Text on screen: PIMCO

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Text on screen: John Nersesian, Head of Advisor Education

John Nersesian: Welcome everybody. I'm John Nersesian, head of Advisor Education at PIMCO.

I'm now joined by my friend, Dave Hammer. Dave is a managing director at PIMCO. He is the head of municipal portfolio management. Dave, welcome to our conversation.

David Hammer: Thanks, John.

John Nersesian: Let's start our conversation, Dave, by talking about the recent volatility in munis. What's happened to municipal securities so far this year?

Text on screen: David Hammer, Head of Municipal Bond Portfolio Management

David Hammer: Well, it's been an exceptionally volatile period, the worst by recorded history, going all the way back to 1980. This is the worst start to the year for the US muni market. IG indices down 8%-9%, high-yield indices down as much as 10%-11%.

So, you know, a really big move. And you know, I think I'd say at the outset, it's not about credit. It's really about liquidity and valuations, adjusting to draw in a crossover buyer, so a non-traditional buyer of munis.

You know, liquidity has gotten more challenging in the muni market over the last decade. If you go back to 2006 and '07 before the financial crisis, broker dealers used to hold about 50 to 60 billion in tax-exempt munis, to make markets in intermediate-risk transfers. Today, that number is all the way down to 10 to 15 billion.

Over the same time period, long-only muni strategies — think ETFs, open-end funds — they've more than doubled in size, from 400 billion to over a trillion. So there are more frequent bouts of volatility due to this mismatch between the amount of investors that might want liquidity, versus the amount of capital that's there to provide it.

John Nersesian: For context there, Dave, that's within the total size, total universe of how much?

David Hammer: Uh, so that's relative to, you know, open-end fund universe that's a little over a trillion dollars.

John Nersesian: Wow.

David Hammer: But you think about the quantity of it, this is 4x what broker dealers actually hold on their balance sheet. So as a result, valuations have had to cheapen.

John Nersesian: Dave, that sounds like a lot of bad news. Is there anything good in this commentary that you can share with us now? Are there specific opportunities in muni land?

David Hammer: Yeah. So the good news is that valuations have become attractive, the muni-treasury ratio, that's just the yield of a tax-exempt muni bond divided by a treasury yield.

Text on screen: The muni-treasury ratio has moved from about 65% to 90% -100% in ten years.

Images on screen: Bridge construction

That's moved from about 65% in ten years to as much as 90%-100%, so cheap to long-term averages.

And then versus corporate bonds — munis have traded as cheap as 90%-100% of corporate bond yields. This means a lot of additional after-tax pickup for US investors. So we see this as, you know, attractive valuations across the board. And if we look back historically at these big outflow cycles, these tend to be pretty good times to allocate to munis.

John Nersesian: So let me just put that ratio into context. What you're suggesting at that 100% number is, I can get a similar yield in a security that is tax-exempt than is available to me in the taxable market?

David Hammer: Yeah, that's right. You know, and we look at specific opportunities in this sell-off for our portfolios.

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We've seen examples of US utility issuers issuing a tax-exempt bond that has parity debt in the taxable market. And just the simple yield has been equal to, to actually a little bit higher, in some cases.

John Nersesian: Doesn't make any sense.

David Hammer: So there's, you know, quite a bit of dislocation. The long-term average, it's much closer to about 75%.

John Nersesian: And maybe that's the advantage of, you know, utilizing a great portfolio management team to select and manage municipal securities. That illiquidity, that market inefficiency, which is generally considered to be a negative attribute, that's maybe an opportunity; right?

David Hammer: Yeah. You know, we think this is structural. It's here to stay. It's really changed the way we manage our portfolios. Where munis are very, very rich, we'll increase our cash balances much higher today than we would have a decade ago.

Images on screen: People working on the trade floor

That allows us to avoid needing to sell during an outflow cycle. But also is gives us dry powder to really go on offense and select individual securities that are more dislocated than broader indices might suggest.

John Nersesian: Okay. Dave, I read a recent piece from you, and I hope I'm paraphrasing this accurately, where you referred to the opportunity in munis and you were banging the table, saying, it's a 9 or 10. Something along those. Can you expand on that a little bit in terms of a context of your remarks?

David Hammer: Yeah. You know, it's really based on valuations. We manage a lot of pools of capital here at PIMCO. And as munis cheapen, we allocate not just for our dedicated muni strategies, but they begin to become more attractive for, uh, mandates we run with lower tax rates. And in some cases, even those that don't pay a tax rate at all.

John Nersesian: Okay.

David Hammer: And when munis cheapen to those levels and they become attractive for these different pools of capital, these tend to be really good times to allocate to munis historically.

You know, another thing that I'd add is that we're thinking about investing here at PIMCO through a late-cycle lens. As the economy, you know, potentially slows due to tighter monetary policy over the next several years, the probabilities of recessions — even though it's not our base case — they're rising.

Text on screen: TITLE: Why we like munis in late-cycle investing:, LIST: Lower correlation to equities, Lower default rates than corporate bonds

And as we think about late-cycle investing, munis are a part of the market that we tend to like. They have lower correlations to equities, much lower default rates than corporate bonds, and credit health this time around. And the muni market, quite different than the last several outflow cycles, it's broadly improving in the mini market, as opposed to deteriorating like it was throughout most of the last decade.

John Nersesian: Interesting. Interesting. So if we think about the possibility of being in a late-cycle environment, right — growth begins to slow, Fed become a little bit more aggressive in terms of policy — munis become an attractive asset class in that environment.

David Hammer: Yeah, much lower default rates. And this is, you know, obviously true in the IG portion of the market. It's also true in the higher-yielding portion of the market. Cumulative default rates, and Moody's tracks this, somewhere in the 7%-8% range. For high-yield munis, that compares to 25%-30% for high-yield corporate bonds. So much less default risk.

You know, and just to reinforce the credit point here, we're seeing far more upgrades than downgrades across the muni market. You know, and the reason is that munis came into this period with a lot of support from both fiscal and monetary policymakers.

Looking back to 2020, sales taxes, income taxes collected, were only down about 1%-2%. But the expectation was that it could be much worse, and there were allocated relief funds based on that expectation. Those are continuing to flow through to state budgets. Much of this money won't be spent until 2024, if not 2026.

Images on screen: Illinois state capital

So it's a significant tailwind at the state level. We're seeing this in, you know, upgrades in places like Illinois, which has been upgraded now for the first time in 25 years.

And then at the local level, house prices have accelerated. Assessed values, which determine how many property taxes are paid in a local area, these are what ultimately back the credit quality of local municipal bonds. And they tend to lag. And with mark-to-market values and house price appreciation approaching 10%-15% in many of these areas, assessed values will grow much more gradually in the coming years. And that's a tailwind to credit improvement at the local level.

John Nersesian: So any comments about this idea that some current muni holdings are down in value? Any comments on what an investor might think about doing proactively to take advantage of this temporary decline in market prices, Dave?

David Hammer: Yeah. Well, if you're rotating from one security into another in this environment, you're likely harvesting a tax loss.

Text on screen: TITLE: Potential benefits of tax loss harvesting in muni portfolios:, LIST: Rebook at a higher tax-free distribution yield, Accumulate deferred tax losses to offset future gains

And we're doing that across our muni portfolios. It allows us to do two things. One is rebook at a higher tax-free distribution yield, which we pass on to our investors.

The second is, in our funds, we can actually accumulate these deferred tax losses. We can use them against active trading gains in the future. So for our active strategies, it makes them more tax efficient when we have these accumulated tax losses to offset future capital gains. It's something we think makes sense broadly for investors across the muni market.

John Nersesian: Some, some dry powder to take advantage of in the future if you're trading more actively and producing what would otherwise be taxable distributions. That makes a lot of sense.

Well, Dave, thank you so much for your time today. We really appreciate your comments. Thank you again for all the insights that you bring to all of us here at PIMCO.

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