Text on screen: PIMCO
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Text on screen: Alex Etzkowitz, Municipal Fixed Income Strategist
Etzkowitz: Can you give us a sense of how relative value looks today, and what are the factors underlying the shifts in relative valuations that we’ve seen over the last four months?
Text on screen: David Hammer, Head of Municipal Bond Portfolio Management
Hammer: 2021 was a massive year of inflows into the muni market, and that led to very tight valuations. 2022, we’re now in the midst of a pretty significant outflow cycle, $20 billion plus out of the municipal asset class to start the year.
TEXT ON SCREEN: TITLE – A New Outflow Cycle; SUBTITLE – The record 18 month, $164 billion inflow cycle is over
IMAGE ON SCREEN: A bar chart shows estimated weekly municipal fund flows from May 2020 to March 2022. Volume of the flows are expressed in billions of dollars on the Y-axis, and the time horizon is on the X-axis. Before roughly January of 2022, flows are positive for almost every week with the exception of one week in September 2020. Yet starting around January 2022, flows have been negative every week. Three weeks show outflows around negative $4 billion each, and most others are in excess of $1 billion. Before this year, weekly fund inflows ranged between zero and almost $7 billion.
The impact on prices has been further compounded by tax related selling.
There’s also an increase in supply on the horizon. So all of these factors are compounding, putting downward pressure on muni prices.
TEXT ON SCREEN: TITLE – Outflow cycle: Muni indices down – 6.5% YTD – the worst quarter in 40 yrs;
SUBTITLE – Not a Covid-level dislocation, but a significant one
IMAGE ON SCREEN: A line graph charts the amount of cumulative outflows for six different periods, dating back to 2015. The periods range from two to three months, shown as a time horizon on the X-axis. Cumulative outflows are expressed on the Y-axis, working down from zero at the top of the graph, and increasingly negative moving down the side. The cumulative outflows are charted incrementally by month. For 2022, outflows have been negative $14.8 billion over three months, the third biggest drop among the periods on the chart. A two-month period in 2020 shows outflows of negative $47.9 billion, the deepest on the chart, and a two-month period in 2016 had outflows of negative $24.6 billion. Less significant outflows are shown as follows: negative $7.6 billion over three months in 2018, negative $1.9 billion and negative $1.6 billion in two separate two-month periods in 2015.
And major muni indices are now down somewhere between 6% and 8% to start the year. That’s the worst start to the year in 40 years. That’s how significant this is. Now because of the lack of liquidity in the muni market – and when I say liquidity, I mean broker dealer liquidity to buy and sell munis every day – these outflow cycles in recent years have led to big overshoots in valuations from very rich to very cheap.
TEXT ON SCREEN: TITLE – Relative Valuations Have Turned Attractive; SUBTITLE – Muni Valuations Tend to Overshoot During Periods of Retail Outflows
IMAGE ON SCREEN: A line graph charts triple-A-municipal bond-to-Treasury ratios for three different tenors from December 2020 to March 2022. By March 2020, the three ratios have risen off of lows from December 2021. The ratio of five-year munis to comparable Treasuries climbs steeply to about 80% by March 2022, up from about 45% in December 2021. Similarly, the ratio of the 10-year muni to Treasuries rises to about 94%, up from 65%, and the 30-year ratio increases to about 103%, up from 75%. The March 2022 ratio levels are at or above their chart highs, with the last peak around February 2021 showing ratios at the various tenors between 70% to 85%.
And we’re seeing that right now. So it’s been a big adjustment to relative valuations, and historically, these are attractive entry points for the tax exempt muni market. I had to work
And one of the reasons we like munis from an asset allocation perspective is that they tend to do well late cycle, because they have lower correlations to riskier parts of the market like equities and high yield corporate bonds than many other investable options for U.S. investors. It’s a relatively high credit quality asset class. Defaults historically are much lower than in same rated corporate bonds.
And I would just add, this time around,
Text on screen: Total tax collections at the state level set new records over the last year
Images on screen: California State Capitol
there’s the additional tailwind of a very positive credit cycle. State and local governments, due to all of the fiscal and monetary policy support received during the recession have emerged in nearly all cases in better shape than when they went in.
Etzkowitz: Digging in a little bit deeper into munis, where are you seeing the best opportunities in the market today?
Hammer: Yeah, well, the muni market is comprised of 50,000 different issuers and a million plus CUSIPs, so there are plenty of opportunities today for active managers
Text on screen: Muni yields look attractive versus corporate bonds and treasuries
Images on screen: Bridge and hospital construction
Across the curve, muni yields look attractive versus corporate bonds or treasuries
But some of the specific sectors where we’re allocating today, the first is prepaid gas bonds.
TEXT ON SCREEN: TITLE – Current Market Opportunities; SUBTITLE – Retail outflows and market volatility have created an attractive opportunity set in our view
IMAGE ON SCREEN: A table details information for three categories of market opportunities in municipals: crossover, Puerto Rico, and high yield bonds. In the crossover category, a 2029 prepaid tax-exempt gas bond is highlighted in the video, with the chart noting it has credit rating of A3, a coupon of 4, a duration of 6, and a yield to worst of 3.15% and a tax equivalent yield of 5.32%. Non-profit healthcare, affordable housing, and Puerto Rico bonds are also highlighted in the video.
The not for profit healthcare sector is one that we like quite a bit at PIMCO, due to the resiliency of their balance sheets.
In the high yield part of the market, we’re seeing opportunities there as well. I’d say two of our favorite sectors at the moment, the first is affordable housing.
Many of these deals are not rated, they’re a little bit more complex. We’ve seen opportunities with yields in the 5% range, tax free.
And then the MSA tobacco market. This is a part of the market that is backed by settlement payments between big tobacco companies and states.
And then just the last place where we’ve been really active is in Puerto Rico. Many post-bankruptcy Puerto Rico bonds are trading between 4% and 5% tax free. If you’re a U.S. taxpayer in a national state that’s not California or New York, that means 8% plus taxable equivalent yields. And if you are in New York or California, that can mean low double digits on a tax adjusted basis.
For many of these bonds, we see a path towards investment grade trading spreads over the next several years, due to the strength of both the security protections themselves and the improvement in the island’s overall credit quality.
Etzkowitz: Interest rate risk has become front and center for investors as they think about a continued Fed rate hike cycle and the potential for higher rates.
How do munis generally perform in a rising rate environment, historically?
Hammer: Historically, munis tend to perform well over a cycle of Fed tightening, and so why is that?
The taxable equivalent yield of munis, it increases as rates go up. And the taxable equivalent yield just simply means what yield would an investor need on a taxable bond after paying taxes to equal the current tax free muni yield.
TEXT ON SCREEN: TITLE – Municipals have historically performed well during Fed rate hike cycles
IMAGE ON SCREEN: A line graph shows the Fed Funds Target Rate from May 2004 to November 2021. Yield is shown on the Y-axis and time horizon on the X-axis. The chart shows two distinct rate-hike periods: from 2004 to 2006, when rates staircase upwards to 5.25%, up from 1%, and again from 2015 to 2018, when rates rise to 2.5%, up from 0.25%. A table above the chart shows the cumulative performance of various ratings of municipal bonds versus that of Treasuries for each period. The table shows how every ratings class of munis fared better than Treasuries during the rising-rate periods. For example, in the first period of rising rates, from 2004 to 2006, taxable-equivalent high-yield munis gained 31.04%, high yield, 22.83%, taxable-equivalent investment grade munis, 13.69%, investment grade munis, 9.19% and Treasuries, 5.26%. In the second period of rising rates, from 2015 to 2018, taxable-equivalent high-yield munis gained 34.47%, high yield, 18.53%, taxable-equivalent investment grade munis, 13.57%, investment grade munis, 7.82%, and Treasuries, 4.09%.
When conditions stabilize, what you’d expect to see is that investors will allocate more capital to munis that pay taxes over other bonds that they would have to pay taxes on. And historically, that reallocation of capital has meant tighter spreads of munis versus corporate bonds or versus treasuries and a bit of excess return throughout the cycle.
The last two Fed hiking cycles, whether it’s a 200 basis point cycle or a 400 basis point cycle, investment grade munis have returned 7% to 9% pre-taxes, just in absolute returns. High yield munis have been at 18% to 22%, again, absolute positive returns without adjusting for taxes.
You know, it can be quite bumpy along the way, and I think this is a bump in the road, but as rates rise over the fullness of a cycle, we think it’s important to use history as a guide.
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