Bond Ambition: Why There's Never Been More Opportunity In Municipal Bonds

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Stacie Jacobsen: [00:00:00] Thanks so much for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. I'm your host, Stacie Jacobsen.

Today, our topic is municipal bonds. Daryl Clements, MuniBond Portfolio Manager for Bernstein, will update us on the current environment for bond investing.

First, let's take a pulse of the market. On the back of an inflation reading earlier this month that was more favorable than expected, investors have been looking for further signs that the Fed's rate hikes are coming to an end.

Last week, as expected, with economic growth remaining strong and inflation slowing, the Fed raised the target Fed funds rate by 25 basis points.

To a range of five and a quarter to five and a half percent rates could still go higher in September or even November if Economic data suggests more inflation pressure, but it appears that rate hikes beyond that time frame are unlikely.

While we do [00:01:00] expect growth to slow we are not currently forecasting a severe downturn given the combination of slowing inflation and resilient economic growth.

We may still see an economic so called soft landing, meaning a slowdown, but not a recession.

However, if economic data is stronger than expected, the Fed could decide to raise rates even higher and hold them there for longer, raising the risk of negative effects on economic growth.

And that's this week's market update. 2022 was not a great year for bonds. But so far, 2023 has been quite a different story.

Continuing a rally that started at the end of October last year, munis have performed strongly this year. But despite their attractive returns, investors have remained skittish.

Many are staying in cash or cash equivalents for the moment, waiting for the right time to reenter the bond market.

After the break, we'll hear from our guests on several topics, including where yields are headed, how a soft landing for the [00:02:00] economy might come about.

And where he sees opportunity in the current landscape for bond investors. We should note that my conversation with Daryl was recorded prior to the Fed's July 26 meeting.

Clare Golla: I'm Clare Golla, head of Philanthropic Services at Bernstein and host of Inspired Investing, a podcast for those engaged in the nonprofit, philanthropy, and broader social sectors.

Listen and subscribe to Bernstein's Inspired Investing on your favorite podcast platform. So you can focus on what's most important, your mission.

Stacie Jacobsen: Welcome back to The Pulse by Bernstein. I'm here with Daryl Clements, Muni Bond Portfolio Manager. Thanks so much for being with us, Daryl.

Daryl Clements: Oh, Stacie. Thanks for having me. It's a pleasure.

Stacie Jacobsen: So following up on the worst municipal bond market in over 40 years, the muni market has not rebounded as quickly as many would have expected.

Can you provide any insight as to why?

Daryl Clements: Yeah, it's a little surprising, isn't it? You're right. It was the worst bond market [00:03:00] in over 40 years.

Actually, Stacie, if you stop the clock on October 27th of last year, it would have been the worst bond market. In history, if not for a late year rally that began on October 28th.

So part of the reason the bond market sold off so hard was there were outflows, massive outflows in the municipal market last year.

And you define that by thinking of mutual funds. So mutual fund outflow, it's best way to gauge it. There were 125 billion of municipal mutual fund outflows by far a record in the market.

Now the expectation would have been that once the market began to rally, that investors would come back into the market. And this year, you've only seen about, let's call it about 7 billion.

Of that 125 billion or so that left come back in Many investors are sitting in t bills. They're rolling t bills Let's say three months six month t bills or they're sitting in [00:04:00] money market funds since yields are so high.

And money market fund assets are about six trillion dollars at this point and again by far A record so I think until you begin to see more investors come back in bonds, probably don't pick up ahead of steam, but Investors have missed out on a pretty significant rally 28th timeframe.

And if you look at it through, let's say just current, the bond market, the general bond market is up about 8%. And if you were rolling a T bill over that time, a T bill would have earned you from a return perspective after tax about 3%.

So investors have already given up a lot, but they're still sitting in those T bills and money market funds waiting for the all clear sign.

Stacie Jacobsen: And I just want to put an emphasis on the 8% return in muni bonds, right? That's a significant

Daryl Clements: number. It is. It's significant when you think of [00:05:00] put it in, that's not an annualized number.

That's about an eight month number. So it is a very significant number. And when you look forward, it doesn't take a lot from here to get into, let's say over the next 12 months, high single or low double digit return for municipal bonds.

Stacie Jacobsen: So, where do you think we go from here? The Fed paused in June.

Um, it does appear that their rate will increase in the July 26th meeting. What impact do you expect that to have on the muni market?

Daryl Clements: I think you're right. I think the, the Fed will move 25 basis points. We don't think they'll move much from there.

The economy is slowing enough. You see that in the employment numbers, maybe not as fast as they would like.

They'll slow down as fast as they would like. Inflation is moderating, but again, not. Perhaps not as fast as they would like, but nevertheless, it is at this point.

The expectation is. that they'll move one more time, probably don't move two.

But you know what, Stacey? The Fed is in the ninth inning. They're in the [00:06:00] ninth inning with perhaps one or two outs.

They're so much closer to the end than they are at the beginning of the middle of this interest rate cycle.

So at this point, it's setting yourself up, investors should be setting themselves up 12 months, not looking back over the last 12 months.

Stacie Jacobsen: So, as a bond manager here at Bernstein, you can uniquely manage the portfolio and engage in relative value trading. Can you explain what that is and why we

Daryl Clements: do that? You know, Stacie, I'm a Muni guy, right?

I've been doing this for over 30 years, but I'm not so myopic in my thought process. Where it's all immunities all the time no matter what's going on in the world because there are times When municipals can become expensive.

So when you ask about relative value when you're comparing a municipal bond you want to compare it to something of the same risk profile not a corporate bond, but rather a treasury a U.S. Treasury municipal treasury now at times [00:07:00] that can get a little out of whack.

Meaning municipal yields may fall more than treasury yields or rise more than treasury yields.

For some various reasons. So right now, Municipals have been rallying. Meaning that their prices are going up a little bit more so than treasury's and their yields are coming down.

And if that continues, at times we would say municipals become expensive.

And in that environment, what you want to do, what you want your manager to do is take some of that risk down because it becomes a risk at that point, meaning that it's not going to stay expensive forever.

Nothing stays expensive forever. Nothing stays cheap forever.

So if municipals are expensive and their yields are too low, at some point those yields will gravitate back. And get back into more of that normal range, let's say 85% ratio, if you will.

So what we'll do at times, if municipals are expensive, well let's move some of those municipals out where it's expensive and [00:08:00] replace them with treasuries.

Because if municipals underperform, meaning their yields have to rise again to get back closer to treasuries, that means treasuries will outperform, hold their value better than municipals.

And the idea of a municipal bond portfolio in part...

Stacie Jacobsen: Okay. So given all of that background, how are you actually positioning portfolios in light of today's market environment?

Daryl Clements: Ooh, there's a lot, lot we're doing. So one thing we're doing, if you look at it through the lens, if you will, that yields are likely going to be lower 12 months from now, then what you want to do and what we're doing is we're adding duration.

To portfolios so whatever the strategy is. We're about 10 long of our benchmark and what that means about a half a year.

That's generally what it means. So we're adding about a half a year duration than our benchmark because again If yields are going to fall, you want to be a little bit longer because then what that means, the value of the portfolio is [00:09:00] going up more.

But within that duration, we're also what's called barbelling, our maturity structure.

You may have heard of this, or the investors may have heard of this, that the yield curve is inverted. And what that means is that shorter yields are higher than longer yields.

And if you look at a treasury yield curve, it's short yields all the way to long.

And so it's a straight line. Municipals are different.

Municipals have a wonky shape. It's like a U, right? So it's like a U and so it's inverted up until about 13 years and then it becomes upward sloping.

So what we're trying to do is avoid that part of the yield curve where yields are low, where they're inverted.

Because at some point you would expect either those yields come up or longer yields come down.

Either way, that part of the curve, that belly, if you will, Those bonds will underperform. So we're lengthening a little bit adding duration.

We're barbelling we would call it so I could go out and buy a let's [00:10:00] say a 10 year bond and a one year bond, which has a higher yield than a five year bond Right?

So, or I can go out and buy a 15 year bond and a one year bond and have a higher yield than an eight year bond. So there, so you want maturity structure. That's very important.

And credit as well.

We want to own single a rated bonds. We want to own triple B rated bonds and maybe even high yield for those clients who have that risk tolerance of owning high yield because the difference in yield on those bonds.

Versus let's say a triple a rated bond municipal bond is nearly twice the historical average Even though the credit quality the balance sheet strength of municipalities today is as strong as it's ever been.

But the reasons the additional yield they're earning is so much higher Is because of those outflows that we talked about early in this conversation.

So it's more of a technical sell off than anything else.

So that's pretty much what we're doing, Stacie, a little longer duration, barbelling, and a little bit more credit [00:11:00] in our portfolios.

Stacie Jacobsen: Daryl, there is still discussion of this looming recession. Would your approach to credit quality change if the economy does fall into a recession?

Daryl Clements: You know, this has to be the best telegraph recession.

Ever everyone is waiting for a recession everyone and that's part of the issue, right? Why?

Investors seem to be stuck whether it's in money market funds or rolling key bills now a couple of things there So do we expect an economic slowdown?

Yes, we do expect a soft landing. So we look at it this way credit fundamentals are as strong as they've ever been. Credit spreads are wide wider than they've been and even if spreads widen out a little bit more.

The credit will still have positive performance and there is an offset because if we do run into a recession Which bonds are going to perform really really well in the media market?

It's going to be your double a rate of bond your triple a rated bonds and with longer duration. That'll offset some weakness [00:12:00] if we do see it on the credit side.

So, we are confident in terms of how we're positioned around credit.

The further we go into this interest rate cycle or approach the end of this interest rate cycle, it's appearing more and more that the Fed will be able to land this plane.

Stacie Jacobsen: Okay, but let me ask you this because it appears that states and cities are beginning to report budget gaps instead of surpluses. So is credit quality as strong as you claim?

Daryl Clements: Yes, because there's two ways to look at it, right?

There's a P and L, your revenues and expenses and your balance sheet. So, from a balance sheet perspective, states are sitting on more cash than they've ever had.

But you are right. From a revenue perspective, they're feeling it first.

So give you an example, California, largest state in the country.

Not too long ago, they were running 75 billion budget surpluses. They recently closed the budget gap of 32 billion and never needed to touch [00:13:00] their 36 billion cash funded reserve.

So they have flexibility to maneuver.

So, when you say, are states experiencing budget gaps, yes, that will continue, but they have the wherewithal.

And that's what cash reserves are. They're rainy day funds.

So when it rains, they're going to use these. But um, we're quite confident in the ability of states and municipalities to see themselves through.

Stacie Jacobsen: All right. That's helpful. Thank you.

I've also heard you say that even equity managers have some bond math envy. Can you explain what you mean by that? Yeah.

Daryl Clements: What I mean by that is bonds are math.

That's the beauty of them, right? So let's, let's do a little back of the envelope math. And sometimes I feel I live my life on the back of an envelope.

But let's say the starting yield, let's say on a portfolio on the general index is about 4%. Okay. Now let's say yields fall by just 50 basis points over the next [00:14:00] 12 months.

Now the index has a duration of about six years. So you take your six years divide it by 0. 5 and that's three. So that's the appreciation So you take that three and add it to your four, which is your starting yield.

Now your total return is seven What if yields fall one percent over the next? 12 months.

And if you look at our economic forecast, that is absolutely in the cards over the next 12 to 18 months, then multiply that six times one, right?

So the 1% change in yield time to six year duration, that's a 6% increase in value on top of your 4% yield.

Now you're up 10%. And that's not even including Stacie.

If we talk about credit spread narrowing a little bit. And that could add another 50, 100, 200 basis points, depends on how much spread's narrow, on top of that 10%, let's say.

So you can easily, without much movement in yields, over the next, say, 12 months, or [00:15:00] credit spreads, get to very high single digit returns, or low double digit returns, in municipal bonds.

And that's where the bond math envy comes from, because finally, it's been a while, but we finally have income in fixed income. Finally,

Stacie Jacobsen: it certainly has been a roller coaster ride and to say that about muni bonds is certainly a big statement.

So for investors who do continue to roll their t bills and are just waiting They're continually investing in money market funds.

What would you recommend as the opportunity in muni bonds today?

Daryl Clements: Oh boy Timing is difficult.

We know that and I know that many investors are scarred with what happened from last year and there's a lot of uncertainty around the Fed and they're kind of, all right, I'm just going to stick in this three month T bill, earn my 5, 2%, but remember there's always taxes and if you're in a top tax bracket, it's about 3% that you're earning.

So I get that. So the opportunity is this Stacie, and I'll try to be as pithy as I can, but when you have yields that are amongst the highest [00:16:00] they've been in over a decade, credit spreads that are twice their historical average.

You have the Fed that is in the ninth inning with probably one or two outs in terms of their interest rate height cycle and the likelihood that yields are going to be lower 12 months from now.

It's hard to paint a better opportunity. In bonds that exist today what you don't always get right is the timing of it Nothing moves in linear fashion.

Nothing goes in a straight line up or down.

And I didn't know last year I thought we were talking earlier that October 28th of last year would have been the beginning of a rally and municipal bonds.

Who knew that and it hasn't been a straight line either there's been up months and down months up weeks and down weeks, but it skews towards It's been positive performance.

And right now I would say that performance is asymmetric to the upside, meaning there's much more in terms of upside potential than downside [00:17:00] risks at this time.

So I think if you take it all in balance and you look at all the variables.

Honestly, then you'll say that the opportunity in bonds is significant.

And one other thing, if you look at, and I don't have the numbers right in front of me, but if you look at when the Fed pauses during past hiking cycles, and if you look at the returns of a three month T bill over, let's say three months, six months, a year after that, um, pause.

Bonds materially outperform three month T bills by 2x, if not more.

And the reason for that is at some point they pause, but then at some point they cut. And when they begin to cut, your yield on the T bill comes down and your value on the bonds go up.

Stacie Jacobsen: Daryl, I hear there is seasonality to the municipal bond market, which can either benefit or at times be in hindrance. [00:18:00]

How is that impacting the market?

Daryl Clements: No, you're right. There is a seasonality to the muni market and it tends to be around bond supply, new issue supply and about reinvestment.

So for example, we're going through a period now where I'll refer to it as a summer technical where a woeful, woeful lack of new issue supply is met with a significant amount of reinvestment and that reinvestment is coming from bonds that pay their coupon payments.

Uh, June, July and August, a little bit in May, but primarily June, July and August.

Those are very, um, large significant months for coupon payments as well as bonds maturing.

It's like an El Nino weather pattern, just like sets the weather for a period of time. The summer technical is just that in the municipal market is such a.

For us in the municipal market during the summer months, that bonds tend to rally.

So investors, if you can, you want to take advantage of that, right? By putting cash to work and that will likely benefit over the summer [00:19:00] months.

Stacie Jacobsen: All right, Daryl. Well, thank you so much for being with us today. I think I need to go take some action on the cash I have set aside, but really appreciate the conversation.

Daryl Clements: My pleasure. Stacie. Thanks for having me.

Stacie Jacobsen: Thanks everyone for tuning in.

Join us next time when my co lead of sports and entertainment, Adam Sansiveri and I speak with NFL veteran Kyle Rudolph. Be sure to subscribe to the Pulse by Bernstein wherever you get your podcasts to ensure you never miss a beat.

I'm Stacie Jacobsen wishing you a great rest of the week.