Caitlin Devitt (00:01):
Hi Wesly. Thanks so much for joining us.
Wesly Pate (00:04):
Good afternoon, Caitlin. Thanks for having me.
Caitlin Devitt (00:06):
So it's been such an interesting time for the muni market recently. I mean, in part because of the way in which the market is being impacted by federal policies in Congress and the Trump administration, the impact both on the credit side and potentially the market technical side like we saw in early April with some of the tariff volatility. But let's start with the credit side. The house has recently passed a massive reconciliation bill. It mercifully left untouched the municipal bond tax exemption, which some of us were worried about, but it still carries or still could carry depending on the changes that it makes as it moves through Congress, it could still carry implications for various sectors in our market. So let's start with higher ed. We've seen this unprecedented battle between Harvard and the Trump administration today. I did a story on that sort of the way the bonds have cheapened over the last several months as a result of this battle between 'em, cheapened as much as like 40 basis points in some cases. And so just tell me generally, how do you view the higher education sector right now with policies like this potential endowment tax increase that in the reconciliation bill and the Trump administration cracking down on international students and picking fights with elite universities like AAA rated Harvard? Is it a sector to stay away from or are there opportunities there?
Wesly Pate (01:32):
Yeah, that's a great question. We would rather passionately say that it's creating opportunities, and in saying that though, you really do have to create a level of distinction amongst the various borrowers or issuers of debt in the asset class. But anytime we're seeing names like Harvard and Princeton and some of these, to use that same term, elite universities really started to widen in terms of spread. We view that very much as a buying opportunity as long as, and this is a very important caveat there, as long as there's not redemption language in specific deals that if a entity was to have a change in their taxes up status, there are a lot of bonds outstanding across the entire municipal market that does allow for unique what's called extraordinary redemption provisions. So that's the watch out. But as long as that is not present then in these NC that are going wider, especially those that are aaa, we very much would view it as a buying opportunity. So we've seen names like Harvard and Princeton and several others that have drifted a little bit wider in this instance. In our opinion, that's a nice opportunity to pick up bonds at incrementally more attractive yields, more attractive spreads than really what the fundamentals are being impacted by. So it's broad-based spread widening, but not necessarily broad-based credit deterioration. And when those two are diverging from one another, that really is the definition of a buying opportunity.
Caitlin Devitt (03:05):
So you don't see something like that increase endowment tax, which could go from 1.4% all the way up to like 21%. You see that maybe as nibbling at the edges of the credit. You don't see it as really something that could hurt a place like Harvard or some of the other big universities. Well,
Wesly Pate (03:25):
I think there's an important distinction there. It does hurt the university, but it doesn't hurt the university's ability to service their debt. And what we mean by that is we do see a potential adverse economic type situations that occur from it. As a nation, one of our largest and most important assets is really that intellectual property that we carry and educating of the masses. And so it does hurt Harvard's ability to oftentimes extend that asset to other parties. But that said, in terms of servicing their debt, we would say truly zero implication there. So what does it mean? It means you'll see fewer grants, you'll see fewer research projects coming out of some of these universities, but what you won't necessarily see is any sort of adverse implications for debt service.
Caitlin Devitt (04:22):
Do you think some of the Trump administration's targets against these elite schools could have any reverse positive effect for some of the other schools? For example, the president last weekend on his truth social website said that he wanted take that 3 billion into they're frozen for Harvard and send it to trade schools. Are you guys looking at any other schools that you think maybe it'll have a better impact for? Is it too early to say? Is that too speculative?
Wesly Pate (04:50):
Yeah, it's still a bit speculative and we've done a little bit of research in trying to find what sort of names might benefit from a shift in those resources. But a couple of things we would note. One is still very much preliminary and too early to tell, and secondly is the ability to source those sort of names. So usually a lot of those trade schools don't necessarily trade, especially within the investment grade market and or have a sufficient amount of deal flow that allows for participants to go out and buy those specific names. A lot of times they might be part of a larger borrower or a lot of times those trade schools might be, they might exist as part of a a public university or a system or something of that nature. So the ability to actually go out and source those names that might be the benefactor of the shift is really too early to tell and is a little bit misaligned with how the market trades in terms of availability of debt.
Caitlin Devitt (05:47):
Yeah, makes sense. Okay. Well, what other sectors do you see facing potential credit pressure from the big reconciliation bill and the administration? For example, healthcare, there's been a lot of talk about Medicaid cuts. We still don't know what's going to make it out of a final bill, but rural hospitals that are still going to have to take patients that may no longer qualify for Medicaid and then will have to be collecting up that bad debt. Do you see that, or also states, some people talk about how states are going to start to see pressure if some of the plans to shift some of what the feds cover now onto the states, onto the state budgets that might pressure that sector. What are your thoughts there?
Wesly Pate (06:34):
Yeah, it's a really good point. The first thing we would know is we view the pain that comes from some of these pullbacks within Medicaid spending. It's going to hit the hospital sub-sector far more than what it will states. And the reason for that is it sort of always flows downhill and you're seeing that, right? So the federal government sitting at the very top of that hill, if they decide to push expenditures down, either push expenditures down or simply share less of the revenue down the hill, well as a result, states do the same and then cities and counties do the same, but ultimately it's usually the last borrower in that subset or in that elevation. And so what we mean by that is states will shift to if they suddenly receive less in that revenue sharing, they will share less with hospitals. So unfortunately it is the hospital subsector that will suffer the most from this shift or from some of these legislative changes if they were to be enacted in the most draconian form of what's been proposed.
(07:39):
You pointed out rural hospitals, that is definitely our largest concern in amidst these shifts and these changes that are occurring. The reason being is if you look at sort of how reimbursement rates occur and what margins look like, those are the very sort of borrowers that are most susceptible to even a modest downturn in terms of the revenues that they receive. They tend to operate at the lowest margins and usually have the thinnest balance sheets as well. So that's an area of concern. It's actually an area that we've been pulling back various exposures to. But as a result, we've really shifted some of the portfolio allocations though instead and of still favoring various hospitals. So what we mean by that is the larger players that exist or the larger borrowers, those with more fortified balance sheets and beefier margins are the ones that'll weather the storm quite well.
(08:33):
And really the good thing about this though from a credit perspective is we actually do have really good insight into how these hospitals would act and perform because this is really how a lot of the hospitals perform back before the A CA or the Affordable Care Act. And so what you're starting to see there is a shift back to those slimmer reimbursement rates or those slimmer number of folks that are now being covered. And so what you do is a lot of times you'll shift from Medicaid reimbursement rates to basically no pay, and ultimately the hospitals, those smaller ones are going to be the ones that have to absorb that pressure.
Caitlin Devitt (09:13):
Interesting. So are you seeing spread widening? Are you seeing the impact through, I mean, I know you said you're kind of moving away from some of those rural hospitals and then liking some of the bigger places better. Are we seeing that throughout the healthcare sector, some of that, some of those moves?
Wesly Pate (09:31):
So what we're seeing is widening. What we're not seeing is widening and differentiation. And what we mean by that is the muni market historically does a lot of sort of the baby out with the bath water type approach and a lot of it's trading. And so as a result, we're seeing hospitals as a whole go a little bit wider and trade a incrementally more attractive spreads. And what's not occurring though is a sufficient level of differentiation amongst noting the hospitals that'll struggle and those that'll continue to do just fine in those sort of environments. And so that is in and of itself a rotation opportunity, and so we're looking to take advantage of that in the market these days.
Caitlin Devitt (10:15):
So expecting some bifurcation there down the line.
Wesly Pate (10:17):
Absolutely. And just to be clear, bifurcation is good. Bifurcation is a sign of a healthy credit market right now that bifurcation is an occurring, but ultimately when it does, that really serves to really ensure that credit risk is being appropriately compensated for.
Caitlin Devitt (10:38):
What about at the state geos? Do you see some states that might get hurt more by some of the federal policies than others? Are you taking, are you analyzing any kind of differentiation among the states on the geo side?
Wesly Pate (10:51):
Yeah, so we've dissected some of that analysis and really one of the quickest ways to look at that is the proportion of population that was enrolled in the A CA and the Medicaid expansion because that's going to be the very same population that will be disproportionately rolling off. And so you do have hospital, or sorry, states that with lower incomes that expanded Medicaid are those that are going to be most susceptible. They tend to have a disproportionate amount of the population that's going to unfortunately suffer through some of these shifts. So that is where you'll see it. That said, if you were to then dissect that and look at the revenue and expenditure implications for those states, it's still rather small. And so it's one of those of you could have, I would say there's no real winning states in that scenario, but those that do lose, even the ones that lose the most, it doesn't show up in terms of a meaningful type of shift. So it is dollars and oftentimes they are large dollars, but when you translate those large dollars into sort of the percentage of revenues or the percentage of expenditures, it's not going to be one of the largest avenues or largest pillars that are really going to move and have major credit applications. In other words, we wouldn't expect to see ratings, actions or any sort of disproportionate amount of spread reaction as a result of this.
Caitlin Devitt (12:21):
What about fema? Are you guys thinking about if the administration pursues its policy? I mean it's very early what they're thinking about, but they sort of want to dismantle it and maybe give some of that money to the states or have the states handle it. Are you guys thinking about what a shift in FEMA might mean for the states?
Wesly Pate (12:39):
Yeah, and that's a much bigger one. And the reason for that is because if you really dissect how various states would be impacted, now you're talking about states that if FEMA was to suddenly no longer exist, for example, so we take the most negative outcome of that. And if FEMA no longer exists, then you have the exact same moment when revenues get pressured, expenditures are also going to be growing, so let's take a natural disaster type situation. Revenues fall because suddenly economic activity has to slow. People have to focus on really just ensuring safety and basic necessities as opposed to earning a living and paying taxes at the exact same moment. You're going to have an uptick of expenditures through emergency response requirements. So a movement of less FEMA support does have true credit implications during the most adverse times. So if we were to see major hurricanes or major wildfires, so if you think about the states that are most susceptible to either climate risk or natural disaster risk, those are going to be the ones that a shift in FEMA spending does have a disproportionate negative impact to.
Caitlin Devitt (13:57):
Yeah, that's something we need to take a look at too because it seems like whatever the administration ends up doing, it's going to be interesting and it's going to impact some states over others. And we'll be right back after this short commercial break. And we're back with Wesly Pate from Income Research and Management. So let's just talk, let's turn to the market a little bit. So we saw this drama in early April as a result of the president's tariff policies or proposals I guess, as they were back then. And then in part because of the bond markets dramatic moves, he imposed a 90 day tariff. And then as part of everything shifting, then yesterday a federal court said that actually blocked his ability to impose tariffs. So now we don't know what's going to happen as usual next, but let's just say that they end up taking effect in July as was originally expected after his 90 day reprieve. How is the muni market preparing for this, if it is at all, and what do you think the weeks leading up to it and afterwards will look like?
Wesly Pate (15:15):
Yeah, so it's really unique. First off is reading through the court's decisions there in many ways we would say they didn't actually block his ability, but rather they provided some unique prescriptive or unique approaches as to ways that it could still be enacted. There's still a couple of various sections within legislative maneuvering that can occur to enact various tariffs. It just might not be quite as broad based. And that's why I think even today on the 29th, you're seeing the rate rally that the market's experiencing today is only a couple of basis points. I think the market's actually doing a really good job of saying, okay, maybe these tariff won't be quite as inflationary. However, this was not a full on stop of the tariff policy, but rather it was providing, in many ways insight into other ways that can, various sections of congressional action or even executive actions that can actually be taken in order to make that shift.
(16:21):
So a unique, not a blockage the way that I think some of the headlines might read, but rather is a temporary reprieve, but also a providing of guidance in other ways. It's one of those unique rulings that's really unlike other things that we've seen as far as the way the market's reacting right now is, or I should say if that 90 days had been allowed to expire and tariffs had gone in, you are already seeing the market sort of prepare for it. Tariffs are usually one of two things, and sometimes they're both, they're either recessionary or they're inflationary in our opinion here in the us, which is really, since this is a municipal bond focus discussion within the us, they're unlikely to be recessionary in this environment, but much more likely to be potentially inflationary. And you're already seeing the bond market, including the municipal market, react to it.
(17:19):
So you weren't seeing necessarily a great level of differentiation amongst credit, but what you were seeing was a shift higher in rates and then naturally occurring is that retail phenomenon where individual investors sort of exacerbated it. So you saw a rise in treasury rates and you also saw rise in ratios. And so as a result, I think the market was very much pricing in incrementally higher inflationary pressures, but they went a little bit beyond that. And what we mean by that is you saw rates move higher than what breakevens did in tips and other inflation indicators. So the market is starting to prepare for it, but in classic muni market fashion, it's sort of fear allowed to exacerbate that trade, which has probably created an outsized buying opportunity in the muni market today.
Caitlin Devitt (18:06):
Yeah, we know that to your point about the ruling, we know this isn't the end. Trump is pretty determined to do something on tariffs and they're going to find a way, and the court was sort of pointing some of that out, but it sounds like they're going to try to find a way to continue to pursue that. So it's going to be something that the market's going to have to continue to deal with.
Wesly Pate (18:27):
We would characterize it as it's the end of the beginning as the classic saying goes. So there's more to come, there's more to process, but it does have a very large impact on the treasury market, the corporate bond market, and definitely that of the muni market. But each one is sort of dissecting it a little bit differently.
Caitlin Devitt (18:51):
Just to go back for a second to the credit side, do you see any credits that are impacted, let's say, if the tariffs do end up going through, are there any sectors that you're watching in particular for impact from that?
Wesly Pate (19:03):
Yeah, so the first one we would know is in our opinion, it deserves a lot more attention than what's getting is actually ports. So if you think about tariffs, the concept behind tariffs is to really shift a lot of the manufacturing back here to the us, which therefore means by definition we import and export less or at least import less. Well, if you import less, that has direct implications for port credits. So if you think about some of the ports specifically in Florida and those in California, those are some of the areas that in our opinion, hasn't really received and sufficient amount of attention to potential credit implications. So that's where we see it most directly. And then the other side of that is away from sectors as a whole. If anything though, what we would really highlight though is specific credits where, especially at the geo side where maybe a smaller borrower, oftentimes a small town where maybe you have a disproportionate amount of the employment base or the economic base really in either one sector or even one company.
(20:11):
You think about various parts of this country where you can really have just one company, it's the largest employer within a local town. And if that employer was to have sort of some outsize implications, it could really rattle that issuer. So you think about if a small town and their largest employer is a provider of auto parts and they import a lot of those parts, well, if tariffs really make them incrementally less economically viable or economically competitive, you could see a major downturn there. You could see a pullback in the employment side, and that has some cascading effects. So this is going to be one of those policies that has some far reaching implications, but some of those implications are really going to create a greater level of credit divergence within the muni market largely different than what we've seen over really the last decade or so.
Caitlin Devitt (21:09):
Interesting. So as a whole, I mean the market has started to recover from some of that tariff induced volatility that we're talking about. Are there any factors that you're thinking about that could derail this recovery?
Wesly Pate (21:23):
Yeah, so it's not just recovering of tariff policy. There's also that to your earlier point, a little bit of a deep breath of relaxation that maybe the tax policies were also not nearly as draconian as what they could have been for the muni market. As someone that's been in the muni market for a while, and as a firm that has a longstanding experience in it, we view this, it comes up every several years. So tax implications and changes and proposals come up every presidential election cycle it seems for the muni market. But I think the investor base definitely has taken a sigh of relief. And so we would look at some of the rally that we've seen and outperformance that we've seen most recently is really a product of a couple of things. One is that sigh of relief from tax policy. And then secondly though, and just as importantly probably is an awakening of the relative value right now, if you were to think about the tax equivalent yield in the muni market versus just about any other asset class of similar quality, similar liquidity, munis are just exceptionally compelling right now. And so as a result, you're seeing inflow start to occur, you're seeing a buying pattern start to emerge, and that's really just reflective of the valuations that were present at the time.
Caitlin Devitt (22:44):
Okay. So let's turn to high yield for a minute. Recently we saw Brightline Bonds, Brightline Florida bonds, which were a prominent name in high yield market for a long time. And then they kind of crawled out of that last year with a massive refinancing and a lot of it went investment grade and then they got downgraded. What impact do you think, if any, that has on the high yield market sort of broadly, and then in general, how do you expect the demands fly dynamics to play out in the high yield market for the rest of the year?
Wesly Pate (23:16):
Yeah, so whenever you look at the high yield buyer base, both individual investors, but most of that's done at the institutional side, it's not really a benchmark aware approach. And we would actually say that's a really good thing. And so you'll have issuers come in and out of the index and in out of the high yield market, but a lot of high yield funds and high yield managers were buying bright line even when it moved to investment grade, and now they're going to continue to hold it and maybe even buy more with it, moving a little bit, moving back and trading at a little bit wider spread. So unlike other asset classes where you have a larger passive component that really has to pay attention to the index constituencies, that is not really present in the high-yield muni market. So I think really what you're seeing is the high-yield muni market is really driven just by flows.
(24:13):
It is truly a technically driven market, so much more so than a fundamentally driven market, at least in terms of near term pricing actions, unless there's a single large borrower that exhibits outdo influence sort of like Puerto Rico, a better part of a decade ago. But as a result, when you look at Brightline as a large constituent though, they don't really have this huge reckoning within the high, high-yield market, even though they might be a large base or subset of the buyer base there. So back when they got upgraded to ig, you didn't see suddenly high-yield managers go out and sell. It also wasn't really a name that I think a lot of investment grade managers went out and bought. So I think it actually stayed in rather sticky hands, and that's continued to be the case even with the most recent move back lower.
Caitlin Devitt (25:05):
Okay, interesting. What about the supply demand dynamics for the rest of the year in high yield?
Wesly Pate (25:12):
Yeah, supply foresight within high yield is, in my opinion, one of the trickiest things to figure out. Every year. We usually have rather good insight into what it'll be within the investment grade market. The high yield market trying to forecast supply is one of those tasks that, in my opinion, never really winds up being as rewarding as what the input of effort looks like. And so the way we really sort of take a step back and look at the high yield muni market and we say, okay, what's supply likely to look like? It's really uncertain. But the other side of that is what is demand likely to look like? And in our opinion, it's going to remain quite strong. And the reason for that is, in general, higher yields disproportionately benefit high yield buyers. The tax exemption is proportionate to all end yields, and so as a result with higher yields and incrementally higher spreads, it really just makes the high yield market look at sort of outsized level of attractiveness. We wouldn't be surprised to continue to see a strong buyer base there, strong demand. If anything, it probably creates a little bit of a stickier investor base than what we've seen in the past. So while the forecast for issuance is quite muddy, I think the forecast for demand is actually quite positive.
Caitlin Devitt (26:40):
Okay. All right. Good stuff. Wesly Pate, thanks so much for joining us.
Wesly Pate (26:44):
Thank you.