A veteran manager assesses which parts of the muni market appear attractive, the pros and cons of buying individual munis, and which municipalities he’s avoiding.
Our guest on the podcast today is Lyle Fitterer, a senior portfolio manager and co-lead on the municipal bond sector for Baird Advisors. He has 36 years of experience managing bond portfolios. Prior to joining Baird in 2019, he served as the co-head of global fixed income and the head of the municipal fixed income team as Wells Fargo Asset Management. Lyle obtained his undergraduate degree in accounting from the University of North Dakota. He earned the chartered financial analyst designation in 1996 and is currently a member of the CFA Institute and the CFA Society of Milwaukee.
Baird Short-Term Municipal Bond Fund BTMIX
Baird Strategic Municipal Bond Fund BSNIX
Baird Quality Intermediate Municipal Bond Fund BMBIX
Baird Core Intermediate Municipal Bond Fund BMNIX
Baird Municipal Bond Fund BMQIX
“The New Allure of Muni Bond Funds. Two Pros Point the Way,” by Debbie Carlson, barrons.com, Aug. 21, 2025.
“Fitterer: Muni Bond Market Offers Compelling Opportunities,” Podcast with Chuck Jaffe, bairdassetmanagement.com, July 29, 2025.
“Muni Bonds Aren’t Just for Rich Folks,” by Jeff Schlegel, fa-mag.com, Nov. 1, 2024.
“Muni Bonds Are Looking Better,” by Elizabeth Foos, Morningstar.com, Oct. 28, 2025.
Vanguard Tax-Exempt Bond Index Fund ETF Shares VTEB
Vanguard Tax-Exempt Bond Index Fund Admiral Shares VTEAX
“In Wreckage of Muni Market Crash, Brave Investors Eye Bonds at 90% Yields,” by Amanda Albright, advisorperspectives.com, March 25, 2020.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Christine Benz: Hi and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Amy Arnott: And I’m Amy Arnott, portfolio strategist for Morningstar.
Benz: Our guest on the podcast today is Lyle Fitterer, a senior portfolio manager and co-lead on the municipal bond sector for Baird Advisors. He has 36 years of experience managing bond portfolios. Prior to joining Baird in 2019, he served as the co-head of global fixed income and the head of the municipal fixed income team as Wells Fargo Asset Management. Lyle obtained his undergraduate degree in accounting from the University of North Dakota. He earned the chartered financial analyst designation in 1996 and is currently a member of the CFA Institute and the CFA Society of Milwaukee.
Lyle, welcome to The Long View.
Lyle Fitterer: Thanks for having me, Christine.
Benz: Thank you so much for being here. We wanted to harness your expertise in the municipal-bond space today and talk about the muni market, which may be less familiar to some of our listeners. It’s a massive market, and we hear terms like fragmented and opaque to describe it. There are a lot of issuers and more than a million bonds. Can you talk about how the team there at Baird tackles investigating so many different municipal bonds on offer and doing your due diligence?
Fitterer: Sure, and that’s a great question. You’re right, it is a large market, but from a size perspective, much smaller than the broader taxable market. So, we like to think of it as a smaller pool, but with a lot more fish in it. In terms of success, we think it’s one of the most inefficient markets out there. So, the ability to add alpha as an active manager, we think, is enhanced because of that.
When we think about the market and how we go about tackling it, our team is eight people, which a lot of times will get the question, well, how do eight people, how do they cover the entire market? Really, the answer to that, I think, is a couple of things, but the biggest one is through the use of technology. When Duane McAllister and Erik and Joe, which were two other people he was working with at BMO, came over to Baird back in 2015 and really started off the muni business as it exists today, they had implemented a system, which what we call is our credit scoring system. What it effectively allows us to do is take all the obligors that we own, which is probably over 5,000 if you look across all of our different portfolios, and really narrow it down into three different categories, what we call our strong category, our core category, and our watch category. This is from a credit perspective in terms of what are the credits that we need to pay the most attention to and spend the most time on from a research perspective.
Really what it does is it looks at historical default rates; it looks at different types of credit enhancement that may exist. Maybe you have a school district, but it’s got a state school backing behind it. Maybe it’s an insured bond, an escrowed bond.
What state is it in? We look at the pension issues within the different states. Weaker states will assign a lower score to them. Ultimately, again, what it does is it takes all of our credits, and it drops them down into those different buckets. So, we go from roughly, say, 5,000 different obligors down to about 400 that are in that watch category. That watch category doesn’t necessarily mean that they’re on watchlists for downgrade. It just means, hey, we need to spend more time in this sector from an analytical perspective. But in all honesty, it probably represents the greatest amount of additional alpha that we can contribute because they tend to yield more. They have more total-return potential.
The other thing I think that differentiates us is everybody on the team also functions as an analyst. Throughout my career, we’ve always said that we wear three hats in that we have to do credit research, we have to think like a portfolio manager, and we have to think like a trader and think about relative value when we’re analyzing securities. I think that makes everybody better on the team. It allows us to cover the market more broadly.
So, if you take those 400 credits—we now have eight people on our team—that’s roughly 50 credits per person in that watch category. That’s how it allows you to conquer, I guess, that credit issue.
The other thing we do is we utilize technology in other ways. We have a vendor-provided system that we utilize to scrape all news sources across the country related to all the obligors that we own. We may own a small obligor in the state of Missouri, let’s say, and the local newspaper may pick up something. We get a feed every day that would give us the local story on what’s going on with that credit. It sounds a little weird, but it actually can provide, at times, a lot of good information in terms of a local credit and something that may get you out ahead of your competitors.
The other thing is we don’t have a dedicated high-yield business, and that’s where, from a credit perspective, that takes up the majority of your time. When you’re looking at analyzing credits, those are very in-depth credits. You need to spend a lot of time on it. So, when we look across universal managers, the ones that tend to have the largest number of analysts also have a dedicated high-yield business.
Now, I also want to go back and say we do look at all of our credits at least once a year. We have a system that tells us the last time we reviewed a credit, and so it’s not like we’re not doing research, but we just don’t think we can add a lot of value to analyzing, say, the state of Maryland relative to maybe other competitors, and the range of spreads that that’s going to trade at in the market is going to be pretty tight. So again, don’t spend necessarily a lot of time there.
And then finally, just other technology tools to make us more efficient in terms of analyzing bid lists, calculating an option-adjusted spread or an option-adjusted duration on new issues, trade allocation, things like that.
Arnott: So, you mentioned some of the technology tools that you use, and I’m curious if you have experimented with artificial intelligence tools to analyze credits either in looking at the financial statements or summarizing some of the bond covenants, things like that. Has AI been useful at all for you?
Fitterer: Yeah, that’s a great point. And then you’re right, I didn’t bring that up. It’s been more recent. We’re also embedded within our broader fixed-income team here at Baird, and I know you guys know that team very well. They also help us with analyzing structured products on the housing side. They help us there. And then on any corporate-backed credits, they would follow those for us.
But in terms of AI specifically, we have been utilizing AI more and more. I think Baird, as an organization, was very calculated in terms of when they turned on those capabilities for us. They wanted to make sure that we were at a point where we thought the noise surrounding AI and the risks of AI and bad data was low enough that you could turn it on for a broader audience. So, we have those capabilities, and it has been something we’re utilizing more and more. So, like you said, we can put in an offering statement, a roadshow, maybe multiple offering statements, and utilize AI to summarize the credit characteristics, summarize the covenants that are embedded in each deal, and then very quickly be able to compare those across different deals if there’s multiple deals coming within the same week from different issuers.
So, it has been another tool that we are starting to implement. And every day, and I hate to say this, but it’s the younger people. I don’t know how it is at Morningstar, but at least here, the younger people tend to come up with more and more ideas, and then the old guys like myself tend to just copy those. And we’re kind of like, I guess, the Japan model where they’re not going to necessarily invent it, but they’re going to improve upon it and utilize those tools that the younger guys are developing.
Benz: Sticking with the muni market, I wanted to ask about a statistic that seems key in the muni space. It’s the M/T ratio, which is munis relative to Treasuries. Can you discuss that? What drives that ratio, and how you use it?
Fitterer: Yeah, so the muni/Treasury ratio is just simplistically looking at what’s the yield on a certain maturity, municipal bond relative to a similar-maturity Treasury bond. We have what’s called our AAA scale in the muni market. There are a couple of sources for that. They’re usually pretty close to one another. And so, you would look at—let’s just use a 10-year AAA rated muni relative to a 10-year Treasury bond. And today, for instance, that ratio I think is somewhere around 65% to 67% of Treasuries. And really what you’re looking at is, if your marginal tax rate is, if you’re at the top marginal tax rate today, that gets you to 37% plus there’s a 3.7% net investment income tax, I believe. So, it gets you to 40.8%. What you do is you basically say, OK, on a tax-adjusted basis, if I have a bond that yields 3%, if I’m in the, for simplistic purposes, we’ll say the 40% top marginal tax bracket, I simply take that 3%, I divide it by 0.6, which is 1 minus my tax rate. And then I can adjust what my income level is going to be to be able to compare that to a taxable security. So, what sort of tax rate am I paying relative to what that ratio is, should help you back into do munis make sense in my portfolio?
Now that’s a starting point for most individuals. I think rather than try and time that and look at what is it today, where has it been historically, that may help you make your entry point into the market. If for some reason—and we’ve had this before—five-year munis are trading at 50% of Treasuries, for example. Well, they’re not very attractive. Maybe you want to be a little more cautious and take your time getting into the market. But from a long-term perspective, I think you have to look more at those long-term averages. So, a two-year muni, we would say usually trades around 60% to 65% of Treasuries; 5s, maybe a similar area; 10s, maybe 70% to 75%, and then 30 years, maybe plus or minus 90% of Treasuries.
And people will say, well, why is there a difference? And the difference really comes about for a couple of reasons. One, tax rates can change over time. So, you have to build in some sort of buffer for that. And the further you get out the curve, obviously, the higher the probability that tax rates may change over time. The second reason is that once you get out beyond 10 years in the muni market, you basically are buying callable bonds. So, you’re looking at a 30-year bond with a 10-year call, which has different characteristics rather than relative to a 30-year just bullet Treasury security. So again, I think from a long-term perspective, look at what’s my top marginal tax rate? If you’re in that 40% tax bracket, it’s almost always better to be in munis from a long-term perspective. And in most cases, even if you’re down at that 28% tax bracket, it tends to be a longer-term market that you want to participate in on a tax-adjusted basis.
The other way we would utilize those are when we’re looking at where do we see value in the muni market, what do we think about the market, it’s a great way for us to analyze how rich or how cheap are we relative to the rest of the taxable universe that’s out there. And so, it can help us in terms of our curve positioning. It can help us in our Strategic Fund, for instance, when we’re thinking about where do we want to be from a duration perspective. Baird’s philosophy and process always has been that we’re a duration-neutral manager. But within our Strategic Fund, we do make duration bets. Now, it’s generally the fifth lever that we pull because we think it’s very hard to make that decision. But where ratios are has a big impact in terms of making that decision. So, if ratios are extremely cheap, like they were back in April, maybe it’s a great time to look at extending our duration, for instance, within our Strategic Fund.
Arnott: And what’s your take on valuations overall currently? I know that you had indicated that earlier this year when munis were underperforming relative to taxable bonds, they were pretty attractively valued. Do you think that’s still the case? Or where do you think valuations stand at this point?
Fitterer: Yeah, we’ve had some pretty dramatic shifts this year in terms of valuations in terms of munis relative to taxables. Back in April, I guess we started talking about the fact that munis has experienced, relative to taxables at least, quite a bit more volatility, especially in April. We personally think some of that is related to the fact that ETFs have become a bigger component of the market. There are different investors now that are interested in trading ETFs in the marketplace. It allows you to short the muni market, which you could never do historically. They tend to be more, what I would call, beta buyers within the marketplace. So, they’re just looking for muni beta exposure, not necessarily a long-term investor. They tend to have more turnover within the ETFs. So, we think that contributed to some of that volatility we saw back in April. And so, ratios on the long end got close to 100% of Treasury. So, you could buy 5% coupons out on the long end. And this kind of persisted throughout the summer close to 100% of Treasuries. Well, at that point we were saying, and in August, we were pounding the table that the long end of the muni market looked especially attractive.
The front end was a little bit different. Retail tends to be a bigger buyer of 0 to 5 or 0 to 10-year munis. And when you looked at those ratios, they tended to look more like their long-term averages back around that 60% to 65% of Treasuries. Maybe they cheapened up a little bit in April and throughout the summer, but not nearly the volatility that you saw on the long end.
What we’ve seen since August is that a couple of things. One, ratios kind of across the curve have come down. I think the 30-year ratio is now sub-90%. Again, it was as low as I think in the low 80s, but again, it got up to about 100. On the front end, interestingly enough the two-year part of the curve has actually cheapened a little bit in here, but then 5s and 10s really—or the 5-year part of the curve and the 10-year part of the curve actually looks a little bit rich or not as attractive. So, we’re still seeing value out there. I think Baird, as a firm, would tell you that we just think the absolute level of rates looks pretty attractive from a long-term perspective. Historically, looking at the yield that you’re seeing today in kind of that 10-year space, maybe 15-year space, is a good indication of what your return is going to look like for the next, say, five to seven years. And right now, if I look at it, you can buy a 15- to 20-year muni at a 4% absolute yield, and that’s for a high-quality bond. So, if you go down and credit from there, you could even generate more income. On a tax-adjusted basis for the top marginal taxpayer, that gets you to maybe 6.75%.
And so just on an absolute basis, we think rates look pretty attractive from a long-term perspective on a tax-adjusted basis because rates have come up so much from where they were say, three or four years ago. And tax-adjusted yields at 6% to 7% look pretty interesting relative to other asset classes. And so, they’re not as attractive as they were, say, three months ago or six months ago, but we’re still finding value. The value has just shifted a little bit, and we would tell you it’s probably more in that two-year part of the curve and then, again, in that 15- to 20-year part of the curve.
Benz: I wanted to follow up on your reference to exchange-traded funds in this space and ask about indexing municipal bonds broadly. I think there had been this widespread perception, maybe you probably think it’s legitimate, that the muni market isn’t a great place to index, that you’re better off going active. But I was looking, Vanguard’s Muni Bond Index Fund, which has been around for about 10 years now, has been pretty competitive within its category. So, do you think it’s reasonable for investors to opt for some sort of a really inexpensive muni index fund?
Fitterer: Again, I think just philosophically, we would argue that fixed income in general is a great place for active managers to add value in the marketplace. I think we would take that a step further and say within the muni market, an active manager should be able to add value—I don’t want to say more easily, but there are just more opportunities because of the inefficiencies we talked about earlier. So, I think you really need to look at a couple of things when you’re looking at index ETFs. So, you have to look at what’s the underlying index that they’re managing.
So, I think the Vanguard fund that you’re referencing is in that intermediate category, the 1- to 15-year.
Benz: Yeah.
Fitterer: And you’re correct, I think it’s had a pretty good long-term history of at least matching or maybe even slightly outperforming the index. I looked at the numbers here recently, I think that Vanguard fund roughly was up over the last five years, 1.35%. And I think the index was up 1.19%. So, 16 basis points of outperformance. That’s pretty good actually for a passive index fund.
I think if you compare that to our Core Intermediate Muni Bond Fund, it was up 1.63% on average annual. So, another roughly 20 to 30 basis points of additional average annual return, which again, if you compound that over time, adds up. So, our goal again is to outperform our benchmarks on an after-fees basis by 25 to 50 basis points. One of the things that attracted me to Baird when I moved over here in 2019 is that I do think when they rolled out their mutual funds 25-plus years ago, they were very thoughtful. They priced their institutional funds at 30 basis points, which is still very competitive today. So, funds were priced attractively. They were looking for that 25 to 50 basis points of additional total return. There are other reasons, obviously, I came to Baird. But I think that simple philosophy in that if we just stick to what we do and do it well and can produce 25 to 50 basis points, which they’ve done, that’s going to outperform in most cases, not only index, but index funds.
The second thing I would say is that getting back to looking at what that underlying index is, when you get out into the long-term category, the ETFs within that category in many cases have a benchmark that is quite a bit different than the broad muni benchmark. And so, when you look at their total returns over a longer period of time, they’re leaving some return on the table relative to that national index, primarily because they exclude certain things, I believe, like housing bonds, maybe healthcare from that. So, they give up some income. So, by going with that index product, in most cases, their index actually minus a little bit from a long-term perspective. That muni-bond category is one of the largest categories out there. So again, when you look at active managers relative to the passive, I would still say that you’re better off from a long-term perspective being with an active manager, whether that be an ETF or an open-ended fund. But within that intermediate category, if you’re just looking for index returns with low fees, they’ve actually done a pretty good job of mimicking that index.
Arnott: So, if we look at the municipal-bond landscape overall, one of the key distinctions is the type of funding and whether a municipal bond is revenue-backed or a general-obligation bond. Can you unpack the difference between those two things, and do you favor one type over the other?
Fitterer: So just unpacking what a general obligation, or as people would refer them to as a GO bond is relative to a revenue bond. I’m going to keep it pretty simplistic. So, a GO bond is really backed by the full faith and taxing authority of that municipality. So, let’s just use, I don’t know—I don’t want to use Chicago because that’s an extreme example, but maybe use Madison, Wisconsin. But they have the ability, obviously, to tax their constituents, whether that’d be property taxes, sales taxes, you name it. And in many cases, from a GO-bond perspective, you’re backed by that full faith and credit of that municipality and their ability to tax.
What we have found out in the last 10 to say 20 years is that you can only basically extract so much blood from a turnip. So, if you have a municipality like Detroit, where you saw just decades of declining population, where economic activity is continuing to decline, you can only tax to a certain point and then effectively people will leave, or you’ll hurt the economic backdrop. And people argue that that is happening in certain cities. And Chicago might be one of them where if you tax too much, people leave. And the rich will be the first to leave, and you hear about it in New York and some of the East Coast cities. You hear about it in California, where people are leaving and going to Texas. So that’s what a GO is. So, do you have that full faith in credit, which is a strong pledge and most cases, they’re very high-quality credits. But if you do get into an experience something where the economy turns south or you get a rapidly declining population, it can impact that ability to pay back that debt. In many cases, they also have large pension obligations that they are on the hook for.
If you move over to the revenue-bond sector, you’re backed by a specific revenue-bond pledge. So maybe a water and sewer district where you’ve got a fee that you’re paying to get water and sewer access to your home. It’s an essential service. People are going to continue to pay that even if they have a condition where their ability to pay their debts declines, you need to have water and sewer service. And so that would be an essential service revenue bond. You could look at the healthcare industry where you’re backed by the revenue from that particular healthcare entity. Higher education, similar type of situation. You’re backed by tuition and other fees that are generated by the universities. So, you could go through a number of different sectors where they’re in the revenue-bond sector. They’re defined revenue pledge.
And what has become important to bondholders is that some of these credits have gone through bankruptcy. And I think Detroit would be a great example. Detroit water and sewer was sucked into that. But those bondholders had a pledge of the revenue of that water system, which didn’t only serve Detroit, but it served a big portion of the population of Michigan as well. And so, when all was said and done, water and sewer bondholders never lost a dime, whereas GO bondholders obviously were crammed down. I think they still got back $0.70 to $0.80 on the dollar, so it wasn’t zero. But that’s the biggest difference is that in many cases revenue bonds have been that pledge has held up in a bankruptcy. Within a GO bankruptcy, you don’t know necessarily how it’s going to play out. And then in many cases, those revenue bonds don’t necessarily have any sort of pension plans that are tied to them. And so there aren’t necessarily unfunded pension obligations. And then finally, they have the ability to raise rates on say a water and sewer system. And in many cases, bondholders have a covenant that says, hey, we have to charge a rate that basically covers that payments by 1.1 time.
So, it used to be many, many years ago when I first started in the business that everybody said you wanted to own GO bonds because of that full face and credit of that municipality. It switched a little bit saying, oh, maybe revenue bonds are more predictable. You’ve got a claim that’ll survive bankruptcy. But in all honesty, I would tell you that it just ebbs and flows over time based upon valuations or relative value in the market. So, we still think that in times of economic upheaval, many of your large, high-quality GOs are going to actually outperform relative to the credit sector, which tends to be more revenue bonds. But again, I think it depends upon what sector you’re in, what the quality is, and it’s really going to be issuer by issuer. So, we’ll move that around. Actually, today we’re actually slightly overweight local GOs, we’re underweight state GOs, and revenue bonds, we’re actually pretty neutral in our portfolio. And that’s primarily been driven by what we call an up-in-quality trade in our portfolios.
Benz: So, I wanted to follow up and ask about whether there are any particular municipalities that you’re worried about today that you would be avoiding because of some of these secular headwinds? You referenced Chicago and some of its issues, but are there any ones where you might say, yes, the yield looks really attractive, but I wouldn’t touch that with a 10-foot pole?
Fitterer: Yeah, so I know you guys are located in Chicago, but maybe we can start there. And we’ve kind of been saying this all along that as we’ve gone through the pandemic, the money that flowed from the federal government really covered up a lot of problems within a lot of different credits. And now that that money has gone away, what we said was that, look, we’re probably going to go back to where we were prepandemic in that the credits that were having issues then are probably the ones that are going to have issues coming out of it. And many of it, especially in like Chicago and the state of Illinois had to do with where was their pension funding at that particular point, where is it today, what did their taxes look like at that point, what was happening from a broad economic perspective? And so, you are seeing it already.
I think Chicago, Chicago Board of Ed, you’ve seen credit deterioration, you’ve seen spreads widen to a certain degree. State of Illinois actually is a little bit different in that I think they recently actually got an upgrade from the rating agencies, but we would say that’s a little bit looking in the rearview mirror. But what are the issues plaguing them? Well, the issues plaguing them are the fact that they’ve got a big pension problem. The Chicago Board of Ed, obviously enrollment has declined. Cost per student remains very, very high. They’ve got a huge amount of deferred CapEx. Within the city of Chicago, I think people would argue that are you seeing large corporations that are actually leaving the city? What’s going on with commercial valuations? And again, this isn’t just specific to Chicago. This is across the country. So, Chicago, Chicago Board of Ed, what we would consider more high beta names within the state, just meaning that they have more spread volatility and more credit volatility are names that we really have little or no exposure to because of that.
But that being said, we actually are overweight the State of Illinois and probably overweight local GOs, specifically school districts within the state, simply because we think that they get negative taint to them because of what’s going on with the state. So, we always like to say you can always find good credits in a bad credit environment. So that’s one example.
I think away from that, people are concerned about healthcare. But again, I would say there, it’s a credit-by-credit type of situation. Some credits are actually improving, and you’ve seen some credit upgrades. Obviously, you have to monitor what’s going on from a national perspective and some of the changes that will happen because of the change in Obamacare and what’s going on with Medicare and Medicaid from a longer-term perspective. But large systems with good management, strong balance sheets, you actually saw spreads cheapen up a little bit because of this concern surrounding the healthcare sector. We’ve actually seen some opportunities recently. And even rural healthcare providers, which some people say you should just avoid outright, we’ve even found some opportunities there where it’s just a unique story. It’s great management situation. It’s actually a growing area that just happens to be classified as a rural healthcare provider. So, you have to, I think, do your work and get into the weeds.
Higher Ed, another one that a lot of people are just saying you need to avoid. Demographics aren’t on your side. You’ve seen a lot of colleges and universities that are looking at closing or have closed. But again, there are the haves and the have-nots. So, because there’s a taint on the entire sector, I think it has impacted valuations, and you can find some opportunities.
So, some areas where I think we just tend to avoid in general would be unenhanced multifamily housing. So that tends to be a 501(c)(3) or charitable organization buys an apartment complex from a for-profit entity. We like to say they put lipstick on a pig and that they repave it, maybe put in new appliances and new carpeting, and initially the occupancy goes up. But within two to three years, there’s deferred CapEx again and the ratings tend to get downgraded. So that’s an area we tend to avoid.
We do like enhanced. So, Fannie- or Freddie-backed multifamily housing, on the flip side, we actually have been finding some opportunities. Project finance, which most of that is in the high-yield market, is an area that we just tend to be very skeptical of. Most of those deals, or many of those deals, are getting priced in the muni market because other markets won’t underwrite them effectively. And you’ve seen some large defaults. And again, there are still some good projects there, but you just need to be very careful. And then, I would just say tobacco has been another area where we’ve been pretty much don’t own it. We own some state-enhanced tobacco bonds. But tobacco-consumption numbers have been declining pretty dramatically. Some would argue that the sector has underperformed and maybe there’s some opportunities there. But just long term, we think that’s a trend that continues and that tobacco consumption will decline pretty dramatically.
And then finally, you asked what are some things you can look for? Generally, we like to say if the yield looks too good or looks extremely attractive, there’s probably a reason behind it. So just be careful on that. If you see a muni and it’s yielding 7% or 7.5% or 8% or 10%-plus, there’s a reason behind that. So just be careful and do your due diligence.
Arnott: So, one of the reasons that munis were under pressure earlier this year was the possibility that they would lose their tax-exempt status. Do you think that there’s any possibility that that debate could surface again and municipal income would become taxable or is that sort of a nonstarter?
Fitterer: Yeah, I think it’s always going to rear its ugly head. It seems to like every four years plus or minus that something comes up that the municipal exemption is under threat. We think from a long-term perspective, the market is going to persist. It’s a great way for state and local governments and other tax-exempt organizations to raise attractive funding. If you get rid of that, you can supplement it maybe with some sort of federal rebate like you had in the BABs program, but I think people are skeptical of that in that that rebate, the percentage rebate that you got from the federal government changed. It takes away control from state and local governments. And again, from a long-term perspective, and it seems like going forward, there’s going to be even more need for this, this is the market where you fund infrastructure projects throughout the country. You’re funding higher education, you’re funding healthcare, you’re funding essential services. And so, again, I think to effectively take away that tax exemption and basically increase the cost of that funding substantially, which is going to have a direct impact on taxpayers from a longer perspective, just isn’t going to happen.
So, could you selectively see changes like we saw in terms of the AMT provisions that changed in the last tax bill and were carried forward in this one? Potentially. Could you see maybe a select part of the marketplace that they say, hey, this is really tax arbitrage and maybe we need to take away the tax-exempt financing for this particular sector? Possibly. But we think in terms of the broad market, we just think it’s something that’s going to rear its ugly head. In most cases, it presents an opportunity for investors and so, we don’t get overly excited about it from a long-term perspective.
Benz: Lyle, I want to follow up on something that you just mentioned. You referenced tobacco bonds. And it’s been a while since I’ve covered a municipal-bond fund. But can you tell our listeners why tobacco-related bonds would show up in a municipal-bond portfolio at all?
Fitterer: Yeah, so, good, good question. So, many years ago, all the tobacco companies reached a settlement with the federal government in terms of the master settlement agreement effectively to pay for all the healthcare issues that came about from cigarette consumption. They effectively agreed to make payments, I think, in the perpetuity, based on the consumption of cigarettes going forward. So, you have these huge payments that are coming from the manufacturers and distributors of cigarettes in the US that get paid to state and local governments.
Now, they are, I think, indexed to inflation. So, if inflation goes up, those payments do go up. But at the same time, they’re also based upon consumption. And it had been this way for quite a while, I think that cigarette consumption was declining at roughly 4% plus or minus, and that held pretty true. And so, when they structured these deals, which what state and local governments do, as you know, they’ve got a source of revenue, they’re going to try and monetize that. And so, the first deals, they should have been done effectively. They were supposed to be done so that you could monetize these and you could pay for healthcare, additional healthcare costs within the state. that drifted, and over time, they just tended to use them for various operating costs, or it wasn’t necessarily specific to the healthcare sector. And so, you saw these future payments securitized in a municipal bond, and effectively, bondholders were paid back from those master settlement agreement payments that were supposed to come in, again, into perpetuity.
The problem has been that cigarette consumption hasn’t been declining at 3% to 4%, more recently, it’s been declining at, say, 7% to 10%, which, again, from a society is probably good, in that it’s going to make us all healthier and bring down healthcare costs from a long-term perspective. But for these bonds that are backed by these particular issues, it means that you have more variability in terms of the cash flows and lower cash flows on a long-term basis. So, if you run the models and you look at how bondholders are going to get paid back, many of them won’t pay by their actual maturity date. They could get refinanced, they could get refunded, but the risk associated with these in getting paid back has gone up, and so the price of those bonds has cheapened in the marketplace. Again, there are other issues there. You have to be very careful in that some actually have a state appropriation behind them, so they’re higher quality; some can withstand much higher cigarette consumption decline, so you need to do your homework. But that’s what the tobacco bond sector is.
Benz: So, going back to the topic of geography and risk factors, I wanted to ask about climate, and how the team thinks about climate issues with respect to some of these bonds. It seems like there could be risks for certain regions, maybe most regions at this point. Can you talk about how you triangulate climate risk?
Fitterer: Good question. It’s been, I think, something that a lot of people have been thinking about. We get that question from investors. Some investors are more ESG-aware or want to structure their portfolios around that. I think what we’ve determined is a couple of things. One, it’s very difficult to figure out where that next disaster is going to occur. So, obviously, there are areas that have a higher probability—coastlines. You think about wildfires where they’ve had a greater history of occurring. So, again, statistically, you can say, well, the coast of Florida probably has a much higher probability of experiencing a hurricane, and California has had more wildfires than other parts of the country. But I think what we’ve learned is that these disasters can happen anywhere. We had a hurricane that went up into the Carolinas, and you had substantial damage that occurred from that hurricane. You had a wildfire in a major metropolitan area that impacted a fairly strong credit in terms of LA water, for instance.
So, it’s hard to predict where these are going to occur. And so, I think we think about it more in terms of you need to build a broadly diversified portfolio, one. Two, the probability that a high-quality credit is going to default if they have a disaster like this is obviously much lower than a lower-quality credit. So, the way that we manage around it is really through diversification and looking at the credit quality of the issuers that we’re investing in. And then you do want to assign some sort of maybe slight premium to investing in areas where maybe statistically there’s a higher probability that you have a hurricane, or you have a wildfire. And maybe even I would say that we, generally speaking, have avoided utilities in California, for instance, just because of some of the specific risks that we’ve seen there and how it’s impacted some of these credits. So, again, I think diversification and quality are going to drive how we think about it rather than trying to identify where that next disaster is going to occur, if that makes sense.
Benz: It does. Thank you.
Fitterer: And the other thing I would add is that I do think people really need to think about it when they’re structuring small, separately managed portfolios. So, if you think about a $250,000 to even a million-dollar portfolio—let’s go with a million-dollar portfolio that wants individual muni bonds, which is a big business out there. Now, it’s not a business we’re involved in. But if you think about how those portfolios have been structured historically, they’ve had pretty large position sizes, maybe a 5% position on a million-dollar portfolio, that’s 50 bonds, which is a small size. Maybe they do 25, which is a 2.5% position. But if you think about that, and you’re doing 5% positions, even in a AA rated credit, and you have an issue that nobody was really thinking about, and again, I’ll bring you back to the LA water, which was impacted by the LA fires that occurred out there, those bonds widened in terms of spread by probably 100 basis points initially. And so, if you have 5% of your portfolio, let’s just say in a bond that has an eight-year duration, so maybe a 10-year bond, and the price of that bond, the yield goes up by one full percentage point or 100 basis points. Now, you’re going to have eight points of underperformance on 5% of your portfolio. That hurts.
And so, again, I think what people need to be asking questions about is, gee, I have a separate account, and I have 5% to 10% positions, but they’re in high-quality issuers, but what happens if there’s an environmental issue that I’m not thinking about that impacts this credit? So, again, I think that gets to the heart of diversification. And when we look at our mutual funds, we don’t have over 1% positions, and in most cases, they’re 0.5% or less. So, again, I think that mitigates a lot of the risk that we make a credit mistake because of ESG issue, but it doesn’t effectively materially impact the overall performance of the portfolio, if that makes sense.
Benz: Yeah.
Arnott: So, from a portfolio perspective, we’ve talked to a lot of financial advisors who do like to use individual municipal bonds with their clients, partly because they want to match the maturity to the investor’s holding period, and it’s easier to take advantage of the state and local tax breaks. So, are those legitimate reasons to use individual bonds as opposed to a bond fund, assuming that you can buy enough of them to have a diversified portfolio?
Fitterer: Yeah, I think that’s the ongoing debate is, does it make sense because of the specific tax requirements and benefits that you get? So, if you can build a truly diversified portfolio, like we talked about earlier, and get away from these kind of single obligor risks, I think in many cases, owning some individual bonds probably makes some sense, especially in some of your very high-tax states like New York or California.
That being said, I still think that do you want to have a portfolio that’s 100% invested in the particular state that you live in because of that benefit? We would argue no, and we’ve had these conversations. We manage some large accounts for what we call insta-viduals, which are basically very wealthy individuals, and so they have diversified portfolios, but do you want to have 25% or 50% of your portfolio, or even higher, in California or New York? And really looking at, because of some of these specific state risks or specific ESG risks that we talked about earlier, and the conclusion we came to is no. So, maybe you need to think about in terms of, hey, I’ll own some individual bonds in the state that I’m in because of that benefit from a tax exemption. I’ll do it in a very diversified fashion but then look for an open-ended mutual fund or an ETF or some other pooled vehicle where you can get national exposure, it diversifies some of that risk away for you. You can do it, again, on a diversified basis. You can add lower-quality credits to your portfolio because you generally don’t want to buy those lower-quality credits in a SMA because, again, you can’t get the diversification that you’re looking for.
So, within a mutual fund, you’ll get higher ed, you get healthcare, and you can probably make up the difference in terms of income on a tax-adjusted basis from those credit sectors, and so put part of your money in that pooled vehicle, and then that also gives you some liquidity. Mutual funds, ETFs have much better liquidity than individual bonds. So, that might be a way of thinking about it rather than just simply saying, hey, I want that SMA because I want to be able to manage that maturity risk or that tax risk that I have in my portfolio.
The other thing that I think you guys had mentioned, or others have mentioned, is there are some fixed maturity funds and other vehicles that have popped up out there. Again, I think in terms of, hey, having a fixed maturity and you know that at X period in the future, you’re going to get paid back on your investment and it’s going to roll down the curve and what was a five-year will become a four-year and then a three-year and a two-year, like you’d get into an individual bond.
The difference in those pooled structures is that they don’t close after they get initially invested. So, if the first person gets in and they buy a 5% bond and 10 years and then rates rally and now rates are 4% and then investor number two gets in, now you have to buy another bond with that same maturity and you buy it at 4%. So, now the yield on your portfolio—book yield goes from 5 down to 4.5. So, now you’re splitting some of that 5 with that new investor and then also your price on that particular entry point actually went up on that mutual fund because the price has gone up. So, you’re not guaranteed to get that car on that mutual fund like you would in an actual maturing bond, if that makes sense.
Benz: It does. It does. That’s very helpful and clear. I wanted to ask about the trading costs for individual munis. I remember hearing from our analysts that they could be quite punitive for small investors, that they really get killed on the bid-ask spreads. Has that gotten better for small investors venturing into individual munis?
Fitterer: It definitely has gotten better. There’s a lot of the electronic platforms that are out there, algorithm-driven platforms. You’re still going to pay a price. So, instead of it being a point or 2 points, maybe it’s a 0.5 point or maybe it’s even a 0.25 point. So, the cost has come down for individual portfolios and again that can vary over time. So, on a bad day when rates are going higher in the Treasury market and the bid has slipped, maybe it is a point or two or something like that. But on good days, again, it could be a quarter to a half a point. Now, if you think about that though, even a half a point, again on a bond, and if you think about it for an entire portfolio, if you have to liquidate your portfolio and it costs you a half or a point, that’s a lot of basis points that you lose in terms of an expense ratio that you’re paying on a fund because you had an liquidity event and actually had to liquidate that portfolio.
So, it’s gotten better. Obviously, it’s still more efficient in many cases for these pooled vehicles to trade larger size and you’re not subjected to that, and you have the daily liquidity that you would get in those pooled vehicles. But if you truly do want an SMA, it has gotten better, and your provider should be able to get you better execution because of the different systems and the trading platforms that are out there.
Arnott: I also wanted to ask about municipal bonds from a risk-reduction perspective and typically, if people are allocating to fixed income, that’s one of the key reasons. And if you look at high-quality corporates or Treasury bonds in particular, they’ve usually been excellent shock absorbers in an equity market selloff, except for maybe a year like 2022. But it seems like municipal bonds haven’t been quite as reliable on the downside. Why do you think that is?
Fitterer: So, again, I think a couple of things. One, from a longer-term perspective, you are going to get less volatility in municipals relative to taxables. And why? Because of that ratio. So, the fact that a two-year muni trades at 65% of Treasuries, freights go up 100 basis points in Treasury land, muni rates are only going to go up 65 basis points and vice versa.
Now, interim volatility could be higher than that, but again, the market generally settles down and when you think about point A to point B, you’re going to get that longer-term volatility that will be reduced because of those ratios. What you also have to remember though is that people think about municipalities and munis as a credit sector. So, when corporate credit spreads widen out, when credit underperforms, munis tend to underperform Treasuries as well and maybe do experience a little bit more volatility. And more recently, I think you’ve seen periods or bouts of volatility in the muni market have to do more with supply demand, technicals, or maybe some sort of extraordinary shock, potential tax changes.
Meredith Whitney going back many, many years ago, which again, the market reacts and it reacts quickly, but then I think it settles in, and people realize that it was more of a buying opportunity. So, we would argue that over the long term, munis are actually going to have less volatility because on a tax-adjusted basis, it just mathematically works that way. Two, it is a much higher-quality asset class when you think about it relative to corporates, for instance, and you look at historical default rates. The historical default rate on a BBB rated muni cumulative over the last 10 years is less than a AAA rated corporate bond. So, when you think about the market, it’s a high-quality market. Long term, it has less volatility. Near term, it could have more spikes in volatility. Again, I think ETFs have enhanced that volatility because of introducing outside investors and the ability to short the sector.
But if you want an asset class where—and I think you mentioned it—this is supposed to be a sleep-at-night part of your portfolio and also a place to get liquidity in times of distress if you want to do an asset-allocation shift and go back into more risky assets like equities. So, that’s the reason why we manage the portfolios the way that we do, why we have a lot of high-quality securities, why we have a liquidity scoring system as well to make sure that we can always provide liquidity to our investors no matter what type of market it is and that it’s a sleep-at-night part of the portfolio. What that means is, for our portfolios at least is in periods when munis do exceptionally well, for instance, like the last three months, we may underperform our peers. If we look at our peer group rankings in Morningstar for the last three months, we might be in the third or even fourth quartile, but year to date, we’re in the top quartile in most of our municipal products.
And over the long term, that’s the case as well. Why? Because we run diversified portfolios. We tend to focus on balancing credit relative to structure in terms of ways to add income in our portfolios because we think about liquidity and want to make sure that we have plenty of liquidity in our portfolios. And again, that provides better downside protection in a volatile market. We participate in a good market, but you get to the same endpoint, or even a better endpoint, from a total return perspective over a five to 10-year environment, but you’ve got a lot less volatility along the way. And I think that’s what people invest in munis for.
Benz: Well, Lyle, you have given us so much good food for thought. Thank you so much for being with us today.
Fitterer: Christine and Amy, it’s been a pleasure. If you ever have any follow-up questions, happy to get on the phone with you. Thanks a lot.
Benz: Thank you.
Arnott: Thanks so much, Lyle.
Benz: 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.
You can follow me on social media @Christine_Benz on X. Or at Christine Benz on LinkedIn.
Arnott: And at Amy Arnott on LinkedIn.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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