Municipal Bond Reset: Volatility, Selectivity and the Active Advantage

EPISODE:

Please stay tuned after the conclusion of the podcast for additional important information.

GREG HALL: Hey, everybody, welcome to another edition of Accrued Interest, PIMCO's podcast, dedicated to serving financial advisors and their clients. As always, I'm your host, Greg Hall. I lead the wealth management business for PIMCO here in the United States. We're recording today's episode on April 8th. It's about 01:30 in the afternoon Pacific time. So markets have just closed on this first day of the purported ceasefire in the Middle Eastern conflict. And I give you that timestamp, just recognizing that things are changing.

I think at a time like this, we always wanna make sure that our thoughts are with folks who are directly impacted by the conflict. And even though we're gonna talk about financial markets in as objective a way as we can over the course of today's conversation, don't wanna take away from the human drama that's playing out on the other side of the world in a time of geopolitical uncertainty, of market uncertainty. You know, there's one thing that I think we can all depend on, and as we approach mid-April, of course, that thing I'm talking about is taxes.

The last episode that we released was with Devin Ekberg, one of our specialists in practice management, walking through some of the implications of the One Big Beautiful Bill Act and what that might mean for advisors and their clients as they approach tax season. And today, really, really happy and lucky to have with us Dave Hammer. Hi, Dave. Thanks for joining us.

DAVE HAMMER: Hey, Greg. Thanks for having me.

GREG HALL: Thanks. Thanks for taking, I know you just came off the desk, and it was a bit of a day, I'm sure, in markets. So really appreciate you making the time to speak with us today. But Dave runs our municipal bond investing business. And as we approach tax season, there's usually a pretty good time to start talking about or keep talking about municipal bond investing and what it can do for clients who are tax sensitive, which is, you know, I think all of us at this time of year.

So, Dave, thanks for making the time to be with us, and thanks for helping us kind of think through the implications for your market in the coming 12 months.

DAVE HAMMER: Thanks. Good to be here. And yeah, taxes are inevitable, I'd say, unfortunately, but as a Muni manager, I guess fortunate for me that they exist.

GREG HALL: Yeah, I was laughing as I walked over here. I was rehearsing the opening in my head, and I'm like, oh, we're really happy to have Dave here. And I'm like, actually, is it more like we're begrudgingly reluctant?

DAVE HAMMER: We have to have. There's very few other options.

GREG HALL: Taxes not everybody's favorite topic, but we'll temper that with a lot of opportunity in your market. And I think a lot of ways in which advisors can hopefully do better for their clients in the coming 12 months, three years, five years, 10 years by paying attention to Munis as a great portfolio tool for managing tax impact. So by the time anybody's listening to this, hopefully you'll have released your annual municipal bond outlook.

I say that with some trepidation, because I'm sure it's in draft form now and going through some revisions. But if it's out, folks, we'll link to it in the show notes. And if it's not, you'll have it to look forward to. Dave's gonna give us a little bit of a preview today of some of the themes of that piece.

DAVE HAMMER: Great. Yeah. We have had to make a few revisions throughout the month of March. It's been, you know, it's always busy in our market as we approach tax time, but with all the geopolitical volatility, it's been particularly chaotic.

GREG HALL: I think people don't, well, I certainly, when I think about what's going on geopolitically in the world, my first thought isn't the municipal bond market, right? I might think about oil prices, I might think about the equity markets and what they're discounting. I certainly have been thinking a lot about overall rates in the economy and where the Treasury curve is and all those things.

But your market, given kind of, I'll let you get into it, but the nature of what you do actually, it really is impacted by what goes on overseas and in broader macro markets. So why don't we start there? And so how has the last six, eight weeks' events affected your market, and what are you seeing right now?

DAVE HAMMER: Yeah. I mean, the Muni market is a credit market, and it's an interest rate market, and most Muni bonds are longer duration than most corporate bonds. The index has an average duration somewhere between six and a half and seven years, a little bit longer, more sensitive to interest rates.

And while Muni credit is its own animal, relative valuations after tax for different types of investors, individuals, corporations, compared to things like mortgages and corporate bonds, you know, that's what drives capital and moves valuations around. So we're always tied into the macro more than you might initially think. It's been a tale of two markets this year.

The first two months, the market was in massive inflow mode. So if you recall in 2025, munis had a period of pretty sharp underperformance versus taxable fixed income. At one point, performance diverged by about 500 basis points. It's very rare that that happens.

GREG HALL: Yeah.

DAVE HAMMER: Yeah. A lot of it was due to excess supply around the big beautiful bill. But the fourth quarter of last year…

GREG HALL: This was when municipalities, they were issuing in anticipation of punitive measures in the OB3. Am I remembering that correctly?

DAVE HAMMER: Yeah, but Muni issuers, so it was states, local governments, but healthcare systems, other private activity bond issuers, public-private partnerships. There were many different sectors within the market that were afraid the big beautiful bill would limit their ability to issue tax-exempt bonds in the future.

And then use that as a pay-for. You know, ultimately that didn't happen, but it was certainly a very rational response to pull forward and do deals the first half of the year that an issuer otherwise might have done the second half of the year.

GREG HALL: Yeah, yeah. There's some rhetoric that certain classes of borrower wouldn't be allowed to issue tax. I think the university endowments came under, right?

DAVE HAMMER: Exactly. Yeah, universities as well.

GREG HALL: Right.

DAVE HAMMER: Right. So the Muni market's been, you know, I say broadening catch-up mode, and that catch-up really in earnest, it was complete by January and February this year, even so much so that parts of the market began to screen as pretty rich.

GREG HALL: Okay. Relative to taxable?

DAVE HAMMER: Relative to corporate bonds, yeah. Relative to Treasuries. A month ago, we were rotating out of, in some cases, Muni bonds in the two to five year part of the curve and instead buying Treasuries. You'd actually get a better after-tax yield than muni. So a sign that conditions were pretty rich. January and February were two of the biggest inflow months since 2007. So really a historic period of strength as the Fed was lowering rates, investors were coming back to munis, and then that was all sharply reversed in the month of March.

GREG HALL: Sure, sure.

DAVE HAMMER: You know, two-year Treasury up at one point as much as 70 basis points, found that the start of the Iran conflict, that settled into up about 40 basis points, I think today. But munis, which are sensitive to interest rates, experienced some modest outflows instead of inflows. Supply picked up, and the month of March, down about two and a half percent on average, was the worst month of performance since 2022.

So a very dramatic difference between the first couple months and month of March. You know, as we sit here today, munis year to date are up, just quoting the IG index, up about 37 basis points. The Barclays Agg is up about 17 basis points. So a lot of noise, but back to kind of modest outperformance.

GREG HALL: Yeah, yeah. That's year to date?

DAVE HAMMER: That's year to date.

GREG HALL: Yeah. Is that common for folks in your part of the market to be able to swap between Treasuries and Muni bonds or taxable instruments and non-taxable instruments when you see that rich-cheap ratio flip itself?

DAVE HAMMER: Yeah, I'd say it's more common than it used to be. But there are still, you know, the majority of investors can't do that. Which is why things get so rich. A lot of it's due to the growth of the separately managed account business in laddered form. A lot of those buyers are programmatically reinvesting inside of five or 10 years. They tend to like to stay short duration, and a lot of strategies don't have the flexibility.

You know, our view here at PIMCO is that because of the lack of liquidity from banks and broker-dealers, these really extreme valuations, they're here to stay, and it's really in both directions. So in 2000 and 2021, even AA-rated 30-year munis were so rich you could buy a corporate bond, pay taxes on it, get a better after-tax yield. That was the first time that had been true in my lifetime. And then fast forward to 2022, munis got so cheap, you could buy a tax-exempt bond at about the same yield as a taxable bond.

GREG HALL: The same nominal yield?

DAVE HAMMER: Same basic yield, yeah, without adjusting for taxes.

GREG HALL: Yeah.

DAVE HAMMER: Yeah. So the takeaway for us as active managers is we want more flexibility in our strategies to allow us to do what munis are really there to do in the first place, which is to earn a better after-tax return with less volatility.

GREG HALL: Yeah. It's interesting. I think we have this conversation a lot, and other folks that we've had on the pod, just talking about volatility, friend or foe, right? There's been a lot of strategies, probably direct lending being the most obvious example over the last five or 10 years, that have capitalized on a perceived lack of volatility.

And that's been appealing to a lot of people. But maybe that's showing some of its own limitations in the market right now. And what you're describing is much more of being on offense, taking advantage of volatility.

You're making a really compelling case to refocus on the Muni market. We went through a period of relative richness earlier in the year. You guys adapted. Now you've got some technical factors, you've got an overall higher rate environment and you think it's gonna be a pretty decent entry point over the next few months.

One of the things I hear from advisors, many of whom own a lot of Munis on behalf of their clients and they're really steeped in the market, know it quite well, but they often kind of feel like they're waiting for Godot. And they ask me, hey, when is this gonna work? And so I'm curious, when you develop conviction, how are you confident that we're catching a good entry point here versus three years ago, four years ago when we might have had this conversation?

DAVE HAMMER: Yeah. You know, most of the return in a Muni portfolio comes from high tax free yields, low defaults, and ideally some alpha on top of that. And I think if you look back over history, in fact I just freshened up some numbers before coming in here, and you compare Munis to taxable fixed income on a tax-adjusted basis, whether you look at the last 1, 3, 5, or 10 years, the taxable equivalent returns of Munis versus the Agg, if you're in the top marginal tax bracket, you've picked up somewhere between 200 and 300 basis points over all of those time periods of excess return.

And if you look at PIMCO's capital market assumptions, what do we expect over the next five years, they look really similar. We do think tactically the next couple months are a pretty good time, but a big driver of those returns is just earning that yield over time.

Yields are relatively high today. So that gives us a pretty high degree of confidence. The one exception would be the high yield Muni market. We've talked a little bit about dispersion in some of the low-quality portions of the market and increase in default rates that's actually beginning to play out.

So if you look across the Muni market today, and you said if I think yield's the best predictor of return, a lot of the highest yielding strategies over the last year or two have actually had the lowest absolute returns. And in the high yield space, there's been really big dispersion, as much as four or 5% between different fund styles.

And that's when times are good. So all my comments are very true for the IG space. The high yield space, we think it's a bit different. You have to be more selective, and defaults really can eat away your long-term returns if you're not careful.

GREG HALL: Yeah. So I think what I hear you saying is one, it's not waiting for Godot. It's happened, it's performed, it's done what it's meant to do. Looking back 1, 3, 5 years, I think that's as true for what we manage as it is for the industry. Maybe some of it actually is just the psychology of lower nominal yields in Munis and then the sort of invisibility of taxes, right? You pay taxes once a year. You see that yield or that coupon throughout the year.

And I do think I fall prey to this. I think advisors fall prey to it sometimes, is when you're thinking about a three or four or 5% yield in a Muni portfolio, you're not automatically doubling that for your highest tax bracket investors to think about it on a tax equivalent basis. So I think that maybe plays into the misperception a little bit.

And then on the high yield front, what you're saying I think is really consistent with PIMCO's broader credit view, which is that we've been in an environment where taking credit risk, really almost any form of risk, has been to your benefit. That is not a sustainable or infinite phenomenon. And generally, if you're taking more risk, it comes home to roost at some point.

DAVE HAMMER: Yeah. Absolutely. Default cycles are inevitable. It's been a while since we've gone through one. And at some point that will affect your ability not just to earn that yield, but to keep it through absolute returns.

GREG HALL: Yeah, yeah. One of our more recent guests on the podcast, a guy named Ted Seides who runs the Capital Allocators podcast and has been observing markets for a long time, we were talking about private credit and he said something which was very simple, but I thought profound. He said, you didn't know when it was gonna happen, but you knew what was gonna happen. Well said. So I think it's a good lens through which to look at risk-taking and credit.

DAVE HAMMER: Tactically, we are dialing risk up and down because relative valuation can move around a lot. And we're excited about the next few months. The reason we were de-risking in January and February, it had nothing to do with expecting taxable yield to be a lot higher due to a geopolitical event.

It was just because munis were really rich, and we thought that supply this year is likely to be really big. The Muni market used to issue $350 to $400 billion a year in supply. Just on inflation alone, and the cost of construction, new capex projects cost 50% more than they used to. There's been a big federal bill passed to incentivize infrastructure spend from state and local governments.

And relatively speaking, balance sheets are really healthy. So state and locals feel good about embarking on that new capex project. They've got federal funds there to match it. The cost is higher. You know, what does all that mean? That means that the new steady state for the Muni market's probably $550 to $650 billion a year.

GREG HALL: Okay.

DAVE HAMMER: So we think supply's coming just on that alone, combined with very predictable weaker technicals due to tax time selling, which is really common in the Muni market. This tends to be a pretty good time of year to invest to begin with. And on top of that, we've got this move higher in rates.

The PIMCO house view is that while it will cause an increase in headline inflation, maybe it's one-ish percent, growth is likely to slow. And as a result, we see more value today in high-quality fixed income than we did a month ago. Munis are cheaper. We're being patient and selective, but if you have dry powder, it's a pretty good time to be an investor.

GREG HALL: So is there seasonality to that issuance pickup that you talked about? Is that a predictable phenomenon, or is it just spread over the course of the year?

DAVE HAMMER: It's fairly predictable. And what matters, we really look at, it's not just the gross amount of supply, it's the net supply. How many new bonds are being issued, minus the reinvested coupon and bonds maturing. And so what you see is that December, January, February tend to be a big net negative time period. The market's actually shrinking. That happened this year. It then really picks up March through May.

Net positive technicals get a little bit better in June and July. Weaker in the fall. You know, it's not a hundred percent success rate, but if we look back over time, it's about three quarters, maybe 80% accurate that relative valuations will follow with that seasonality.          

GREG HALL: Yeah. Yeah. So it's, of course, there are lots of factors that influence pricing, but you've got heightened issuance, you've got tax season selling and liquidity creation to pay tax bills. And our starting point, of course, is coming off of an international conflict that's got yields higher across the board. So it feels like a pretty opportune time to be looking at this.

One of the things you said early in the conversation was that munis are both a rates and a credit market. So maybe thinking about the credit side a little bit. You started on it saying municipalities are in pretty good shape, but as long as you and I have been talking about munis, you felt pretty sanguine about the credit outlook for most of the issuers that you guys deal with. I wanted to ask if that's still the case.

Have those themes changed at all? Are there sectors or areas that you're more or less attracted to? And also maybe just sort of an overarching question, I probably, you don't have to remember all these, but just sort of like what's your risk appetite? You know, where do you want to be in terms of higher quality or lower quality, kind of given all the things you've discussed?

DAVE HAMMER: Yeah. It's interesting. There's been a lot of noise in the last several months, including on some pretty prominent podcasts about the deterioration of Muni balance sheets at the state level. California is an example that it's often pointed to.

GREG HALL: Yeah.

DAVE HAMMER: You know, I think as a long-time Muni investor who's been doing this long enough to recall California being compared to Greece after the great financial crisis. When it was a low triple B rated credit.

GREG HALL: We're sitting in Orange County.

DAVE HAMMER: Sitting in Orange County, California, you know, our team has the exact opposite view. In aggregate. So what's happened over the last 15, 16 years is that after the financial crisis, state and local governments were forced to deal with two problems. Number one was recognizing unfunded pension liabilities on their balance sheet, that the methodology from rating agencies from governmental accounting standards, that's an exciting thing to talk about, but there was a change that basically just made state and locals recognize unfunded pension liabilities.

Agencies started downgrading as a result. And what that did is it forced state and local governments to deal with it. So many state and local governments, instead of investing in new infrastructure projects, they were finding ways to make their full pension payments, reducing expenses, doing some modest pension reform at the local level. Property values came down after the financial crisis, and most local municipalities get their revenues predominantly from property taxes.

So it took five, six, seven years for mark-to-market valuations on homes in the United States to basically catch down to the assessed values where they're on the property tax roll. The reverse of that is happening today. So we've seen property valuations increase 20, 30, 40% depending on the market. Assessed values are lagging. So that's a big tailwind for local credit.

GREG HALL: Right, right. And they ratchet them up kind of modestly each year. Is that how it generally works?

DAVE HAMMER: Depends where you live. If you live in Texas, you're likely to get reassessed pretty quickly. Here in California, Prop 13 sets a cap of 2%, so it just takes longer. So it depends on the jurisdiction. But yeah, on average, it takes a long time for property taxes to catch up with actual valuations. So, and again, I'm going back a long ways here just to illustrate a point, but state and local governments were repairing their balance sheets for a decade while the corporate bond market was growing and doubled in size.

The US Treasury market just about tripled in size. The tax-exempt Muni bond market barely grew. Then in 2019, if you were to talk to anyone on my credit team, they would have said these are the best credit conditions we've seen in a long, long time.

Then during the pandemic, the federal government tried to figure out just how bad that would be for state and local governments and tax collections, property taxes, income taxes, sales taxes. And the models they were running predicted that there would be a decline of 10 to 20% in tax collections. They created a relief bill based on that expectation.

For what it's worth, we thought it was very reasonable at the time that given the size of the unemployment shock and the hit to GDP, you'd see a massive reduction in tax collections. Historically, that's what's happened. But high-end income earners kept their jobs, they just worked from home. And then fiscal stimulus actually helped tax collections. Inflation became a good thing. So tax collections today, they're 40 to 45% above pre-pandemic. The relief money was sent out anyway.

GREG HALL: And so instead of just holding even, actually it ended up being kind of an injection of additional liquidity and resources.

DAVE HAMMER: A huge injection. And the state of California, again, which our analyst team would have said was in the best shape they'd been in in 2019, their rainy day funds and reserves are now triple what they were back then. So the initial conditions broadly are as strong as they've ever been. The caveat to that is now the tide's going out. 2026 is the last year that federal relief funds will support state and local government balance sheets.

GREG HALL: Is that the crux of the bear case on a state like California? What is that bear case, and where do you prefer?

DAVE HAMMER: You know, it doesn't make us bearish on the state of California. No. The state of California has managed their fiscal very well. You know, they have a high correlation to the US economy, so in a recession, we would expect their credit profile to weaken. But their reserves and rainy day funds are so substantial that they can buffer a recession fairly well. What's different, I'd say, are areas that haven't rebuilt their reserves and rainy day funds.

They've used that federal money to paper over deficits in the short term, and that's no longer an option. So there's a number of bigger urban centers in the United States that we owned a lot of bonds a few years ago. Today we're at zero, not because we think that they're gonna default, but we see really big emerging budget deficits. We think the probability agencies are gonna downgrade there. We think there's a risk some stop making their full pension payments again, and there'll be a big relevering event.

GREG HALL: Is that as true? I know your market, obviously you've got the general obligation market at the municipality level, and then of course there's projects themselves. How much divergence of outcome are you seeing between either different municipalities, different projects, or types of project? And how meaningful is that divergence relative to what you've seen in the past?

DAVE HAMMER: Yeah, I mean, huge divergence. So we've talked a lot about state and local governments, and I think that's what most people think of when you hear Muni market. It's a minority of what we invest in. It's about 35% of the investment grade index. It's very little of the high yield Muni index. Most of the bonds that we're buying, we're getting repaid by a tax collection that might be on a commercial real estate asset.

It could be a sales tax that's on a parcel of land that has a number of big box retail stores or high concentration. Sometimes they're big and diversified and it's pretty easy. But there's a lot of local bonds issued for a specific purpose that you get repaid from a variety of sources. Then we have not-for-profit healthcare systems, toll road and transportation, airports, airlines, which have become topical over the last few weeks with jet fuel rising.

GREG HALL: Of course. Yeah.

DAVE HAMMER: All sorts of asset-backed securities, commercial real estate bonds that are issued for affordable and workforce housing. So the divergence is always quite large. I would say to your question, is it bigger now or smaller than it's bigger, because the tide's going out. And the economy's been running at a pretty good clip here for a long time.

Credit spreads have been very, very tight. And we think there's a risk that as the economy slows, default rates in some parts of the market we think are actually gonna go a lot higher. Because a lot of investors made bad decisions generally from 2016 to 2021 when rates were low. They were trying to support really high dividends and willing to take a lot more risk to do so.

GREG HALL: Yeah. No, I mean, of course that rhymes with so many segments of the market right now. And it's also a bit of an advertisement for active management, right? The more divergence you have in outcomes, the more important it is that you choose the right credits to be aligned with. And when the rising tide isn't floating every boat, you want to make sure you've picked the right ones. We talked about some of the fiscal policy and governmental policy during COVID. What, if any, impact of late does the Big Beautiful Bill Act have on your market?

DAVE HAMMER: Yeah, I think the most important thing, it preserved the tax exemption. That is without a doubt.

GREG HALL: The worries from last year that we just talked about.

DAVE HAMMER: All the worries from last year, but both for investors and issuers. Yeah. You know, it changed corporate tax rates. It made the lower tax rate more permanent. That's probably the most significant impact because banks and insurance companies used to buy a lot of tax-exempt Muni bonds. They're buying less, because their tax rate is 21% instead of 35%.

GREG HALL: Right. So the incentive for them to hold it is a little bit lower.

DAVE HAMMER: Munis have to be cheaper versus other things in order to have a bank or insurance company make a loan in tax-exempt form or buy a bond in tax-exempt form.

GREG HALL: Right. That's interesting. So that bank retrenchment theme, which has been so powerful for us in the mortgage market, the asset-based markets, the consumer finance market, and certainly for a lot of people in the corporate market as well, you're actually seeing that in your market too.

DAVE HAMMER: Yeah. You know, a pretty common refrain you hear in our meetings is go where the banks used to be.

GREG HALL: Right.

DAVE HAMMER: And there's a couple different places in the Muni market now. The first is just broker-dealer holdings of Muni bonds to make markets every day. That used to be 50 or 60 billion, now it's 10 to 15 billion. And so that means as a liquidity provider, there's opportunities to step into the market and provide bids or offers when there's a lack of depth in the market. So we think of that as just actively taking advantage of the illiquidity in the market-making function. That's one.

Number two is the curve. Banks and insurance companies, they used to buy a lot of munis, but most of them were long dated. As they've stepped back, US retail has continued to buy a lot of bonds inside of 10 years. The Muni curve, relative to the Treasury curve, is about as steep as it's ever been.

The slope between 10 and 30-year tax-exempt bonds, it's been between 140 and 170 basis points, even when the Treasury curve has been flat to 50 or 60 basis points positive. So a lot of value for us, top marginal US taxpayer, to step out a little bit on the duration spectrum, getting much higher tax yield, but also get some good price appreciation as the bond rolls down a steep curve.

And then the last is just direct lending. Banks used to do a lot more direct lending. More and more of that is finding its way to the Muni market through private placements. These tend to be not rated bonds, more esoteric parts of the market, but if structured appropriately, you can earn a six to 6.5% tax-free yield. Adjusted for taxes, you'd have to earn 10% in taxable markets.

So we like it because of the tax-free income, but also we oftentimes are active participants in structuring these deals, making sure that we're comfortable with the leverage profiles, the covenants, and so on and so forth to really protect that downside as well.

GREG HALL: You could take this in a bunch of different directions, but I think it's super interesting, that last point that you made, coupled with the point you made earlier on, which is that your market hasn't seen a ton of net growth. Maybe we're on the cusp of a supply increase as you suggested, but what a contrast to the broadly syndicated loan market, the quote-unquote private credit market, by which people mean direct sponsor lending.

You really haven't seen an influx of new lenders and entrants into this space, which is interesting because if you can generate a 10% after-tax yield depending on your tax bracket, that's a fantastic rate of return, all things being equal. It's interesting that you've not seen as much competition come into that space.

Maybe people believe you sometimes when you talk about the Muni market being, I think you're crafty, you try to convince us that it's boring when actually it sounds pretty exciting and there's a lot of things to do.

DAVE HAMMER: Yeah. I mean, PIMCO loves active management in fixed income. I think the Muni market is very fertile ground for active management. A million CUSIPs, 50,000 different issuers, all different call dates and call prices, lots of different risk types, and most recently an influx of private placement opportunities that I think in the corporate market you'd say this is private credit or direct lending.

Oftentimes in the Muni market, it's a similar process in that we're negotiating terms. It might be through a small regional underwriter. It might be with a borrower directly. But more often than not, that still is turned in at the end of the day to a tax-exempt municipal bond with a CUSIP that can potentially be liquid as well. So I think there's some extra spread there relative to other markets. There's also probably a little bit better liquidity just in the form that it ends up being issued.

GREG HALL: And maybe again, situation specific, but better safety by having been involved in the negotiation and figuring out the terms that matter most to you through the underwriting process.

DAVE HAMMER: Yeah. I mean, that's incredibly important. You know, in our experience, the public market at times can really get over its skis with the amount of leverage investors will lend to a project if the yield is high enough to lure them in.

And when you control the covenants directly, you control the success of a deal being executed, you're able to structure it in a way that, in our view, if you're wrong, and we're gonna get things wrong, your downside is much smaller than really highly levered public market high-yield deals, which we do think there's a pretty high probability that default rates in that part of the market, the public low-quality high-yield market, we think those are going up.

GREG HALL: Yeah. You've been very consistent. I mean, you and I have talked about it, I think on a quarterly basis, you know, going back four or five, six years now. And you've been consistently focused on the higher quality end of the market or a proxy for that through the private market where you're achieving that level of safety.

And you've, you know, I think you look at everything, but your predisposition, I think, has been to avoid some of the perceived kind of juicier project yields out there. And I'm wondering, you know, given where yields are today, given how you feel about the overall credit picture, any change in that quality stance? Or are you, does it actually just reinforce your positioning there at this point?

DAVE HAMMER: You know, so I'd say some parts of the market have begun to price for reality. Senior living's the best example. It's been an area that we've been really underweight for a long time. You know, default rates hit eight, 9% a couple years ago for a Muni sector that's quite high.

And once deals are actually in default and bonds start trading at a reasonable price, you know, there have been numerous opportunities to add bonds at distress prices. Oftentimes it's not that the senior living facility isn't working, doesn't have enough people, there's just too much debt. So if you can buy prices at a discount, you can work it through a restructuring or a bankruptcy and reduce the amount of debt.

You know, it can turn out to be a pretty safe, secure, and profitable investment. So that's an area that's been growing in our portfolio. You know, some of the project finance stuff you mentioned, no. You know, it's harder to find downside in many of these capital structures that is reasonable relative to today's prices. You know, we're always looking, we're spending a lot of time there. But the short answer is no, we don't think prices have fallen enough in parts of that market.

GREG HALL: No appetite for commuter railways in Florida or subway systems in major urban centers.

DAVE HAMMER: At some point, maybe. But yeah, we're not there yet.

GREG HALL: Yeah. Yeah. No bad assets, only bad prices.

DAVE HAMMER: I would agree with that most of the time.

GREG HALL: Most of the time.

DAVE HAMMER: Yeah. In this case, I'm not totally sure.

GREG HALL: Yeah, yeah. I'm curious, you know, you've described a level of dynamism, which I don't know that all advisors would necessarily associate with your market in the last 20 minutes or so. We've talked about relative value versus treasuries, and you guys moving out of the non-taxable market into the treasury market based on a rich-cheap evaluation that you did.

We've talked about moving into the private market to secure the yields with the kind of safety that you want for the overall portfolio. We're talking about responding to technical supply-demand dynamics pretty agilely in your approach. How do you keep your team and frankly yourself nimble to all of these new modes of thinking or new ways of investing that the market is subjecting you guys to right now?

DAVE HAMMER: Yeah. We're fortunate at PIMCO that the team we have is a really big one. It extends well beyond Munis. You know, the big inputs for us every day, there's macro top-down: what do we think of the world? What do we think of inflation, growth, recession probabilities? And we've got some great economists that provide us with their latest baseline outlook and also risks to that outlook.

So that allows us to, I think, top-down look at the way Munis fit into overall high-quality interest rates and the directionality. So that's one.

The second is the Muni team itself. And we have 24 PMs and credit analysts that are looking at individual bonds, individual parts of the market, underwriting individual sectors, covering different regions of the country. You know, our goal there is to cover as much of the market as we can. It's a big market, 50,000 different issuers. In our database, we've put ratings on about 20,000 of those in the last few years.

And on a live basis, we have to update them sometimes to trade. We then pull in our non-Muni analysts. In this piece, I probably can't emphasize enough, we have experts in commercial real estate. We have experts in residential real estate that underpin our view of local governmental bonds that are backed by property taxes.

We have experts in financial institutions, which has become a bigger part of the Muni market through something called a prepaid gas bond. It's a partnership between a Muni power public power company and a financial institution. And they borrow through a partnership. And the goal is to bring down the cost of power to consumers.

So the IRS allows these tax-exempt structures. Typically the financial institution is guaranteeing a discount on power via a commodity swap that allows this partnership to borrow tax free. But there's a guarantee on these partnerships from US financial institutions. So what you see are, for example, Goldman Sachs tax-exempt prepay gas risk that is parity risk with senior unsecured financial risk in the corporate market.

And we have analysts that cover those banks or those insurance companies that directly feed into our credit view. You know, a recent example, in Bloomberg, a story on this yesterday, Athene, which is a publicly regulated insurance company owned by Apollo, issues tax-exempt Muni bonds. There was a Muni seller that sold a fair amount of size. Bonds traded 75 to 100 basis points wider over the course of a week.

We're fortunate that we have an analyst that covers Athene for PIMCO outside of the Muni space. That helps us understand that very quickly. And this last piece that we haven't covered, which is so important, is technology.

It allows us to really scale this investment process across a bigger number of bonds, number of issuers, doing things that sound pretty basic, but taking all of these different CUSIPs, matching them up instantly to our internal credit rating, our own internal proprietary analytics that help us understand the option value, and then connecting us electronically to different venues that we can actually execute by clicking a button.

So it allows us to see more, react, and then get to what might be a really good bid or really good offer faster than others. And with the advent of AI, just watching the way our team has been using that more and more, personally, very very bullish on continuing to expand those capabilities in new and exciting ways.

GREG HALL: Yeah. I mean, I've had a front-row seat to some of your tech investment, because you and I work closely together as it relates to some of our clients who have ladders or SMAs with us. And the tech investment that we've worked on together there has been really significant and quite impactful. It has had benefits well beyond its intended purpose. I think it has made us really efficient in that specific business, but it then has had ongoing effects around how you operate and how you guys trade.

DAVE HAMMER: Tax loss harvesting.

GREG HALL: Well, yeah, exactly.

DAVE HAMMER: That's probably been the favorite thing we've worked on together. I mean, back in 2022 when rates went up, we had billions of dollars in separately managed accounts and a lot of clients that wanted a tax loss harvest and an investment team that wanted to do it on their behalf. It's hard to efficiently do it without really good technology.

And the process that the team has built and migrated to is instead of just tax loss harvesting by swapping a single bond for a very similar bond, we're reoptimizing portfolios on a daily basis in the SMA space, and we're doing ongoing tax loss harvesting, which means in any given market, it allows us to buy more attractive securities and know that we have other bonds that we can sell, harvest the loss for clients, but also improve the future performance of their portfolio.

GREG HALL: Yeah. Creating liquidity along the way, being able to dynamically reorient portfolios, and then in some cases very much making the swap you described very early on in our conversation between taxable and non-taxable when those relationships become inverted.

So I think it's obviously a PIMCO-wide dynamic, but it's had maybe a disproportionate effect in your market when we talk about technology. The other thing I wanted to ask, maybe the last thematic question I'll ask you, is data centers.

DAVE HAMMER: Yeah.

GREG HALL: A lot of debt financing being raised for data centers. It rhymes a little bit with the gas partnership example you just gave, which is oftentimes it's a corporate entity raising money maybe in a form factor that's different than off their own balance sheet.

But their credit rating and their credit posture is really important to the underwriting. Has any of that come into the municipal market at this point? Are state and local governments positioning themselves to be a beneficiary of the data center trend or other aspects of tech capex right now?

DAVE HAMMER: Yeah. You know, we've done a lot of outreach to public power companies and publicly owned utilities. And yeah, I think our instinct a year or two ago was we're gonna see a big increase in debt to fund data centers and also just fund generating assets to keep power costs down, which are increasingly a problem. It hasn't happened.

And the reason is that states, local governments, publicly owned utilities, by and large, they don't want to take the risk that they'll build these assets and that maybe there won't be demand or need in the future. And so I think what you've seen instead is you've seen a lot of public companies, hyperscalers, go out, do it themselves, lend some credit support to those transactions. I know here at PIMCO we've participated in a few outside of the Muni space.

But I think that has effectively taken some of the pressure off of the publicly owned utilities to do it themselves. I'm not sure how long that lasts. I think at some point we'll probably see a bigger pickup in CapEx from publicly owned utilities, but thus far the increase in supply there looks really similar with the broad Muni market.

GREG HALL: Right. So there'll be more followers of demand than anticipating it.

DAVE HAMMER: Yeah. I think that's right. Okay.

GREG HALL: Well, you know, Dave, this is fantastic. I think a lot of advisors listening to us, as we speak here today, probably formulating plans for what to do when a little more clarity emerges on the macro scene and the geopolitical scene. I think you've made a really strong case for including, at least for US taxable investors, including the Muni market in those plans.

We've talked about some of the historical performance relative to taxable, depending on your tax bracket, and then some of the technical factors that are influencing markets right now that may make it a good entry point. I would say for anybody listening who wants to go a little bit deeper on these topics, please visit us at pimco.com in the US or your country's website.

If you're listening to us overseas, if you identify yourself as a financial advisor, you'll be taken to Advisor Forum. That's our one-stop destination for you to get what you want quickly, efficiently, and practically from PIMCO. We've got lots of Muni content on there. We will have Dave's outlook piece as it gets published in the coming few days.

And that'll cover a lot of these themes and back it up with some more numbers and visuals than we're able to produce in a podcast format. And if you've got any further questions after that, of course, I encourage you to get in touch with your PIMCO representative and ask us all the questions that you would like. Dave, appreciate you taking the time. Thanks for coming off the desk for a little while and talking to our advisors and clients and friends out in the marketplace.

DAVE HAMMER: That was fun. Thanks, Greg.

GREG HALL: All righty. So we will be back in a couple of weeks. I think that our next topic is going to be asset-based finance. We're gonna explore some of the areas of the private credit market that are a little bit less penetrated than direct lending and try to point out some of the differences in the various pieces of private credit that we alluded to in the last couple of episodes with Christian Stracke and with Lotfi Karoui. Until then, good luck in the markets. Stay safe, and we will talk to you soon.