you looked at the portfolio that I run, the average credit quality is in the mid-triple B range. So said differently, there’s not enough good junk to invest in. So if you look at a high-yield fund like ours, it’s a little bit more conservatively postured, you’re really looking to enhance your income without a lot of additional default risk is kind of the way we try to manage the fund. It’s a lot of fun because you do get into less vanilla credits and more into some rocky road credits. But in terms of positioning in a broader portfolio, I think it’s very appropriate, depending on the investor’s age and risk tolerance, to use it as a yield enhancement vehicle to the higher-quality part of their portfolio. Many of our clients use high yield as like 10% or 15% of their muni allocation, which I think makes a lot of sense. I’m eating my own cooking, I own a lot more of it myself, but it’s a pretty safe house on a very safe street. But certainly you have to understand the styles of the different managers in the space as well. There are some that are very aggressive in using leverage and tender option bond programs, there are some that carry very, very high percentages of nonrated debt. We try to stick to what we know.
Lefkovitz: Well, unfortunately, we only have time for one more. I wanted to ask you about ETFs, which I think have been getting a lot of flows in the muni space along with SMAs, which you mentioned earlier. I believe you manage funds, ETFs, and SMAs. I’m curious if you can talk about the relative merits of the three vehicles? It would seem that with ETFs in this space, the tax benefit of ETFs wouldn’t be as pronounced.
Hill: Murph, I’ll take that one. So we have recently started an intermediate ETF that is managed very similar to one of the intermediate-bond funds that I manage. When I think of ETFs, I generally think of passive management styles. There are two very large ETFs out there, the MUB and the VTEB. And the main difference between the passive ETFs that are available today and an active mutual fund or an active ETF is just the different types of sectors and credits that they will invest in. The ETFs generally do not buy healthcare. They do not buy airports. They don’t buy AMT. They don’t buy certain lower-rated names in the toll road space or the life care space. So they are giving yield relative to what an active manager can deliver to a shareholder. They are very useful for someone who wants to step out of a mutual fund and take a tax loss in a mutual fund, maintain exposure to an asset class, wait for the 30-day holding period, and then step back into an actively managed mutual fund or a more actively managed ETF. So I think they definitely serve a purpose. I think the ones that I’m speaking of are very well managed. But over a longer period of time, the extra income that you get through an active manager that employs research to deliver a little bit of excess income, over time that excess yield is going to accrue to the benefit of the mutual fund or active ETF holder.
Murphy: Yeah, and from a management perspective, if we weren’t T. Rowe Price muni, but we ran our own muni shop, Charlie and I talk about this whole time, we work in the alpha factory. We want to generate the best risk-adjusted returns that we can in the muni space. The packaging of that alpha, the market is asking us for three things: mutual funds, ETFs, SMAs. So far be it from us to tell the market they’re wrong, we’re going to meet the client where they want to get their tax-exempt alpha from. So that’s what we’re trying to do. But Charlie makes a great point. Thus far, ETFs have been the purview of marginally passive. And what we’re hearing from our clients is that there is real demand for reasonably priced active in the ETF space. And we’re certainly trying to move in that direction as well. Right now, I’m looking at the split in flows this year, about $28 billion of new money has come into the muni market this year—$20 billion of that has been in the open-end mutual fund space and $8 billion in ETFs. So there’s this perception that, oh my God, ETFs getting all the money. Well, they’re really not because right now, most of the best active managers are still in the open-end mutual fund space. I think that’s going to change over the next five years. And we certainly want to be a part of that change.
Lefkovitz: Well, we appreciate you inviting us onto the alpha factory floor today. Thank you so much, Jim and Charlie.
Hill: Thank you.
Murphy: Dan and Christine, it’s been an absolute pleasure. Call us anytime. We appreciate everything you do for our clients. So thank you.
Benz: Thank you so much. We appreciate that.
Lefkovitz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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