Transcription:
Mike Scarchilli (00:06):
Hi everyone and welcome to the Bond Buyer podcast, your trusted source for insights on all things public finance. I'm Mike Scarchilli, editor-in-chief of the Bond Buyer, and this episode our senior reporter and buy-side specialist, Jessica Lerner, is joined by David Hammer, managing director and head of municipal bond portfolio management at PIMCO for a timely conversation about the muni market's recent volatility and where it's heading next, they discussed the forces behind 2020 five's, record setting supply, why Munis underperformed compared to other fixed income assets for some of this year, including as of late, and how investor demand is shifting across ETFs, SMAs, and active strategies. David also shares his outlook on high-yield risk, macro policy, and the fed's role in potentially catalyzing immunity rebound. Let's get into it.
Jessica Lerner (01:01):
Hi David. It's great to have you here and talk with you again. The muni market has been on a wild ride this year from surging supply to the potential elimination of the tax exemption and the significant volatility in April due the tariffs there has been a lot to talk about. As we enter the fourth quarter, what are some of the big topics we should be on the lookout for?
David Hammer (01:26):
Well, hi Jessica. Thanks for having me. Yeah, it's been a bumpy year for the muni market, certainly compared to other markets across the world in both bonds and equities coming into September. Munis were just about the worst performing beta in the world, and it's really because they didn't move. Some short duration indexes were up one or 2% in the muni space, but the bulk of IG muni strategies were around flat. Many high yield muni strategies were down several percentage points, and of course that compares to taxable fixed income where the Barclays Ag was up six plus percent active bond funds were up another a hundred to 200 basis points on top of that. So a really big divergence between Munis and everything else. And I know we've gotten a lot of questions from our clients over the course of the year. What's going on here and what's going to happen next?
(02:22):
And I think it's important just to go through the details of why Munis underperformed. It's really not due to any credit related items. Muni credited health in our view is just about the strongest it's been in the last 25 years on average. There are certainly exceptions to that, but most state local government issuers, they have record revenue collections, record rainy day funds, a lot of that due to federal money that's still moving through the system, but the big beautiful bill in anticipation of that, a lot of muni issuers were afraid that they would lose access to issuing more tactic exempt bonds, particularly not-for-profit healthcare systems. Other private activity bonds airports. And so there was a big surge in issuance. Much of it came through April and May, which was also a pretty rocky time for macro markets, and Munis really had to cheapen up versus other asset classes to draw in more capital.
(03:24):
Maybe the last thing I'd point out is that corporate tax rates were already were lower than they were in 2017, which reduced bank and insurance company demand. In the long end, those corporate tax rates have been made permanent, so less demand at lower yields from banks and insurance companies. Now I think as we look ahead into the fourth quarter, what's the theme we would say it's catching up. We do think that muni supply, while the year 2025 will certainly be a record. We think there was a pull forward effect of issuers doing deals before the bill that there should be some give back. And I think just we're two weeks into September here, we've already seen the beginning of this supply is abated a bit. Munis are now up two to 3%, but in our view that they still have probably a ways to go versus other fixed income markets. And just notable too, when we look at other fixed income bond markets, corporate bonds, high yield corporate bonds, there are just about all time tights in terms of credit spreads. So munis, which look still a bit cheap, really stand out
Jessica Lerner (04:32):
Swinging back to issuance. I mean it's been over 400 billion so far this year, fastest pace, and yet there's a supply demand imbalance where retail wants the front end of the curve for more supply is issued on the long end. Do you see this dynamic changing?
David Hammer (04:50):
Yeah, well, I'll try to take a really long view of supply and we certainly think this year is going to be a record supply north of 500 billion seems pretty much in the cards, but over the last 15 years that the muni market, unlike the corporate bond market and the treasury market, it hasn't grown much. The corporate bond market's more than doubled in size treasury markets. I think about three times what it once was in our view, why didn't the muni market grow? It is really a result of the financial crisis and unfunded pension liabilities at the local level. It took a lot of years for house prices to really catch down to where they were on the local tax roll. So that was a headwind for property tax growth at the local level that didn't really abate until 20 15 16 and then at the state level and the city level, unfunded pension liabilities moved from off balance sheet to on balance sheet over the last 10 to 15 years.
(05:49):
And state CFOs treasurers, they've had to come up with ways to fund these unfunded pension liabilities and that means both tax increases in some places, but also cutting back on new CapEx on that new infrastructure project. And so as a result, the muni market really didn't grow for a long time. Now, fast forward to where we are today, muni balance sheets are in much better shape, so I think they're in a better position to embark on big necessary CapEx and infrastructure projects. There's money coming in from the federal government which should help them as they contribute some portion of the financing themselves and rely on and use that federal money. The cost of everything's gone up. We look at construction costs indices and they're up 50 or 60%. So I think a new normal of annual supply that's about 35% higher than what it was for the last 10 years, I think we should expect it.
(06:53):
I think by and large, it's a really good thing if it helps keep yields a little bit elevated. For US taxpayers, that's a great thing. A four to 5% tax free yielding portfolio, probably something closer to four if it's very high quality, closer to five, if you mix in some credit in taxable markets, you'd have to earn six and a half to eight and a half percent pre-tax equivalent, and that means taking a lot more risk. So I think we are in a new era of higher supply. I think it is probably a good thing for muni investors if it helps keep yields a little bit elevated. The other point you mentioned on the mismatch between demand and supply, that the muni curve is very, very steep and a lot of that is really structural at this point. US investors have historically preferred to stay short a lot of that through separately managed accounts.
(07:52):
At pimco, we manage about $80 billion in muni assets. A big chunk of that are in separately managed accounts, about a third of it and the majority of the money, even though we have very flexible product offerings, the majority of clients end up with a large allocation inside of 10 or 12 years. And so us retails come back to the front end that the long end's a different story. Banks and insurance companies, in a lower tax rate, they will buy tax exempt munis, but yields need to be higher than they used to be versus things like corporate bonds. So the muni curve the last couple of years has hit all times steep levels when compared to the treasury curve, about 140 basis point tens, thirties. We see a great opportunity for US investors to step out and buy longer maturity bonds, oftentimes with shorter call dates to get your duration profile a little bit longer.
(08:45):
Munis themselves, the issuers, they're not as quick to react as US corporations are. When I talk to my colleagues in the corporate markets, they point out that as the steepened corporate borrowers, they took advantage of this. They stopped issuing long bonds and they started issuing two to five year maturities. Even the US Treasury, we've heard talks of changing their issuance and doing more bills in less 30 year treasuries. It's harder in the muni market because many of the issues are for infrastructure. These are naturally long-dated assets and they need to match the useful life. But I do think because this steepness is structural, my guess is we will see muni borrowers begin to change some of their policies to allow them to take advantage of lower cost of financing, shorter in the curve. I think it'll be slow to get there, but my guess is we'll see more of a pivot for muni issuers over the next five years than historically. We've seen.
Jessica Lerner (09:43):
Going back to one of your points, you're right that the muni market did not grow for 15 years and now it's kind of risen to 4.3 trillion and latest Federal Reserve data is out there. Were wild swings in April, but the second quarter data doesn't really show any sort of change beyond trends. I mean Muni ownership of SMAs and ETFs are still growing banks and insurance companies continuing to reduce their holdings. Are these trends that will hold or is there anything that can kind of change them?
David Hammer (10:19):
Yeah, so I'll go through a couple of those. I think on the bank and insurance company holding, I think over the long run we should expect them to own less munis and we see this a couple different areas. We see it from broker dealer balance sheets that are a fraction of what they once were. At one point those were 50 to 60 billion. Today that's like 10 to 15 billion, so much, much smaller. That's due to the cost of capital for broker dealers. It's also due to the fact that that munis are less attractive for their balance sheet because their own corporate tax rate's lower. There's then the long dated buyer, which used to be banks and insurance companies predominantly they will still own munis, just yields have to be cheaper versus corporates to get them to allocate. So just an example for our strategies here at pimco, we went from very, very underweight munis and our multi-asset insurance company portfolios that are subject to a 21% tax bracket to very overweight in the third quarter of this year because there was an after tax pickup for insurance companies of 50 to 75 basis points versus a corporate bond while also going up in credit quality.
(11:29):
We love that trade here. We did a lot of it and I think we're probably not the only ones. So I do think banks and insurance companies will continue to buy, but it's really when valuations are so cheap that it's compelling versus other asset classes. What we haven't really seen yet is US retail come back in a large way into longer duration muni strategies that really have to take the baton from the bank and insurance company buyers. I think it's going to happen by our math of the 150 billion or so that left the muni market in 2022, only about half of that's come back. So I'd say there's still pent up demand and as we sit here this week with the Fed about to actually lower rates and in our view embark on a series of cuts, I think that could be one catalyst to help get some retail investors out of cash and then back into the long end of the market.
(12:27):
Maybe just coming back to your kind of product question on and ETFs and I mean it's been a different experience here at pimco. We have a mix of all those vehicles. We have one investment process, but we do do separate accounts, open-end funds, closed-end funds, ETFs, arable funds, and we have experienced pretty good growth across all of those verticals. But I think part of the story for the long-term growth of both SMAs and ETFs for sma, a lot of these structural forces that have been pushing financial advisors to rely on a third party manager as opposed to doing it themselves, those are still in place, so it's much harder to do today. The muni market used to be a monologue insured market. It's a credit market and there are 50,000 different issuers to choose from. You need a lot of credit resources to underwrite all these individual deals.
(13:21):
Then number two is lack of offerings because broker dealers own a fraction of what they used to. It's just harder to go out and find decent offerings for advisors anymore. So it's riskier. It takes a lot of time. At the same time, the product evolution in SMAs has been pretty impressive. I think back to when I first started at PIMCO back in 2012, in order for us to manage a separate account for an investor, they would need to have a $50 million and the fees were pretty high. Today we go all the way down to 150 to $250,000 minimums. The fees are a fraction of what they once were, and we have the ability to really mass customize these solutions to fit different investors' objectives. That's all due to technology. It helps us scale our investment process. We're doing more and more of our executional electronically every day.
(14:19):
So I think that evolution of technology, the importance of it to both implement our investment process and also deliver different solutions continues to grow probably the next frontier. In our view, it's really active sma. There are lots of offerings that are very low cost, very standard laddered structures, but with rates higher, with more volatility and credit volatility in the market, we see a lot of value in leaning into things like mispriced, callable bonds, individual credits that we think are less well understood by the traditional muni market. And when you put those together, you can deliver some excess return with a risk profile that looks really similar. I'd probably say the same thing about ETFs. I think a lot of our clients and our ETFs, they've moved to an ETF only approach to managing their assets. They have a model they may choose to make different asset allocation decisions at different times, and so muni ETFs, they fit that overall investment approach.
(15:23):
What we're doing in ETFs, it's not anything different than what we're doing in our open end funds. It's just a different vehicle. Some of our clients prefer them because they might be easier to use depending on what platform they're on, they might have greater access there too. I think the next step is really active. There's been a big growth in passive ETFs in the muni space. Active ETFs are really just beginning to catch up now, and it's really different than the equity market. When you look at fixed income broadly, when you look at the muni market, active strategies have a history of outperforming passive ones. I'd say a new kind of pillar of active management. We've always had execution, credit structure, mispriced, callable, bonds. The new one is tax efficiency and some of the active strategies. It can be much more efficient in harvesting losses and increasing distribution yields.
(16:17):
So investors, which of course are equally important. So I'd expect continued growth there as well. Maybe the one exception would be not everything an RV really belongs in an ETF. There are parts of the high yield muni market that are very liquid. They don't trade very often, and having an individual ETF that is just focused on high yield munis, there are a few out there when we look at them, what we found is that they tend to add some extra volatility without necessarily generating extra performance, and that's because liquidity is so expensive. So there are limits to what we can deliver in an ETF, but by and large, I'd expect continued growth there.
Jessica Lerner (16:57):
Well, I mean the high yield market, there's been a couple of headline grabbing events past couple weeks you had easterlies repositioning, bright lines, repayment and refinancing, and now the upstate New York casino deal has been delayed. Again, I mean, how has the sector fared and do these events be trouble?
David Hammer (17:19):
Yeah, so without commenting on any individual issues, I do think these events spell trouble. I think they're just the tip of the iceberg, and I think what a lot of these high profile situations share is that there were bond deals done between 2016 and 2021. Rates were very low and many high yield muni investors were really focused on maintaining high dividend and it was forcing a lot of inflows, and it was really forcing some investors into deals that are quite risky. I think muni investors historically that they look at historical default rates of high yield munis versus high yield corporate bonds. There's a really commonly quoted statistic and chart that Moody's has created, and you look back over the last 10 years and high yield munis have defaulted at about five or 6% versus high yield corporates that were closer to 30%, and I think a lot of investors have taken comfort in some of these statistics.
(18:25):
The problem is that this is only for bonds that Moody's actually rates, and what has grown dramatically in the last five to 10 years is the not rated portion of the muni market. So defaults on these bonds are really not captured in these statistics. When we look at individual sectors, senior living over the last few years, default rates got up to eight to 9%. We've seen an uptick in charter school defaults. I think our view of PIMCO is that a lot of these not rated deals that are highly levered, were based not on asset value, but really structured based on a business plan and numbers that can be quite hard to predict in the future. We do think in many of these situations, if expectations are not realized for whatever this individual asset might be, there's a prospect for really low recovery. And I do think it's a bit different this time and I think it is a theme and what I would expect investors to do.
(19:32):
We haven't seen a big deterioration in appetite for high yield and muni credit yet. There was a blip a few months ago where we saw some outflows. It's been back to inflows recently, but my expectation would be that if some of these defaults are realized they do more permanent damage to portfolios than temporary damage, I would expect clients to really scrutinize what's in their high-yield media allocation and try to ensure that they're getting the best of what the asset class has to offer, which can be five and a half to 6.5% tax free yields, but also avoiding permanent losses of capital through defaults.
Jessica Lerner (20:14):
I mean, there's a lot going on in the market and it'd be remiss not to touch on some of the macro events. Just as a reminder, this podcast was recorded Tuesday, September 16th days before September's FOMC meeting, so without talking about the Fed too much, what's going on in Washington?
David Hammer (20:35):
Yeah, I think from a macro perspective, what is begun to creep into markets here through more recent pricing and curve steepening, it's a realization that growth in the US has slowed a bit and may slow a bit more. Inflation has come down, although not all the way back down to the fed's target range, the combination of slower growth inflation that's moderated somewhat, it does give the fed some room to cut to get back closer to the long-term neutral rate, which we think is probably closer to 3%. Our base case is 75 basis points of cuts between now and the end of the year. The market's just about price for that today. I think there are also risks around that, the risks that inflation stays a bit stickier that would also potentially come with a trade off to economic growth. So with a lot of good news priced to most markets today, the theme here at PIMCO has really been where can we get really stable sources of excess return and out yield or out carry our indices, but make sure that we're protected if growth does slow a bit more than expected or maybe the Fed doesn't deliver on all the cuts that are now priced in.
(21:53):
And then the other thing that comes up consistently with clients or its deficits and what that means for the long end of the treasury curve. It's been interesting to us that we think a lot of probably muni investors have been more concerned about longer duration muni allocations because of some of the headwinds from deficits and higher long-term treasury yields. What's pretty important, I think, for muni clients is to understand that tax exempt muni duration, it operates quite differently. A 30 year treasury or 20 year treasury, it's not callable. It's got a lot of interest rate duration, a 20 year muni bond that has a 10 year par call has about half of the interest rate sensitivity that a non callable treasury would, and the probability of that bond being called in 10 years, it's really high because the muni curve is super steep. A 20 year maturity with a 10 year call today, 10 years from now, it's a 10 year bond that's currently callable. In order for it not to be in the money for a muni issuer to refinance short-term rates would likely have to be upwards of six or 7%. So historically, about 80% of muni bonds are called within five years of their first call date. I think it's closer to 60% within the first year. Our view is that those trends hold, and so taking advantage of this curve steepness, even despite some maybe scary headlines around the long end of the treasury curve or deficits in the muni market, there's a lot of value there.
Jessica Lerner (23:28):
I mean, what happens if the economy slows and obviously there's been further federal funding cuts or, lemme try that again. The economy has slowed and then there are further federal funding cuts that could be down the pipeline. What is that impact going to be on muni geo bonds?
David Hammer (23:51):
Yeah, so by and large muni issuers are really in the best shape they've been in in 25 years. Tax collections are 35 to 40% above what they were pre pandemic. The federal government awarded a lot of relief dollars that also helped buoy state and local government budgets and balance sheets. Rainy day funds and reserves are off the record of a year or two ago, but still a multiple of what they were pre pandemic. So even with some potential funding cuts, the biggest casualty of the big beautiful bill for state and local governments has certainly been Medicaid spending. That's about an 880 billion hit over a 10 year period. But we think by and large, it's manageable at the state level, but credit has peaked. So there are some areas that have not necessarily managed their balance sheets as well, where for the first time, our analysts are now flagging emerging budget deficits over the next, probably the next 12 months, but over the next 24 months, certain parts of the healthcare sector where declining Medicaid reimbursements can really hurt profit margins and profit margins that have struggled since the pandemic due to higher labor costs and slower Medicare and Medicaid reimbursement rates could be squeezed a bit more.
(25:11):
So we think that's an area to be cautious. And then I'd come back to the lowest quality portions of the not rated high yield muni market. Many of those issues are very sensitive to the economy, they're very sensitive to the ability to roll over a highly levered capital structure. Those are the areas that we would say are probably the most concerning.
Jessica Lerner (25:33):
And given all this, how is the market doing, not just on a day-to-day basis, but overall
David Hammer (25:40):
Yeah, mean overall quite well? Right. So I think the picture we would paint is valuations that are attractive four to 5% tax free, equal six and half to eight and half percent pre-tax in an asset class that is still very, very high quality overall, particularly in bonds that are rated triple B or better. It's just in really the lowest quality portions of the market that we would exercise some concern. And then I think what has been a macro headwind shifting to a macro tailwind as we see the fed actually deliver here in the fourth quarter on some cuts, and we'll likely see muni supply, which was probably more front loaded this year, begin to slow down into December and January, which historically are pretty strong technical times in the market.
Jessica Lerner (26:29):
I mean, it's definitely an interesting time to be in the market itself. You have tariffs one week surging supply another, it's kind of just craziness. How do you make sense of it all?
David Hammer (26:43):
So the muni market, I think people think state and local government securities. Much of what we invest in is not that. About two thirds of the IG index is backed by some sort of revenue stream on an asset. It could be a toll road, it could be a power company, it could be a steel company that borrows in the market through an industrial development bond. So all of various pieces of volatility you mentioned, including tariffs, they're really relevant. And so we have a big credit team of a dozen muni analysts that are constantly, I think, trying to make sense of headlines in what is expected, also what's possible, and what the impact would be on individual issuers. They're adjusting their credit ratings based on that information. And then we're fortunate here at pimco, we have about 85 analysts across the world in all different asset classes, and we're constantly leaning on them in areas like commercial real estate, residential real estate, which are probably the two biggest revenue sources for any sort of local muni issuer, commodities related inputs, various corporations. So there's a lot moving and a lot changing. It's important to be on top of it, understand what it means for individual muni issuers or what it could mean over the next three to five years, adjusting our internal credit ratings appropriately, and then positioning in and out of securities where we see opportunity and risk. It's been one of the more active times at pimco. We really are big believers in active fixed income, I'd say the last couple of years here, and I respect that the next few years ahead, probably even more active than normal.
Jessica Lerner (28:27):
Okay. Thank you David, so much for joining me today. I know this conversation will continue.
David Hammer (28:32):
Thanks for having me.
Mike Scarchilli (28:34):
We hope you enjoyed this episode of the Bond Buyer Podcast. A big thank you to David Hammer of PIMCO for sharing his insights and to the bomb buyer's, Jessica Lerner for guiding this important conversation. Here are three key takeaways from today's episode. One municipal bond issuance is on pace to hit record levels as issuers rushed to take advantage of improving rates and market windows, raising concern about pricing power and market indigestion even as demand normalizes. Two ETF and SMA growth is reshaping market dynamics with active strategies and technological advances, enabling greater customization and tax efficiency across investment platforms. And three caution flags are rising in the high yield space where PIMCO sees elevated risk and potentially permanent capital loss from unrated over leveraged issuers, particularly those funded during the low rate boom. Thanks again for listening to the Bomb Buyer Podcasts. This episode was produced by the Bomb buyer. If you liked what heard, please subscribe on your favorite podcast platform. Leave us a review and visit us@www.bombbuyer.com for more of our award-winning coverage. Until next time, I'm Mike Scarelli signing off.