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Text on screen: Rachel Betton, Portfolio Manager, Municipal Bonds

Betton: 2022 has been a challenging year for muni investors. Supply side disruptions and surging commodity prices have caused inflation to remain stubbornly high.

Images on screen: The Federal Reserve building

The Federal Reserve is raising rates faster than initially expected, and the US Muni market is in the midst of the largest outflow cycle ever recorded.

Coming into this year, tax-exempt muni valuations were near all-time rich levels versus both US treasuries and similarly rated corporates. As the year progressed, inflation fears and rising rates have led to substantial outflows from muni open-end funds.

FULL PAGE GRAPHIC: TITLE – Outflow cycles present opportunities. SUBTITLE: Historically returns have been strong following outflow cycles. A bar chart is shown measuring monthly municipal fund net flows over the last 12 years, while a table resides below the bar chart providing data on bond returns. On the bar chart are four highlighted sections, each indicating a cycle of large outflow that corresponded with a significant market downturn. These include the declines caused by the Meredith Whitney forecast for the muni market in 2010-2011, the taper tantrum, Detroit bankruptcy and Puerto Rico headlines in 2013, the 2016 US presidential election, and the Covid-19 crisis in 2020. The chart demonstrates that cycles of large outflows were followed by significant inflows; sometimes sharply and sometimes for multiple years in a row. The table below the bar chart reports on Investment Grade and High Yield municipal bond returns one year after a large outflow cycle. The table demonstrates that outflow cycles tended to last 6 to 33 weeks, and returns following each outflow cycle rose by single to double digits one year after.

As of June 29, muni funds have seen outflows of $76 billion surpassing the prior largest outflow cycle of $70 billion that we saw during the Taper Tantrum.

Historically, sharp outflow cycles have signaled attractive buying opportunities as we believe muni valuations tend to overshoot to attract new capital. We have seen this cycle occur repeatedly during prior outflows– Meredith Whitney, Taper Tantrum and of course most recently during COVID.

In the years after these sharp outflow cycles, we have seen attractive Investment Grade and High Yield muni returns. For example, after the Taper Tantrum – IG munis returned just over 9% and HY munis returned just under 14%.

One of the reasons we launched the PIMCO Flexible Municipal Income Fund, or “MuniFlex”, was to capitalize on the types of opportunities created by outflow cycles, including the dislocation we’re seeing now. MuniFlex is free from daily redemptions and can invest when other funds are forced to sell bonds at depressed prices to meet redemption requests. In the past, these outflow cycles have offered an attractive entry point for MuniFlex.

We see an opportunity for US taxpayers today in tax-exempt munis as muni valuations are now historically attractive versus taxable fixed income. Additionally, as of June 30^th, Muni yields are near multi year highs – especially in the front end of the curve.

Another important tailwind for munis is that credit fundamentals have largely improved across state and local governments. We discuss this in more detail in our latest Munis in Focus outlook.

Images on screen: California State Capitol building, Illinois State Capitol building, residential neighborhood

For example, California has a record budget surplus and Illinois was upgraded recently for the first time in 25 years. Home prices have also appreciated by 10-15% in many areas over the last year, providing increased property taxes that will be a tailwind for local government credit in the years ahead.

In order to take advantage of these opportunities, we’ve been increasing the fund’s leverage thereby adding more risk at what we believe are favorable valuations as market prices have moved down. We started the year with 13% leverage, an all-time low for the fund. As the market has traded off, we’ve been progressively adding leverage and going on offense.

Text on screen: Today we have 24% leverage

Images on screen: Building construction

As it stands today we have around 24% leverage in the fund.

We have also been capitalizing on the increase in market yields by book yield swapping, where we sell bonds with embedded tax losses and buy similar risk at higher yields allowing us the potential to both harvest losses and capture higher yields.

This year we have seen numerous secondary opportunities in work force housing bonds. Workforce housing is considered essential housing and offers discounted rentals to earners who fall within certain bands of an areas average median income.

Many of these deals were issued with lower coupons in the past two years and given the move in rates, are trading at sizeable discounts offering us both attractive tax-exempt yields and the potential for capital appreciation given that many have par prepayment.

Images on screen: Residential neighborhood, PIMCO trade floor

One recent example is an existing 261 unit multifamily workforce housing facility located in California. The project has good access to major urban centers and occupancy has been tracking over 90% since issuance.

Given PIMCO’s deep expertise in the housing market, our integrated investment process allowed our analyst – after a site visit – to leverage our knowledge of the local real estate market including demand trends, rental dynamics and cap rates to determine appropriate base and stress case return scenarios.

We purchased the bonds just shy of 80 cents on the dollar. These bonds actually also benefit from rent increases being passed through to bond holders which can improve the credit quality and shorten the repayment period.

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Disclosures

All data is as of 30 June 2022 unless specified otherwise. Source of data is PIMCO unless noted otherwise.

Investors should consider the investment objectives, risks, charges and expenses of the fund carefully before investing. This and other information are contained in the fund’s prospectus, which may be obtained by contacting your investment professional or PIMCO representative or by visiting www.pimco.com. Please read the prospectus carefully before you invest or send money.

The PIMCO Flexible Municipal Income Fund (“Fund”) is an unlisted closed-end “interval fund.” Limited liquidity is provided to shareholders only through the fund’s quarterly offers to repurchase between 5% and 25% of its outstanding shares at net asset value (subject to applicable law and approval of the Board of Trustees, the Fund currently expects to offer to repurchase 10% of outstanding shares per quarter). Past performance is not a guarantee or a reliable indicator of future results.

References, either general or specific, to securities and/or issuers in the Material are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Investors should consult their investment professional prior to making an investment decision.

Index returns are intended to represent broad market activity and do not represent the past nor predict the future performance of the Fund.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.

A word about risk: Investing in municipal bonds involves the risks of investing in debt securities generally and certain other risks. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax.  Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Concentration of assets in one or a few states, territories (or a particular area) and projects will subject a portfolio to greater risk than if the assets were not concentrated. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged.

An investment in an interval fund is not appropriate for all investors. Unlike typical closed-end funds an interval fund’s shares are not typically listed on a stock exchange. Although interval funds provide limited liquidity to investors by offering to repurchase a limited amount of shares on a periodic basis, investors should consider shares of an interval fund to be an illiquid investment. Investments in interval funds are therefore subject to liquidity risk as an investor may not be able to sell the shares at an advantageous time or price. There is also no secondary market for interval fund shares and none is expected to develop. There is no guarantee that an investor will be able to tender all or any of their requested shares in a periodic repurchase or tender offer.

Except for the historical information and discussions contained herein, statements contained in this material may constitute forward-looking statements. These statements may involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including the performance of financial markets, the investment performance of PIMCO’s sponsored investment products, general economic conditions, competitive conditions and government regulations, including changes in tax laws. Investors should carefully consider such factors.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2022, PIMCO.

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