Co-heads of municipals at Baird Advisors, Duane McAllister and Lyle Fitterer, discuss the challenging environment in the first month and a half of 2022 and where risks and opportunities lie in a volatile investing landscape. Lynne Funk hosts. (29 minutes).
Lynne Funk: (00:03)
Hello, and welcome to another Bond Buyer podcast. I’m Lynne Funk innovation editor at the Bond Buyer with me today are the co-heads of Munis at Baird Advisors, managing directors, Duane McAllister, and Lyle Fitterer. Welcome to you both.
Lyle Fitterer: (00:17)
Thanks Lynne. Thanks for having us. Thanks for having us Lynne.
Lynne Funk: (00:20)
Great. So you two wrote an outlook piece in January titled Chess versus Checkers detailing how the muni market is looking kind of like a more complex game in 2022 than 2021 — pretty apropos comparison after kind of year of mostly static yields, you know, little volatile, massive inflows, near record issuance, and now 2022 different story, quite volatile. A lot of participants pretty surprised at how rough January was on the asset class. Um, I guess I’d like to just invite you to give us a little about how 2021, transpired and what some may call even a boring year has led to where we are now in 2022,
Duane McAllister: (01:07)
Lynne, this is Duane I’ll, I’ll kick it off. Lyle and I’ll kind of tag team on some of the discussion here. The reason we put the piece out there is, that’s just the way it looked to us as we, got near year end, is that looking back on 2021 while, you know, it’s never easy, in hindsight 2021 was a year in which to your point, I mean, a lot of things went right for the muni market. You had very consistent inflows in fact, record inflows last year. And, you know, supply was manageable. The year started with, you know, credit spreads relatively wide. We were still kind of coming off of the COVID wider spreads of 2020. So we’re still benefiting from that. And the relationship of muni yields to tax yields and Treasuries in particular was relatively appealing, you know, in, at the start of 2021, just looking at the front end of the curve.
Duane McAllister: (02:07)
The two year muni to treasury ratio was over 100%. So you, you start the year with a lot of things, you know, looking pretty favorable and the credit backdrop was also very strong. And so if you were overweight, lower quality credit, 2021, and just, just did that and got that, right, it was a fairly simple year to provide, you know, above average performance for your clients, shareholders. We turned the calendar and in Jan. 1 or very early in January, we saw, obviously, this can be a different year. A lot of things have changed. Fed policy has changed. We’ve got the fed pivot, you know, where we began pricing in, um, you know, five or now six potential fed rate hikes that obviously kick started the volatility of this year. And unlike last year, the muni market really fully participating on volatility.
Duane McAllister: (03:00)
In fact, you know, more volatility in munis in January than what we saw in, in Treasuries or taxables. So the piece just tries to highlight that while last year was, you know, fairly straightforward process, a lot like plain checkers, uh, this year is more like chess. You’re gonna need to really look at all the pieces on the board, all the decisions and tools that you have, think about how you deploy those in this game, if you will. And be very nimble. You know, I think this year, which, you know, things like the yield curve position are gonna make a big difference. Your credit weighting is still important, but how you get there is critical — sector weighting and then really security selection. So all of those things are gonna be really important in 2022. And we welcome it, you know? Last year in some respects could be viewed as relatively boring for bond managers and bond investors. This is not gonna be boring. It’s gonna to be a year filled with challenges. And so we’re, we’re looking forward to it. And really, I think this is when you need professional investment management. So hopefully, we and other managers can add value this year.
Lynne Funk: (04:15)
Great. So you touch on credit and credit spreads. You note in your paper, state and local governments are pretty much in the best fiscal shape that they’ve been since, at least before the financial crisis of 2008, you know, they’ve been certainly helped by an influx of federal aid and better-than-expected revenues, but, you know, as we enter 2022, it has led to narrower credit spreads across the board. Can you talk about credit, how it plays out in 2022, tighter spreads? How do investors navigate the credit selection in 2022? Can they be more selective, more demanding of concessions, perhaps due to higher levels on IG paper, particularly maybe looking at high yield?
Lyle Fitterer: (04:56)
Sure. And Lynne, this is, Lyle. While I can give you some thoughts and then maybe Duane can add to it. But, um, I think you’re right, you know, coming into 2022 credit spreads, if you look at ’em relative to, you know, triple a Munis for triple Bs were the lowest they’ve been, you know, and over a decade near the all-time lows. If you look at high yield, a very similar story, and then again, you have the backdrop of positive flows in the funds. In general speaking, funds are your biggest buyers of credit, from a longer-term perspective. So as you see some of that reverse, and also people were searching for income because absolute rates are so low. So within the last month, absolute rates have gone up, you know, 50 plus basis points, flows have turned negative, mostly negative, uh, on a month-to-date basis, on a year-to-date basis.
Lyle Fitterer: (05:45)
So, you know, what’s happened to credit spreads. Well, uh, interestingly enough, triple B credit spreads have only widened about one basis point, year to date. So they were 60. Now they’re 61 basis points. If you look at what’s gone on in the taxable markets, they’ve widen out quite a bit more and triple Bs, they’ve widened out probably around 10 basis points, maybe 15 basis points and off the lows from last year, they’re up over 20 to 25 basis points, high yield taxables, credit spreads have even more, they’re probably 60 plus basis points wider. So the taxable market, again, to us is always a good place to look at. Where’s the muni market going? What is the taxable market telling us? Obviously it told us last year that rates were probably gonna go higher. Now it’s telling us that credit spreads are probably gonna go a little bit wider.
Lyle Fitterer: (06:35)
So I think it is gonna be about, you know, picking credits, what are the credits that are gonna do better on a go forward basis, not just, you know, rising tides lifts all boats. So I think you’re gonna have to be more selective. You’re gonna have to think about your sectors. You’re gonna have to think about what municipalities coming out of, you know, 2022 and 2023 are gonna look like after this federal stimulus dollars goes away. So we’re trying to think 6, 12, 18, 24 months into the future. Right now, what our gut tells us is you’re probably supposed to be thinking about taking your credit exposure down in your portfolios, and you can do that and not necessarily give up amount of income. We’re thinking about things like how can you substitute high-quality structure where you’re thinking about call risk or your coupon features or prepayment risks. If you’re looking at housing bonds in the muni market as an alternative to keep income in your portfolio, but allow your credit exposure to, to kind of, hopefully be able to take advantage of wider credit spreads when that does finally happen.
Lynne Funk: (07:46)
Great. So I, I think I, you know, you, you talked about taxables and how they’re kind of a bellwether perhaps for, for broader muni markets. So what do you think about these rising rates affecting taxable volume, perhaps? I mean, I think that particularly in January refundings and taxables were much, much lower over 50% lower year over year, um, and kept January volume down overall, 15% lower. Is, is that something that you see where do, where do taxables fit in generally in the market in 2022?
Duane McAllister: (08:20)
You know, I think we’ve turned the corner on taxables. For the long longest time, really through most of my career, taxables were a relatively small portion of the total issuance, you know, the 10% or less typically. Now the last few years, that’s been, you know, 25 to 30 plus percent. And we know the reasons for that and, and primarily what you’re alluding to is you could, you could use a taxable bond, taxable issuance to, you know, advance refund, a tax-exempt issuance. Uh, and we, we were all hopeful that the tax-exempt refundings would come back either in the infrastructure bill or in the Build Back Better bill, but, uh, that did not happen. So still a good portion, the majority of the taxable issuance, is tied to those refundings, rising rates, uh, to your point, uh, reduce the savings for municipalities to, to be able to do that.
Duane McAllister: (09:13)
It doesn’t take it away completely, but it definitely reduced it. So you’re gonna see less taxable volume that way. But I think, you know, municipalities will continue to issue taxable debt. They like the flexibility that, that, that offers, you know, obviously there’s fewer IRS restrictions and how the money is used, how the proceeds are used. We see it in, you know, things like airport projects where they don’t have to be quite as, as specific and this pool of money goes here and this pool of money goes there. So I think it’s gonna, continue to be a reasonable and perhaps even growing percentage of the market over time. And, the other thing I would say is the secondary market — one of the criticisms of the muni market generally has been lack of liquidity, but that’s been particularly true in the taxable municipal market historically, but that has changed too.
Duane McAllister: (10:11)
It’s become a fairly liquid market. The larger issuers are very, very liquid. And so I think the trading desks have beefed up their trading staff and sales sales staff on the trading desk are familiar with trading taxables now. So it’s become a much more important part of our market and likely to remain with us for, you know, for the foreseeable future.
Lyle Fitterer: (10:32)
And, and I would just add Lynne that I think investors have become much more comfortable in the taxable muni universe. It used to be taxable investors, didn’t understand munis, foreign buyers didn’t understand Munis. They’ve gotten a good education over the last, you know, five to 10 years. And I think they’ve also picked up the fact that, you know, from a historical perspective, if you look at credit, the full and credit in the muni market, relative to the corporate market, the old story that muni’s just default a lot less, and when they do default, generally they have higher recovery value. So it’s a great way for traditional taxable buyers to add some diversification to their portfolio and actually potentially bring down overall default risk, but yet still get similar income levels if not higher income levels. When you look at it per equivalent rating,
Lynne Funk: (11:25)
Right. It, it definitely has expanded the muni buyer base. I’m just curious assuming that tax-exempt fundings probably aren’t coming back anytime soon that that part of the market is generally a good thing. So for municipalities themselves, you know, the broader investor base, that’s for sure.
Duane McAllister: (11:42)
Yeah. I, I think we agree that it, the broader investment base is good. It gives municipal is more of an outlet. It allows portfolio managers to diversify. So there’s a lot of good things that have come from that.
Lynne Funk: (11:54)
So let’s talk also about muni volume in general. We’re saying probably fewer taxables, but now that the Infrastructure Investment and Jobs Act is here and it’s providing the $550 billion of direct federal funds still being worked out, of course, how that’s gonna be dispersed, how it’s gonna be used. Do, do you all think that it might spur more issuance as a result, or will it take maybe a longer runway for, for 2022? Where are you seeing issuance? Like, how is, how is the jobs act gonna gonna help the muni market in that way?
Lyle Fitterer: (12:31)
Yeah, I guess on, on margin, it should help issuance in our market pick up. Selfishly we’d like to see that happen, uh, as a buyer, uh, and their debt. The more debt we have maybe need more attractive the levels are, but I think if you look at that, at it a little bit more, realistically, you know, the projections out there I think are as low as, you know, $400 billion of issuance this year up upwards of $550 billion. Plus I think you hit it on the head though, in terms of, even though it’s $550 billion, it’s gonna be over a number of years, and not all of that will, get issued in the municipal market. The good thing about the muni market, one of the good things I think is that from a long-term perspective, outstanding debt in muni market has not grown.
Lyle Fitterer: (13:16)
Whereas if you look at other markets, the corporate market, the treasury market, et cetera, and the amount of outstanding growth in those markets is pretty phenomenal. And muni outstanding debt has been pretty static for over 10 plus years. So we think there, the municipalities have the ability to issue debt it’s needed from a CapX perspective. You, we see the crumbling bridges, and you know the ,poor condition of some of our water and sewer systems, et cetera. So it’s gonna be a good thing in terms of what it does to volume. Unfortunately, I think our view is that it probably could get overwhelmed by some of the broader issues that are going on in the market. What happens to overall rates, we know, as they go up, that probably means less issuance, you know, what happens to municipal credit on a go forward basis. So on margin, it will add, you know, maybe the number is, you know, $30 to $40 billion additional a year, just looking simply at the math, but we don’t have an exact number in mind, you know, in terms of what it means, this year’s specifically,
Lynne Funk: (14:16)
Do you all, do you all think anything and by the way, yes, crumbling infrastructure, I’m a Pittsburgh native. So I saw the bridge collapse there, as wow. Pretty, uh, pretty startling to see that happen in a, in a big city. But do you think that there’s an opportunity through also through the investment for public private partnerships? Or do you have any thoughts on that?
Duane McAllister: (14:40)
Yeah, I think there is. I mean, those tend to be, you know, uh, fairly efficient. I mean, there, there should be some cost savings, perhaps for the municipality to pair up with a private entity and, and perhaps expedite the process a bit. So we’ve seen that in other projects and very likely to see some of that. I think a lot of this you’re right, we don’t have all the details on how this money’s gonna be dispersed, but I think there’s a good chance that they’ll be in the form among federal grants, so, and, and shared costs. So, you know, if the federal governments, if a project qualifies, uh, and there’s lots of projects that will qualify across the country, um, you know, maybe the federal government picks up, you know, three quarters or 80% of, of the cost and local government has to, uh, kick in, you know, 25, 20, 20 5%.
Duane McAllister: (15:32)
Uh, I think there’s a lot of that that’s gonna occur to Lyle’s point. I mean, state and local governments are, are in really strong shape right now. They, on the one side you might argue, well, they don’t need to borrow, but with rates still relatively low and lots of projects to do, cost of financing remains relatively low and modest for them. We think that over time it will add to the supply picture by leveraging those federal monies to, to do as much infrastructure work as they possibly can.
Lynne Funk: (16:07)
Great. So we’re gonna take a short break, but when we turn, we’re gonna be talking about the various demand components. I know we’ve mentioned fund flows, but we’ll be right back. And we’re back with Duane McAllister and Lyle Fitterer of Baird Advisors. So fund flows. Just this morning — and we’re recording this on February 9th — ICI reported $4.3 billion of outflows from muni mutual funds, which is the largest in March, 2020, back when COVID hit. Um, I guess I’m just curious, you know, should we be concerned about the fund complex as a demand component in 2022, after, after those record inflows in 2021?
Lyle Fitterer: (16:53)
Yeah, I mean, I, I think it is definitely is something that you have to pay attention to. You know, from a longer-term perspective, if you look at the outstanding, fund complex assets relative to dealer inventories, you know, dealer inventories have gone down, they haven’t gone up, fund assets on the flip side, have grown you, you know, last year, $102 billion of flows, positive flows. And then just through, you know, through positive performance, they’ve grown as well. And so if you look at the last couple of weeks, I think it started a few weeks ago, you had some negative flows. You actually had a couple of days of positive flows. So I think people are interested in buying munis. I think the, these higher levels, have garnered attention from, investors who really haven’t been able to get any income.
Lyle Fitterer: (17:43)
And if you look at the market and where you’ve been able to buy things, you know, especially on the front end of the curve, you know, on the two- to five-year part of the curve, rates were, you know, anywhere from, I would say, 10 basis points to 35 basis points out to, you know, five plus years, and now you can actually get a one handle on bonds. And while that doesn’t sound super exciting, you know, when you’re looking for income, and you’re thinking about where you want to take risk in your, the portfolio, uh, the backup in the market has provided some opportunities. So flows were negative. The number that you reported, uh, as of this morning was reflective of the last week, but yet if we looked at daily flows, it actually had turned to a little bit more neutral. And in fact there was some positive flows and some ETFs.
Lyle Fitterer: (18:27)
So we wanna pay attention to it though, because as you alluded to it can cause volatility in the marketplace. And we saw that over the last few weeks. It’s part of the reason why some of that short stuff, underperformed when mutual funds lose assets, they tend to sell their most liquid, uh, bonds, the bonds that are gonna go down and price the least. And then as that, uh, if that persists those flows, then they’ll turn to the longer parts of the marketplace, where they have higher income securities, uh, where they’re further off the curve. The prices have maybe gone down a little bit more. Uh, and, and that’s the part that, uh, we’re just starting to see, we’re starting to see some high yield, uh, bonds trading in the marketplace. Those prices are being reflected. Some bonds are getting marked down. And so initially again, it was in kind of what I would refer to as that two to 10 part of the curve.
Lyle Fitterer: (19:19)
And now it’s moved out the curve a little bit, so we’ll have to see where that goes. But again, in our portfolio is the key. This year. One of our themes has been maintaining, good liquidity. We’ve actually been sitting on some cash. So we’ve had the opportunity to buy into this weakness. And the last thing you wanna be is a forced seller, in this marketplace. So it probably means you should carry a little bit more liquidity, a little bit more cash in the portfolios.
Duane McAllister: (19:45)
Yeah, I would just add to Lyle’s last point. I, I think it’s, it’s critically important is, you know, investors expect the funds they invest to provide liquidity when they need it. And so that, that response would really falls on us. And we think about it in terms of having layers of liquidity, you know, unlike the, the taxable market where they can turn to the Treasury, uh, Treasury market for immediate liquidity. We don’t have that obviously. And, but we have to of, you know, different layers in there of, of, uh, you know, whether they be short bonds, higher-quality bonds, you know, bonds, specialty states larger blocks, smaller blocks. We, we think about that a lot. We track not just our own flows, but industry flows. And when we see, uh, flows, uh, going out, it does, uh, cause us to think more about making sure we’ve got plenty of liquidity to meet whatever needs might come.
Lynne Funk: (20:37)
So when you talk about, you know, liquidity, how, how much of a factor, and Lyle, you mentioned dealer inventory, you know, how it picked up in late 2021, they unloaded some in January, you know, how vital are dealers in, in times of market volatility?
Lyle Fitterer: (20:55)
I think it’s a very good point again, that the willingness of dealers to carry inventory really changed after, you know, 2008, 2009, with some of the new bank regulations, uh, the cost of capital, that sort of thing. So, uh, they’re less, I guess, reluctant to step up as quickly as they did historically to maybe provide that buffer. That being said, there are other sources of liquidity that have popped up. There are desks that cater to retail clients bidding on smaller retail blocks. They’ve done a really nice job, I think in, in times of these market pivots of stepping in and providing some liquidity. But, you know, I think what happens again, when you think about liquidity from a dealer’s perspective is they’re more willing, I guess, to step away from the market and to allow the market to find clearing levels.
Lyle Fitterer: (21:46)
Um, so what does that mean again, it means that you, you probably will have more volatility that than we’ve had from a historical perspective, you know, ETFs on the flip side, you know, while when money’s coming in, they’re forced to buy when money’s going out, they’re forced to sell again, there are programs in place I think, to try and limit the impact on the market. But we’ve seen that to where they are a little bit less sensitive, I think, to the prices that they get in the marketplace, they tend to run fully invested. So those flows can cause volatility in and of themselves. And then again, I think we really wanna bring it back to, you know, how long do these outflows persist and therefore what’s sort of bonds are, uh, mutual fund investors looking to sell initially it’s higher-quality liquid bonds. That’s why you get in a market like this, where rates can move fairly rapidly. And then the secondary impact when those flows persist for a longer period of time tends to spill over in the high-yield market. We’re not there yet. We’ve seen a tiny little bit of that, but to the extent that, you know, Treasury rates go up a little bit more and, and redemptions continue, that’s when you may see some selling in the credit sectors and you could finally get some cheapening, uh, in certain credit sectors as well.
Lynne Funk: (23:03)
So, so what are your thoughts on the, what, you know, what some call, the professional retail professionalization, perhaps of retail, you know, SMAs, ETFs growing, how, how are they factoring in, in 2022?
Duane McAllister: (23:16)
Yeah, I, I think that obviously we’ve seen a, a huge growth, you know, almost explosion of, of that in the last several years where the re the true direct retail purchase has diminished and professional manager, the SMA manager has, has really grown a lot. Um, I think there’s pros and cons to it. I, I think that, uh, you know, it allows investors to maybe sleep at night a bit better knowing that someone’s watching over the portfolio of both credit and, uh, diversification and, and all those kind of things. But the flip side is, it, it, it can lend itself perhaps a bit more volatility in that if the professional investor or the financial advisor is part of a model portfolio, and there’s some type of an asset allocation shift and, and suddenly they’re gonna move, you know, their, their bond allocation up or down, that can trigger, you know, both buying and selling and, and can enhance the, um, the volatility.
Duane McAllister: (24:19)
You know, I not, I know a lot of, you know, high net worth investors, like having a, those individual bonds, uh, because they can, you know, at least theoretically hold them maturity during a volatile market. But they can also become subject to the, to the liquidity trap that, that can occur in the market. Particularly if you’re selling smaller pieces, uh, where the bid side really can fade dramatically. So, you know, I think they’re is, uh, pluses and minuses to it. And I guess, you know, that’s the way we would tend to think about it is, is volatility impact.
Lynne Funk: (24:53)
So talk about retail more generally, then, you know, there are some changing demographics going on. There’s definitely some boomers who are retiring, or there are post-retirement income needs. You know, what is the transition of that wealth to a younger generation mean? Do you seeing anything coming down the pike that might change retail investor interest in munis?
Duane McAllister: (25:13)
Yeah, that’s a really important issue for the, for the municipal market. Uh, and we think, I mean, the demographics are our friend, it’s a, it’s a, it’s a tailwind for the market, uh, has been, if you look at the inflow, as we we’ve mentioned the record inflows last year to, to bond funds, the two highest years of inflow were 2019 and in 2021, uh, over the last really, uh, since they started tracking these things. So that tells me that, uh, there’s a lot of demand out there. A lot of this is due to the, the boomers retiring last year, COVID, uh, led to, you know, excess retirements, if you will, by some estimates, you know, as, as many as additional 2.4 million, uh, retirees, uh, uh, left to workforce, and they’re all gonna need some sort of supplemental income. And so that’s, that’s a very good thing.
Duane McAllister: (26:05)
And the boomers control are not just boom, but boomers and the oldest generations, you know, control the majority of wealth. I think a stat I read recently is those 70 and above control, about 27% of all the net worth in this country. And you are gonna have a big transfer to your point, uh, Lynne that, you know, roughly $70 trillion is transferred over the next 20 years or more to the next generation millennials and, and generation X. They may not be as interested in, in munis as the, uh, fathers and, and grandparents have been. But you know, I think a lot of that will be, you know, where the markets are, where rates are. So I don’t anticipate anytime soon, you know, concern over that transfer wealth, anything we’ve got more boomers still coming demand is gonna remain relatively strong. And I think the higher interest rates that we’re seeing what will attract more demand than, uh, and scare people away.
Lynne Funk: (27:07)
Well, was there anything else that, you know, we didn’t touch on that you two would wanna, uh, just wanna chat about before, before our listeners, before we head out?
Duane McAllister: (27:16)
Not really. I, I think I just go back to where we started that, you know, this is gonna be a very interesting, uh, you know, perhaps challenging year, but, uh, that’s what makes it fun. Uh, this year already is off to a, a more, exciting start than most of what we saw last year. So we’re, we’re ready. And I think we’ve covered most of the key topics we wanna talk about today.
Lyle Fitterer: (27:37)
The only thing I would add, uh, Lynne is that I think that people are always nervous about rising rates and what that impact is on their portfolio. And obviously as in a fixed income manager, we are concerned about what that does to, you know, the share price of our funds or the total assets of somebody’s portfolio because of price depreciation. But the flip side of that is, you know, rising rates are from a long term perspective are good thing for investors. Know higher rates means you need to take less risk in your portfolio that gave, give, get you the same type of return. I think it would, it would actually bring some normalization back to the marketplace right now. You know, I, I was just on an investment committee, meaning this morning, a call a committee that I sit on here locally. And the question was, should we be looking at, at fixed income alternatives, things like real estate or dividend paying stocks, and you hear that all the time. And so again, while it hurts to get to higher rates from an overall perspective, we actually think it’s a great thing. And it allows, you know, traditional fixed income investors to get higher levels of income and potentially take less, less risk in their portfolios.
Lynne Funk: (28:47)
Great. Thank you both so much. Uh, I do have one final question for you and, um, I’m gonna ask you to take out your crystal balls. Who’s winning the super bowl. Well,
Duane McAllister: (28:58)
I think, you know, if you, if you had to put money on it, you you’d have to, uh, uh, take the Rams of playing at home, but, uh, the emotional so side is, uh, is gonna be on Cincinnati. So, uh, it should be a great game. I hope it’s a great game. We’ll see. Soon, you know, we’re both Packer fans. Yeah. So, um, you know, but we probably just won’t even tune in. Yeah,
Lynne Funk: (29:18)
Well, we’ll see who’s right, because this is going to be aired on the Tuesday after. But, thank you again, both so much. It’s been a great conversation and I think there’s a lot more, uh, you know, to discuss and, and we’ll, we’ll talk again. I’m sure. Thank you again.
Lyle Fitterer: (29:32)
Thanks. Thank you.
Lynne Funk: (29:33)
Thank you for listening to this Bond Buyer podcast. I produced this episode with audio production by Kellie Malone special. Thanks this week to Duane and Lyle of Baird advisors. Rate us, review us and subscribe to our content at www.bondbuyer.com/subscribe. From the Bond Buyer I’m Lynne Funk. Thank you for listening.