TEXT ON SCREEN: PIMCO

TEXT ON SCREEN: PIMCO EDUCATION –TITLE – Discussing Taxes and Munis in 2022 with John Nersesian and guest David Hammer (8 minutes)

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TEXT ON SCREEN: John Nersesian, Head of Advisor Education

John Nersesian: Hi everybody. I'm John Nersesian, head of advisor education at PIMCO. And I'm joined by my colleague, David Hammer. Dave is the head of municipal bond portfolio management at PIMCO. Dave, welcome to our conversation.

David Hammer: Hey John. Thanks for having me.

John Nersesian: It's my pleasure. So Dave, let's start the conversation by talking about equity market volatility that we've seen recently. And of course the topic on everybody's mind, the prospect of higher interest rates. Can you help our audience understand what that means to the municipal bond market, both individually and from a portfolio management perspective?

TEXT ON SCREEN: David Hammer, Head of Municipal Bond Portfolio Management

David Hammer: Yeah. Sure John. You know, as we enter 2022, investors are contemplating a Fed hiking cycle, about four hikes priced into the market today. Withdrawal of accommodative central banking policy, although it'll still be accommodative less so. And that really increases the probability of volatility. And certainly as you mentioned John, we've already experienced this year in the first few weeks of 2022.

So I think it's important to note for tax exempt munis,

TEXT ON SCREEN: TITLE - Municipals have historically performed well during Fed rate hike cycles, SUBTITLE - Fed Funds Target Rate

IMAGES: A line chart shows the fed funds target rate from May 2004 through November 2021; it highlights two rate hike periods: 1 from May 2004 - November 2008 and 2 from November 2016 – May 2020.

it's these types of environments that they tend to thrive from an asset allocation perspective.

And first and foremost it's performance in a rising rate environment. Looking back to previous Fed hiking cycles, munis have both outperformed taxable fixed income as rates have risen, but also delivered relatively decent cumulative returns over those time periods.

TEXT ON SCREEN: TITLE - Municipals have historically performed well during Fed rate hike cycles, SUBTITLE - Fed Funds Target Rate

IMAGES: The table shows the returns of U.S. Treasuries, investment grade munis, taxable-equivalent investment grade munis, high yield munis, taxable-equivalent high yield munis, during periods 1 and 2, demonstrating that munis have historically performed well during fed rate hike cycles.

So going back to 2004 to 2006, or 2015 to 2018 more recently, investment grade munis absolute returns over those time periods, about 7 to 9 percent. High yield munis have done a bit better, 18 to 22 percent. And of course that's all without adjusting for taxes. So those taxable equivalent returns are even a bit better.

TEXT ON SCREEN: TITLE - Municipals can offer diversification benefits versus a variety of asset classes

IMAGES: A bar chart shows the correlation between a number of indexes that represent variety of asset classes and the S&P 500 and the Bloomberg U.S. Aggregate Bond Index as of December 2021. The chart shows that municipal bonds tend to have a lower correlation to the Bloomberg Aggregate than Treasuries, and a lower correlation to equities than investment grade and high yield taxable credit.

And in terms of diversification, you know, with equity markets near all time highs and corporate credit spreads relatively tight, it's important to note that historically munis have had lower correlations to these riskier parts of the market like equities and high yield corporate credit. And that applies both to IG munis if you're comparing them to the Barclays Ag, or high yield municipal bonds if you're comparing them to the S&P 500, or high yield corporate credit spreads.

John Nersesian: That's great, Dave. Thanks for the comments on that. Let's talk about another aspect of the municipal bond opportunity today. I was reading an article recently where you were quoted, and you referred to the idea that state and local coffers are more flush with cash than they have been in recent history. What exactly does that mean in terms of credit quality for the municipal space?

David Hammer: Yeah. This moment in time is peak credit quality for the muni market. And there are a number of factors that have influenced it. Number one is that despite the severe economic contraction in 2020, state and local tax collections were only down about 1 to 2 percent. High income earners kept their jobs. There were record levels of monetary and fiscal policy support.

TEXT ON SCREEN: TITLE - State and local government revenue streams remain resilient. SUBTITLE – Rolling 12 month state and local government tax revenues.

IMAGES: A line chart shows tax revenues (mm) from Q1 1994 to Q3 2021, rising from $600,000 in 1994 to about $1,850,000 in 2021.

And throughout 2021, state and local governments were experiencing record revenue collections. The state of New Jersey announced in 2021 that they hit all-time new highs in revenue collections.

And then at the local level, many muni bonds were backed by property taxes. And house price appreciation it accelerated during this crisis. Very different than the financial crisis of a decade ago in which house prices were a drag on local economies. In this case they're actually supporting local economies. And investors and rating agencies alike are taking notice here. I know in Illinois, where you're from, the first bond upgrade for the state in 25 years.

So this is a phenomenon that we expect will turn into a multiyear favorable credit environment. Much of the COVID relief, it hasn't been spent yet. State and local governments have until 2024 to allocate it, till 2026 to spend it. They're also improving credit quality by paying down pensions. And as we head towards mid or perhaps late cycle at some point, this improves the overall credit quality of an already safe asset class that has historically low default rates versus IG corporate bonds or high yield corporate bonds.

John Nersesian: An upgrade to the state of Illinois. Who would have thunk. Dave, let's talk a little bit about tax reform. If we were having this conversation in 2021, tax reform was the topic du jour. Everybody was convinced that ordinary rates were going up, that capital gain rates were going up, that there was going to be some sort of meaningful tax legislation.

Of course that hasn't come to pass. And therefore the number of opportunities for individual investors to save on their taxes is still very limited.

Text on screen: TITLE – Individual income tax deductions, SUBTITLE: Itemized deductions BULLETS – Medical expenses, SUB-BULLET: Medical expenses subject to 7.5% AGI floor, BULLETS: Mortgage interest, SUB-BULLETS: Mortgage interest capped based on size of the loan, BULLETS: Charitable gifts, SUB-BULLETS: Charitable gifts limited based on type, recipient of gift, BULLETS: SALT taxes, SUB-BULLET: SALT capped at $10,000

We've got medical expenses, if they exceed 7.5 percent of AGI. Mortgage interest of course is still deductible. Charitable giving is still deductible. And then of course the all important state and local taxes, which are currently capped at $10,000.

Dave, let's talk a little bit about how munis fit into that context of a limited state and local tax deduction.

David Hammer: Yeah. You hit the nail on the head, John. There are limited places to go for tax efficient investing today. The other thing that's become limited is the supply of tax exempt bonds. The most recent bills around infrastructure, they failed to bring back tax exempt advanced refundings, which allows muni issuers to refinance a tax exempt bond with a new tax exempt bond. As a result, muni issuers are actually turning to the taxable market. That's taking tax exempt supply away and converting it to taxable form.  So there's simply not enough supply of muni bonds to satisfy this demand in many cases.

Images on screen: Puerto Rico municipal project

One place that we see opportunity in value for tax aware investors, it's the Commonwealth of Puerto Rico. The island has been going through a multiyear restructuring process. We expect the Commonwealth will fully emerge from bankruptcy in 2022. And we see value here for a few reasons.

Number one is that debt has become more sustainable. The Commonwealth has reduced their debt burden by about 60 percent by imposing haircuts on legacy bondholders. The new bonds also offer better security protections for bondholders than they did pre-bankruptcy. So it's a higher quality asset coming out of the restructuring.

And then last but not least is the high levels of tax free yield. These bonds are not rated. They're trading with a wider spread or a higher tax free yield. That means 4 to 5 percent tax free yields as these bond transition back into the muni market. That's equal to somewhere in the 7 to 8 percent taxable equivalent range. For those investors in California and New York, it actually gets close to double digit returns. So it's an area we see a lot of value this year. And we've increased our allocations here at PIMCO across our municipal vehicles.

John Nersesian: And clearly with that state and local tax deduction capped at $10,000, paper like Puerto Rico becomes really attractive for those residents of those states. Dave, thanks so much for your comments today. Very helpful. I want to thank our audience for joining us. And I want to encourage all of you to learn more about our capabilities in the municipal bond space by visiting us at pimco.com or by contacting your local PIMCO account manager.

TEXT ON SCREEN: To learn more visit pimco.com/advisor education or speak with your Account Manager

TEXT ON SCREEN: TITLE – PIMCO

Disclosure

IMPORTANT NOTICE

Please note that this video contains the opinions of the manager as of the date recorded, and may not have been updated to reflect real time market developments. All opinions 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. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

All investments contain risk and may lose value. 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. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. 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; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Diversification does not ensure against risk.

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

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Bloomberg Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. The index is made up of all investment grade municipal bonds issued after 12/31/90 having a remaining maturity of at least one year.

The Bloomberg High Yield Municipal Bond Index measures the non-investment grade and non-rated U.S. tax-exempt bond market. It is an unmanaged index made up of dollar-denominated, fixed-rate municipal securities that are rated Ba1/BB+/BB+ or below or non-rated and that meet specified maturity, liquidity, and quality requirements.

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