Betting on Munis as America Rebuilds

Jeff DeMaso:

Hello. Welcome to another The Adviser You Can Talk To Podcast. I’m Jeff DeMaso, director of research at Adviser Investments. Today, I’m joined by my colleagues, Chris Keith and Jen Zebniak. Chris is a senior VP and fixed income manager, affectionately known around the office as The Bond Guy. Jen is a research and fixed income analyst doing double duty, working with Chris to analyze individual bonds, and myself digging into actively managed mutual funds.

Jeff DeMaso:

Jen and Chris, welcome to the pod.

Chris Keith:

Jeff, it’s great to be here with you again.

Jennifer Zebniak:

Thanks for having us, Jeff.

Jeff DeMaso:

Yeah. I’m glad you’re both here and able to join me today, as there is a awful lot going on in the muni bond market right now.

Jeff DeMaso:

There’s really three areas I’d like to touch upon. First, there’s a lot of noise coming out of Washington about a potential multi-trillion dollar infrastructure bill. Second, we’ve got to pay for that spending somehow, so there’s also talk of higher taxes to go along with it. Third, big in the media, big worry seems to be inflation right now, so we’ll talk about inflation and its impact on the muni market and issuers.

Jeff DeMaso:

But before we dig into those three topics, let’s just quickly take a step back, set the stage, and talk a little bit about performance, because the bond market, or at least the high-quality taxable bond market as represented by Vanguard Total Bond Market Index, just had its worst three month stretch since April, 1994, so over 25 years ago. What I want to know is how did the first quarter shape up for muni investors?

Jennifer Zebniak:

Well, as you just alluded to, Q1 overall was not really the greatest for bond investors, but while slightly negative, munis actually held up a lot better than other bond market sectors.

Jennifer Zebniak:

Muni investors tend to be those who are attracted to tax exempt interest that these bonds offer. So they typically stick within that asset class. Many people just don’t like paying taxes. So for higher-tax-bracket investors, that means tax-exempt munis are valuable and still in demand, arguably even more so now with yields so low, because with munis, at the very least, they aren’t taxed at the federal level.

Jennifer Zebniak:

As for why the muni market performed better than the rest of the markets in the first quarter, I’d attribute it to the most recent round of additional stimulus, which included direct aid to states and municipalities. There’s also the expectations for higher taxes if this infrastructure bill passes. All of this additional income is really good for both municipalities in general and their bonds.

Chris Keith:

I would agree with that. Just looking at the performance, it continues to show how different the muni market is from the rest of the market, and how uncorrelated they are to other fixed income asset classes.

Chris Keith:

If you look at the performance in January, to start the year, the muni market advanced by 64 basis points, while the taxable bond market declined by three quarters of a percent. Now, I think that’s a pretty big difference there.

Chris Keith:

A lot of what contributed to that was just the fact that January is one of the bigger months for principal and interest payments being returned to muni investors. Oftentimes that money goes right back into the market, so it helps support the market by having all these traditional investors putting money back into place. So that helps support the market, and it set the tone to really get the year off to a good start. That’s why we saw that divergence in the performance between taxable versus tax exempt bonds in Q1.

Jeff DeMaso:

Great. Jen, pulling on a piece that you mentioned there with some of the support for municipalities in some of that stimulus bill that we saw, when we spoke on the podcast about six months ago, we were discussing muni issuers and how they would hold up as they tried to grapple with the economic consequences of the pandemic and the shutdowns that we put into place to try and contain the spread of COVID-19. I guess my question here is, were you guys surprised by what you saw from municipal issuers?

Chris Keith:

I’ll start if I can. I’ll say that yes and no. How’s that for an answer?

Chris Keith:

Yes, I was surprised at how well the asset class performed, and how the revenues came in at the state and local level that were much higher than expected. We were talking about a doomsday scenario there a year ago. It just never materialized. I was also surprised about investor demand, that is once the dust settled. Then of course, the resiliency of the asset class.

Chris Keith:

On the no side of that, no, I wasn’t surprised, because we always knew that the majority of municipalities out there have a variety of ways to raise revenue or reduce their spending. Whatever they need to do, they can adapt to different economic environments. From my perspective, that’s exactly what they did. They adapted. Jen?

Jennifer Zebniak:

Yeah. Like Chris just said, none of the ways to raise revenue or reduce spending are necessarily favorable. No one wants their income or property taxes raised. No one wants to see spending cuts to schools or any public services like the police or fire departments. But the flexibility that these towns have to make ends meet in tough times is there. These things are not permanent. They can be reversed when times do get better.

Jeff DeMaso:

Okay. A year ago, we were talking about trimming budgets, and having to do those unpalatable actions to try and get municipalities to be able to meet their debt obligations. But now, all of the talk is about expanding budgets, and spending, and stimulus bills, and infrastructure pills. So let’s get to that topic. Maybe the place to begin is what is in these fiscal stimulus and infrastructure bills that … One was just passed, and the other’s being worked through right now.

Chris Keith:

Well, I’ll start by saying that they are complex. I think that we’re really talking about two separate measures here, presented by, well, President Biden and Congress.

Chris Keith:

The first is the stimulus bill or relief bill. I guess I’d say that this is pretty much intended to make up for some of the pandemic-induced revenue declines that we saw at the state and local level. It’s about trying to, I don’t want to say reimburse, but trying to compensate for some of that revenue decline that we saw last year. That has really … It’s already been passed. I know, at some level, some of that stimulus money has already gone out. I know, for example, my kids have received their stimulus checks. They’re thrilled about that. So that part has already been done.

Chris Keith:

The second part, Jeff, is the proposed infrastructure spending bill. It contains a lot more than you might really think. We’re learning more and more about that at this point, and what exactly is in there. It’s a pretty big bill, and there’s a lot of moving parts to it.

Jeff DeMaso:

Okay. So we’re still learning, but so far from what we’ve heard, what do we think that this means for the muni market?

Jennifer Zebniak:

Well, for municipal governments, it means a lot of federal funds coming in. With the latest round of stimulus that was already passed, it was, I think, $350 billion or more that will become available to these municipal governments, which provides additional funding for needs such as healthcare, education, transportation, you name it.

Jennifer Zebniak:

A year ago, projections for these budget shortfalls were anticipated to be much worse than they actually were. But all of this additional stimulus is still really beneficial in coping with any lost revenues resulting from the COVID shutdowns we had seen.

Chris Keith:

As far as the infrastructure bill is concerned, in my mind, it’s really about two separate things. First and foremost, it’s about keeping the economy moving forward, putting people to work, and helping the economy recover from what transpired a year ago. The second thing, it’s about upgrading our nation’s infrastructure, which includes a lot more than just travel-related areas that we usually think of, highways and airports.

Chris Keith:

We learned from the Texas power grid freeze that infrastructure means a lot more, and a lot more than we may have thought originally. These are the things that just can’t be ignored. The problem is that people don’t think about it until something horrible happens or something goes horribly wrong.

Chris Keith:

The expanded infrastructure that we’re talking about, by the way, includes things such as electric vehicle charging stations along the nation’s highways; geographic areas that are prone to severe weather occurrences, floods, fires and hurricanes, making them a little more resilient and able to bounce back quicker; clean and safe drinking water. My goodness, that’s something that we can all get behind. Science and research projects, and then expanding broadband Internet access across the country. So there’s a lot to be done in here.

Chris Keith:

As far as getting it done, it comes down to, I think, commitment and financing. I think that the muni market is where a lot of that financing will be done.

Jeff DeMaso:

Yeah. It sounds to me a bit like the stimulus bill that was passed was about continuing to bridge that gap from the pandemic and the economic decline that we saw there. But the infrastructure bill would maybe be characterized more as an investment in the future.

Jeff DeMaso:

Chris, to your point at the end there about financing, even if it is an investment in the future, we still need to pay for that investment. Coming out of the global financial crisis, the housing crisis in 2008, the muni market played a role in that recovery with the infrastructure of what were called Build America Bonds. Do you think we might see something similar again?

Jennifer Zebniak:

Yeah. I’d be willing to bet. Build America Bonds or BABs are munis whose income is taxable instead of tax exempt. So they are a bit different. But yeah, as you said, they were introduced as a part of President Obama’s American Recovery Act after the financial crisis or during the financial crisis.

Jennifer Zebniak:

In a nutshell, a key part of the program was a 35% interest subsidy that was paid by the federal government to the municipal issuer of the bonds. This really helped municipalities raise needed capital during a recession. So it worked before, and I would be willing to bet that we would see either a similar program or the same program return soon.

Chris Keith:

I agree with that. Now, ideally, it would be a collaborative effort between the federal government and the state government to decide what infrastructure projects to focus on. I think at the end of the day here, it’s time to stop putting it off and time to move forward. We have some experience … When I say we, I mean the bond market. We have some experience with this, and how to finance large scale projects. I think it’s time to get it done.

Jeff DeMaso:

Okay. Well, it sounds to me like, one way or another, there’s going to be a lot of new bonds hitting the market. Is this good for investors?

Jennifer Zebniak:

Well, I think giving investors more choices, at least up to a certain point, is beneficial for them. It also has a potential to attract a cross section of investors beyond just traditional tax-free muni buyers. As I said, the Build America Bonds were taxable, so anyone who buys taxable bonds can now look at buying a taxable muni versus, say, a corporate bond to see where they could get the better return. I also think that, with the infrastructure bill, there is the potential for more green bonds to be issued, which could attract ESG buyers as well.

Chris Keith:

That’s right. I suspect there will be a lot of taxable munis coming out of this. Those crossover buyers that Jennifer referred to are buyers that traditionally focus on the taxable bond market. Think about corporate bonds or government bonds. They would cross over from that market into the taxable muni market, that is if the taxable muni market comes with competitive yields. They have no reason to believe that they wouldn’t. That’s how you attract those buyers. So I think it’s something that will work. I think that it will hold a lot of benefit for investors.

Chris Keith:

As far as all of that volume coming on, I don’t want to call it all at once, but I have every belief that they’re not going to flood the market. I know that the infrastructure bill that they’re talking about has an implementation phase that extends between six and eight years. So I think there’s plenty of time there, and a timeline that they could spread it out over, and that they would ensure that it would be successful, because this is a pretty big thing. The last thing they want is for it to have any setbacks. So I have a feeling that they’re going to be very careful about how they roll it out and how they introduce it. I think it will ultimately be successful.

Jeff DeMaso:

Okay, well, while the bond market is one way we can finance some of these projects, the other way to pay for it is by raising taxes. I think this is maybe where people get a little hung up. As you said earlier, Chris, everyone likes the idea of infrastructure spending. “New roads? Sure. Better internet? Of course. Oh, wait, we have to pay for it. I have to pay taxes? Maybe what we have is okay.” How should we think about the prospect for higher taxes in the future?

Chris Keith:

Well, I think they’re going to be necessary. I don’t know if it comes from the corporate side or the individual side, or more likely, some combination thereof. But taxes, user fees, there’s a variety of ways that you can raise revenue for these projects. I believe that we will get to that point, some equilibrium where we have a fair and equitable distribution of it. I’m repeating myself here, but in the end, I believe that this is needed, and it’s time to get going on it.

Jennifer Zebniak:

Yeah. Higher taxes will probably be needed to pay for part of this as well. But I saw a statistic the other day that was pretty interesting. It gets to the other side of it.

Jennifer Zebniak:

At least for Massachusetts, I was reading, the average driver pays $620 per year in costs due to driving on roads in need of repair. So with any higher taxes that come with this infrastructure bill, the people are also benefiting in this way. You’re saving that $620 per year in costs because you’re driving on these updated roads.

Chris Keith:

Jen, that’s a very rational way to look at it and to think about it. I agree. There’s a cost and there’s a benefit. Unfortunately, I think that our internal wiring makes us look at the cost side first, and then under-emphasize the benefit side. But I think when you look at the benefit, you’ll see what you get out of it. Then you realize, “Oh, okay. At least it’s going to be worth what we have to pay for it.” I think that helps shape the argument.

Jennifer Zebniak:

I agree.

Jeff DeMaso:

Yeah. I agree. I think that’s a really helpful stat to reframe it, to think about the benefits. Again, as we said, we try and think of infrastructure spending as an investment in growth for the future.

Jeff DeMaso:

But let me talk about the other maybe big worry out there for investors. I’d really be remiss if I didn’t ask you about inflation today. It’s so front and center in the media right now. I think over the weekend, I read three different articles on it. Simply put, are you worried about inflation?

Chris Keith:

Come on, Jeff. We’re bond managers. We’re programmed to worry about everything.

Chris Keith:

I think that we’ve been spoiled by below average inflation for an awful long time. Now, the possibility exists for that to change. It’s understandable why it’s receiving so much attention, because we have to deal with something that we haven’t had to deal with in a long time. It’s not anything new, but I think there’s a lot of people who are just unfamiliar with it. The stories that we’re hearing talk about how damaging it can be or how concerning it can be. I think that’s why we’re having a lot of attention paid to it. I think it’s something to be understood rather than to be feared.

Jennifer Zebniak:

Yeah. It’s definitely one of the things we continually think about, but this is why portfolio structure matters. If you’re really concerned about inflation, there are steps you can take to blunt the effects of it. For example, you could avoid investing in longer maturity bonds, and concentrate on shorter maturities, but then there is a trade-off; less yield. But when these bonds mature, theoretically, you’re able to invest in higher yielding bonds.

Chris Keith:

Jen, that is an excellent point. I think it’s worth mentioning that inflation doesn’t happen overnight. It happens over a period of time. If we hold a five-year bond today, and inflation is rising at whatever rate per year, we have to remember that, by the time the inflation level gets to a higher rate, my five-year bond, after one year, becomes a four-year bond, and then a three-year bond and so on. The shorter the maturity, then the less negatively impacted that bond is going to be by inflation.

Chris Keith:

I think that when you talk about portfolio structure, if inflation is something that’s really on your radar screen, there’s a way to structure the portfolio around that, and to do something to mitigate its impact on the portfolio.

Jeff DeMaso:

Okay, Chris, let me maybe push back a little bit on the inflation side here, maybe take the other argument that we’re going to have inflation. The CPI just came in at 2.6% over the past year. We’re reading about supply chain disruptions, shortages in chips, backups at the ports, not enough rental cars on the lots. It seems like inflation’s here and inflation’s coming.

Chris Keith:

Well, that’s right. It is here. There’s always inflation. But I think that you have to look at why are the numbers so high right now. I think that, if we go back exactly a year, we had the very low prints, or the pandemic era prints, the numbers that came when we first started the lockdowns and whatnot. Those numbers were artificially low.

Chris Keith:

Those numbers are falling off the calendar now, and they’re being replaced with numbers that are more normal, if you will. So there is some inflation there, there always is. But I think that it looks a little higher than it might actually be.

Chris Keith:

Jeff, I think about what Chair Jerome Powell said, that he thinks that inflation will be neither high or persistent. I think that he understands that there are low numbers that are falling off the calendar and being replaced by higher numbers. But in the back half of the year, perhaps we get back to a more normal level or a more acceptable level of inflation. Remember, the Fed’s preferred rate or target rate of inflation is a little above or a little below 2%.

Jeff DeMaso:

Okay. But even the math aside, Chris, we’ve got these shortages. Could we have persistently higher inflation? We have a huge deficit. We’ve got fiscal spending and stimulus spending, the fiscal and monetary policies both aligned for the first time in a long time. Is there a case for higher inflation for longer?

Chris Keith:

Well, those are certainly inflationary all by themselves, but I don’t think we should assume that there aren’t forces battling against that. We still have a lot of jobs to be made up in the US economy. We’ve made a lot of them back, but we’re still not at the level of employment that we were a year ago, or pre-pandemic, I guess I should say. Also, we haven’t seen wages pick up particularly strongly either.

Chris Keith:

So I think there’s something that diminishes from the level of inflation or the inflationary pressures. That’s what I think will keep it balanced. At least that’s a what I’m reading and how I interpret the data.

Jeff DeMaso:

Okay. Now, of course, we’re not necessarily economists, and inflation is always difficult to predict. But we are investors. How do we then think about investing and building a portfolio in light of all that we’ve talked about today and potential risk for inflation?

Chris Keith:

It all comes down to portfolio structure and your point of view. If you have clients, or if, as the manager, you’re worried about inflation down the road, then you can structure a portfolio that will insulate it, to a degree, from any damage that might be done from inflation.

Chris Keith:

I think it’s worth noting that we buy a five-year bond today, a year from now, it’s a four year bond, and then a three-year bond, and so on down the line. We know that the shorter the maturity is, then the less it’s negatively impacted by inflation. So structure does matter. I think that when you have an opinion about inflation, if you think it’s going to be a problem, then there’s something you can do about it.

Chris Keith:

Just because the government and corporations are issuing 20-, 25- and 30-year bonds, it doesn’t mean you have to invest in them. It doesn’t mean you have to buy them. You can still concentrate and focus on the front end of the maturity scale, as you made reference to.

Jeff DeMaso:

Great. I think that is a perfect spot to end on. It gives us a sense of how we might want to think about our portfolios. Thank you, Jen and Chris, for taking the time to speak with me today.

Chris Keith:

Jeff, thanks for having us. As I said at the beginning, it’s a pleasure to be with you again.

Jennifer Zebniak:

Thank you, Jeff.

Jeff DeMaso:

Great. To sum up, you’ve shown us that there is indeed a lot going on in the muni bond market. It doesn’t appear to be slowing down or losing its appeal to investors. By and large, we expect munis to maintain their reputation for being higher quality and lower volatility. For that matter, they’re going to play a vital role in keeping great swaths of this country up and running.

Jeff DeMaso:

This has been Jeff DeMaso, Jen Zebniak and Chris Keith from Adviser Investments thanking you for listening to the Adviser You Can Talk To podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at Adviserinvestments.com/podcasts. Your feedback really is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. Thank you very much for listening.