Crunching Numbers: Expert Insights on Muni Bonds from Bernstein’s Daryl Clements

This transcript has been generated by an A.I. tool. Please excuse any typos.

Stacie Jacobsen: Thanks 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.

With the AI boom driving equity returns, especially tech stocks, to record highs over the past year, it's easy to forget that opportunity can sometimes hide in less flashy areas of the financial markets. Muni bonds, for example, deserve a closer look as we enter the summer months, which is often their best time of year.

Our guest for this episode is Daryl Clements, Senior Vice President and Municipal Bond Portfolio Manager here at Bernstein. Daryl, welcome back to The Pulse.

Daryl Clements: Oh, I appreciate it, Stacie. Thanks for having me.

Stacie Jacobsen: Muni Bonds had a slower start to the year, uh, especially after the rally that ended 2023. I've heard you, I'd say, rather passionately talk about the significant opportunity for Muni Bonds now, but before I unleash you to talk about that, uh, I'd love for you to give us a bit of a short rap on the first part of the year, right?

What was the cause to the slower than expected start?

Daryl Clements: Well, you know, it's funny. The market was expecting the Fed to cut. So in October of last year, municipal bonds were selling off on the entire fixed income market was selling off. And then there was some hope that the Fed would begin to cut. So municipals had become very cheap at the end of October.

Then with the anticipation that, Hey, you know what? The Fed may begin cutting here the beginning of 2024, the market just ran and it ran very, very heavily November, December. And then kind of some data points came out, um, pointing to, well, you know what? Maybe inflation has not been beaten yet. Employment's coming out a little bit stronger than expected.

So the market took a step back and said, well, the Fed is not going to cut six or seven times this year. Maybe they're only cutting once or twice. And that caused the market to kind of reassess. And since that point, yields have been moving higher. Uh, at least up through the end of May.

Stacie Jacobsen: Okay. So let's get into the opportunity that you see now.

We're in the summer technical season, 22 billion of reinvestment cash just hit the market June 1st timing is always an issue, but maybe even more so this year. So let's talk about the road ahead. Is it becoming a bit clearer now?

Daryl Clements: Oh, absolutely. I think the market got a little enthusiastic back in November, December of last year.

And I, now I think the expectations are more reasonable. And the re the reason is this, you, you have, the fed wants to be higher for longer in terms of their rate outlook. And we are in the longer part of that higher for longer. So the markets kind of come to grips with that. The market is forecasting to rate cuts by the fed to 25 basis point rate cuts beginning in November.

We, by the way, internally, our internal house call is one cut in December. So with that, the market is beginning to rally, right? But to your point that you made the summer technical season, that's a bigger, right? The fed and what they're going to do. That's a macro. You get down into the micro side of the municipal market.

That summer technical Stacie is huge. It's 22 billion now, but it's going to be about 45, 46 billion for the entire summer. That means there is 46 billion more in cash to reinvest. Coming from coupon payments, bonds maturing, bonds getting called away, then there will be bonds to buy. So, all things being equal, that is a tailwind to the municipal market coming at a time when municipal bonds sold off for the entire, really, through May, but really sold off in May because there was too much supply coming in through the month of May, cause yields to spike, municipals become relatively cheap, versus treasuries, and So you got to that point, almost like October, Stacie yields weren't quite as high, but it's kind of a second bite at the apple.

So yields backed all the way up. And now you have this reinvestment cash coming in looking for bonds to buy. And there's not a lot of bonds, some municipal bonds are rallying.

Stacie Jacobsen: Can you break down the idea of the summer technical season? It's more than just the reinvestment of cash, right?

Daryl Clements: True. It's also a lack of supply.

So we put out a weekly piece, right? And a few weeks ago, I titled it death taxes and the summer technical because it's a certainty. And what that means is during the summer months, two things happen, June, July, and August are three months where there is a significant amount of coupon payments that come in bonds, maturing and bonds being called away.

That is met with typically A woeful lack of supply for various reasons summer people on vacation underwriters whatnot It's also the end of fiscal years in the beginning of fiscal years in that time So you a lot of issue is avoid issuance at that point So you have those two kind of coalesce? And it's like buying flowers on Valentine's day, right?

When there's a lot of demand, the prices go up and there's a finite number of roses you can buy there. So there's a finite number of bonds to buy and you have a lot of demand and that tends to rally the market.

Stacie Jacobsen: All right. So maybe make those dinner reservations early, right? Not wait until right before Valentine's day.

Daryl Clements: The day before the day after that's always tough.

Stacie Jacobsen: So far we've been talking about the Muni market in general, but it's not all created equal. There's divergence between higher quality bonds, which seem to have actually been underperforming while high yield bonds have been performing a bit better. Let's break that down as well.

Daryl Clements: Well, you look back at this year, bonds are up almost 2 percent in the month of June, where they were negative through the end of May. And the reason that bonds were negative, especially high grade, as you point out, is because yields were rising. And I think many investors missed this point. High grade bonds are more interest rate sensitive.

And the reason behind that just math, you have higher yields in higher yielding bonds or mid grade bonds. So that reduces your interest rate sensitivity. So when rates are rising, high grade bonds are more sensitive. So they were doing quite poorly relative where credit single a triple B rated bonds, which are mid grade or high yield bond.

We're doing well. Not only because they're less interest rate sensitive, but because there was a lot of demand finally coming back into the market. So demand, one way to look at it or gauge it, Stacie, is by looking at mutual fund flows. So mutual fund flows in the municipal market during 2022 and 23 were woefully negative.

Like 175 billion net outflow of municipal mutual funds. This year you've had about, let's call it 13, 14 billion in, and half of that is going into high yield funds. So. We talk about that. There was a lot of supply issued during the month of May, but not a lot of high yield supply or credit supplies, but you have a lot of demand.

So credit spreads are narrowing, which is offsetting the drag from interest rates rising where high grade bonds that have no spread, they're fully exposed to interest rates where credit single A triple B high yield. there and that's what's happening. It's offsetting the rise in rates.

Stacie Jacobsen: Got it. Now, when you talk about high yield, you also are going out further on that risk spectrum.

So munis are usually thought of as being in the safer side compared with some of these other fixed income instruments, although we've emphasized the opportunity in high yield, right? They're certainly riskier. So how do you manage the risk?

Daryl Clements: I look at it this way. There's not one portfolio. For every client, right?

Some portfolios that we build that are all high quality. And, and there are some that add a little bit of single A or triple B and some that adds in high yield, depending on the investor's risk tolerance. A couple of things I'll say around that is number one, municipal bonds, regardless of the rating, whether it's single A, triple B or high yield rarely default, they default much less than corporate bonds.

Over rolling aggregated five year periods. The high yield default rate in municipals is about seven percent. Now, that's a little high, but half of that number comes from Puerto Rico, right? One outlier. If you took Puerto Rico out, it's like three, three and a half percent. Compare that to corporate bonds of about 27%.

So corporate bonds default at the high yield level far greater degree than municipals do. And then with our municipal team watching over every high yield bond that we own, I'm very comfortable in this environment, having some exposure and Stacie, if you give me some latitude here, real quick back of the envelope, Matt, just to show what the opportunity here is and why some investors should take some of this risk.

If assume your yield is about 5 percent on a high yield bond, a 10 year duration, If municipal yields just fall a half a percent, 50 basis points on a 10 year duration, the value is up 5%. On top of your 5 percent yield, your total return is 10. If credit spreads just narrow just 20 basis points, that's 10.

10 year duration times 0. 2 is another 2 percent on top of your 10. Now you're up 12%. So when we talk about the opportunity in bonds, high grade or high yield bond, that's the opportunity. Now it may be tactical. You're in there for a little bit. And then you, after a year is 18 months, maybe you move that risk bucket somewhere else, but Oh boy, Stacie, there's a lot of value built up in bonds, especially high yield.

It's just a matter of when does it all get released? And that time is coming. I think it's already started quite frankly.

Stacie Jacobsen: So you don't want to ignore the high yield side of the market here. Okay, Daryl, you mentioned the muni bond team. The concept of active management is not just for equity portfolios in the bond world, especially the muni bond world.

It might be more important now than ever. Uh, why is that?

Daryl Clements: Yeah, I think that's a fair statement that you make. We really haven't been in this environment before. We have a Fed fund rate that's at five and a quarter, five and a half percent. That's the range. You have municipals that are as cheap as they've been in quite some time relative to, let's say their taxable counterpart treasuries, let's say you have yields that are as high as they've been in a generation, basically 2010.

So now you're looking ahead. And you see the Fed is pretty much done here. I think most people would agree their next move is to cut rather than increase. And you have municipal credit quality that is strong as it has ever been. So you take all of these variables, say to yourself, when will it get any better?

When would there be a better time? And it's hard to envision a time where it would get much better. And the active management side of it. Allows us to take advantage of all of this, allows us to take advantage of duration. The maturity structure in bonds, given an inverted curve, I can tell you a horror stories about what some managers out there do or don't do.

When I look at active managers versus passive managers, one thing I can tell you is that when you look over two year periods, I look at Morningstar data, that active managers in municipal bonds outperformed passive managers 97 percent of the time over rolling two year period. Active management is a slam dunk, quite frankly.

Stacie Jacobsen: And that's a significantly higher percentage than the equity market active managers.

Daryl Clements: Yes. That makes sense to me because the municipal market is highly inefficient. And the equity market, you would argue, I'm not an equity guy. You probably know more about them than I do, but the equity market is more efficient.

So once you have inefficiencies in a market, if you have the ability to sift through those inefficiencies to find opportunities. That's how you outperform.

Stacie Jacobsen: That makes sense. Okay. So Daryl, the yield curve is inverted right now. So how do you, as an active manager in bonds, think about this even versus other managers?

Daryl Clements: You're right. The yield curve is inverted. It's like a U shape. It's like a Nike swoosh almost. Right. And, and what you do with that information is from a maturity structure perspective, we're barbelling. And what does that mean to the audience? Well, when you're barbelling, we're focusing on bonds in that one to three year part of the curve yield curve.

And let's say 15 to 20 year maturity. So one to three, 15 to 20. And the reason you do that is that belly that's inverted, it's not going to stay inverted for long. So you eventually, those yields will come higher. And if you are in that part of the yield curve too much, you're not going to be 100 percent in the barbell.

But if you are plowed into that part of the yield curve too much, eventually, That's going to hurt. And it has hurt this year because that part of the yield curve has been more recently, the worst performing part of the yield curve. So from a maturity structure, we're barbell today, and I will not guarantee many things.

Performance, but what I will guarantee is that that will change. That maturity structure will change. And what concerns me at times is what I see some other managers doing. Some managers are intermediate managers like we are, but they'll just stick. Meaning they'll buy bonds that in that five to 10 year part of the curve, they bought them last year.

They're holding them this year and they will continue to hold those bonds no matter what. So what you see is as those yields in the belly start to rise, if you will, those managers, the performance is pretty dreadful. And you mentioned it earlier, again, one of your comments, the role of a municipal bond portfolio.

And for us, it's really simple. You provide income. Preserve capital and dampen volatility. So recognizing that the yield curves inverted and eventually it will become a normal shape revert, if you will. And to avoid that part of the yield curve that will do poorly, that's my job. That's how I will avoid that volatility and protect my client's assets.

But many other managers are not doing that.

Stacie Jacobsen: All right. So you can still keep that targeted average duration, but you can play outside to get there. You don't have to stick within that five to 10 year range.

Daryl Clements: Oh, absolutely. Many ways to skin a cat, Stacie. And for those cat owners, I hope that didn't offend anybody, but there's many ways to get there, right?

So if we have a four year duration, well, you can either concentrate with all four year bonds, or you can barbell it. Or if you have a seven year duration, you can buy all seven or you can, it's an average of all the bonds in your portfolio. So there's many, many ways to do it, but you need to recognize that the environment changes, the market changes.

And when that changes. You want your bond portfolio to best represent. What is going on out there in the world? And this is just one of those representations.

Stacie Jacobsen: All right. I do want to take a second to talk about premium municipal bonds. These are bonds that trade above par. So at first glance, it often seems like an investor might be overpaying, but that.

Isn't really the full story. So let's dispel that myth here for a minute. Why might a bond that's trading above par be more advantageous to an investor than a bond that's trading at, or even closer to par?

Daryl Clements: You're right. There's a misunderstanding in the municipal bond market. And part of the reason is when you look at corporate bonds or you look at treasury bonds, they tend to be more par like bonds, meaning their yield.

Equals are very close to the coupon that it pays in municipal bonds. It's a little different, right? The average coupon 80 percent of the municipal market is 5 percent coupons or greater. Well yields are not at 5 percent right tax exempt yields They tend to be let's call it 5% Today, two and a half to four.

So bonds can, will have premium, meaning you have a premium coupon. The coupon is higher than the yield. So some investors that I talked to and say, Daryl, why would you ever do that? Why would you buy a bond at one 10? And because that maturity, I'm only getting 100 back. So you lost me 10 points. We're not splitting the atom here.

This is not the most complicated thing that we do, but that's not the case. We're not giving 10 points up. If that was the case, we'd all be fired. What happens though, with municipal bonds is. The reason you have a higher coupon, you're paying up for that. So you're going to pay, let's use an example, a five year bond and you paid one 10 for that bond.

Okay. And your, your coupon is five and your yield is three. Okay. Let's just use those numbers. Play along with me. You're going to hold this bond for five years. So it matures in five years. So what that coupon is actually doing, the higher coupon, which is above the yield. Every year it's paying you a little bit of those 10 points, basically two points a year.

It's paying you back in the higher yield and the higher coupon. So every year you get two points back of that premium. So by the time the bond matures, you get 100 back at maturity, but you also receive those 10 extra points in the form of the higher coupon. Plus on top of that, The yield that you are earning that 3 percent yield.

So you get it all back. You don't lose it. It's there, but many investors think you lose it. Now that I mentioned earlier, how high grade bonds are more interest rate sensitive than mid grade bonds, single A triple B or high yield. Well, the same is true for coupon. So a 5 percent coupon is much less interest rate sensitive.

Then a 3 percent coupon. So I'll give you an example. If I go out and buy a 10 year municipal bond with a 5 percent coupon, that duration may be seven and a half years. But if I buy the same bond at a 3 percent coupon, so a 3 percent coupon with a 10 year maturity, that duration is going to be about nine years.

So it's going to be more interest rate sensitive. So you go back to 2022 when the market really did poorly. Do you know some of those bonds were down? Two, 3 percent coupon bonds because investors wanted par like bonds were down 30%, 35%. So the part of the reason you want premium coupon bonds is to your point earlier, again, you said bond portfolios are meant for stability and safety.

Well, 5 percent coupon bonds give you that even during bond rallies, as you build your portfolio. A bond portfolio made up of 5 percent coupon bond would rally just as much if you structure it properly than a lower coupon bond. So it's a lot of safety, Stacie, that you want when you are buying a 5 percent coupon bond.

And it also allows you to reinvest your cashflow more efficiently because you're receiving more cashflow along the way. So investors should not be afraid. Of 5 percent or premium coupon bonds. They should just seek to understand, understand them a little bit better.

Stacie Jacobsen: Okay. So we, uh, definitely threw out a lot of numbers in that one.

Not everybody followed it's okay. Can either go back and re listen to this or just realize that, that you, Daryl have made a very good point in that you shouldn't just shy away from the premium bonds, just because they're trading above par, they add safety, you know, higher coupon and really diversify the overall municipal bond portfolio.

Daryl Clements: Yeah, no, yeah, sorry. I'm a bond guy. So we deal a lot numbers. I

Stacie Jacobsen: love it when you jump into it. Okay, so given all of this, there are still investors that keep significant assets in money market funds, right? Maybe they're, they're kind of like waiting for that signal that the time is right to move into bonds.

What would you say to those investors right now?

Daryl Clements: Get out, start getting out now because quite frankly, cash feels good. It's like a warm blanket. It feels good. Cash outperformed bonds in 22, then 23 bonds outperformed cash. When investors tell me, Stacie. Many times is, Hey, well, I'm getting 5 percent in my cash.

Well, you're really not FD pay taxes. You're getting more like 3 percent in that range last year, bonds were up about 6%. So you kind of lost there. You're winning this year cash is, but I think bonds will continue to rally. So here's what I think investors should think about. There is a time and a place for every investment.

There are times when cash makes sense to hold on to a little bit more cash, whether that's cash cash in a money market fund or rolling a T bill, let's say a three month T bill. Sometimes that does make sense. But now we're at a point where there's more likelihood the Fed will begin to cut. And if they cut, let's say twice that the market's right, or let's say they move one time 25 basis points, that means that's a direct cut.

Impact to your cash level. So your cash is coming down at least 25 basis points. If not more bonds as yields fall, we'll rally. So the Delta between the two will get even greater. And one other point I'll mention to you, Stacie, we look back at the last six periods where the fed was in an easing cycle. And we looked at, well, what if you were early to that first fed rate cut?

Or late to that first fed rate cut. I can tell you this. I'm not going to throw a lot of numbers out. I promise. But on average, if you were three months before the first fed rate cut bonds were up an average of 10 and a half percent, if you waited for three months after And that's, that's a 12 month return.

Okay. So 12 months, um, return if you were three months early, if you were three months after you were up about five and a half percent and both meaningfully outperforming cash that was up about two and a half, 3%. But you leave a lot of money on the table if you are late. So the idea would be get in early.

If you have 100 in cash, you don't have to take all 100 and put it into bonds. Maybe you take 50 of that 100 and put it into bonds. But I think the returns are asymmetric to the upside at this point. And again, there's a time and a place for everything. Today is not the environment we were in in 2021 going into 22 when yields were rising.

Now they're likely going to fall.

Stacie Jacobsen: Yeah. So that signal might not be crystal clear, but what I'm hearing you saying is it's better to be early than late on this one.

Daryl Clements: It's maybe not crystal clear, but it's a lot clearer than it was just a few months ago. And don't wait for that dinner bell. Once the dinner bell rings and the opportunity, that's going to pass you by.

Stacie Jacobsen: Yeah. You've got to be seated before that dinner bell rings.

Daryl Clements: That's exactly right.

Stacie Jacobsen: All right. Well, with that, uh, thank you so much. You've left us with a lot of really great ideas and concepts to think about. And as always, I appreciate you coming back.

Daryl Clements: Oh, my pleasure, Stacie. Thanks for having me and hope you invite me back soon.

Stacie Jacobsen: Daryl, thanks so much for joining us today and thank you to everyone for listening in. I'm your host, Stacie Jacobsen, wishing you a great rest of the week.