Kentucky & Arizona: A deep dive into their muni bonds, economic landscape


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Chip Barnett (00:04):
Hi, and welcome to another edition of The Bond Buyer Podcast. I’m Chip Barnett and my guests today are Royden Durham and Tony Tanner. They’re both portfolio managers at the Aquila Group of funds, and today we’re going to be focusing in on two specialty states, Kentucky and Arizona. Welcome to the Bond buyer.

Royden Durham (00:23):
Hi, Chip.

Tony Tanner (00:23):
Thank you for having us today, Chip.

Chip Barnett (00:25):
Could you tell our listeners a little bit about yourselves?

Royden Durham (00:29):
This is Royden Durham. I started out as a trust investment officer running a common bond and equity fund, and then I ran a bank bond trading desk. I was an institutional broker with two firms and 17 years as an investment advisor and I’ve been with for 12 years with Aquila as a lead portfolio manager for Kentucky and I’ve been the co-manager on our Utah, Arizona, and Colorado funds

Tony Tanner (00:57):
This is Tony. I was fortunate to step into a buy-side portfolio management role back in 1991 after leaving graduate school and ever since then I’ve been involved in municipal bond market and the fixed income markets for the last 30 years, primarily in managing institutional funds and high net worth accounts. Presented a great opportunity to manage through a pretty wide array of interest rate and credit cycles over that time and more recently, I was fortunate to join the Aquila group of funds in 2018 as lead portfolio manager of the Arizona Municipal Bond Fund, and I also co-manage the Utah and Kentucky funds with Royden as well as our Oregon fund as well.

Chip Barnett (01:53):
Okay. That’s a lot of experience. Great. So let’s dive right in and focus on Kentucky first. S&P upgraded Kentucky’s credit rating to A-plus in June while Fitch raised the state to AA in May. Royden, what’s going on there that’s been making the rating agencies sit up and take some notice of it?

Royden Durham (02:14):
Well Chip, Kentucky was a one party state from 1923 until 2011 and we lost multiple manufacturing jobs in 2003 to NAFTA and we elected a Republican veto proof legislature in 2011, which has reshaped the finances actuarily funding the major pension plans for the state, which was the rationale behind the state’s lowly single A rating and made it one of the first worst funded state pension systems in the country. At the same time, some things just fell into Kentucky’s lap like logistics since it’s within about an hour and a half plane flight of 60% of the U.S. population. And also our bourbon tourism helped show off what a great state we have with relatively low cost. One key aspect has been the right to work and no state taxes legislation that Tennessee enacted way before us, along with the growth that followed had put a great deal of pressure on Kentucky’s politicians to follow suit. Kentucky revenue has grown substantially and has moved us from 37th most friendly business state to the 18th most friendly state to do business in the EV coordination of Ford and Tennessee and the car manufacturing infrastructure in Kentucky has also helped with the increase in revenue has come, the rating increase.
Chip Barnett (03:58):
Okay. Let’s move out west now and take a look at Arizona. There seems to be a new robust trend reshaping the local economy out there. Tony, can you talk about that?

Tony Tanner (04:10):
Certainly Chip, and although semiconductors have been getting a lot of the headlines recently, semiconductor industry has been really a part of the fabric of the Arizona economy. Going back to 1949 when Motorola established the presence out here and when Intel followed with their first manufacturing facility in Chandler in 1980 and more recently, local officials in the government and economic development agencies have been pursuing Taiwan semiconductors since 2013. Semiconductors have been an important component of it, but in the last few years what we’ve really seen as what I would characterize as the Arizona involving into what I would call the nation’s smart manufacturing hub, lots of growth within industries like aerospace and autonomous vehicles. LG recently announced a $5 billion investment of what would be the world’s largest battery manufacturing plant a few years ago, but we’ve also seen the ripple effects of that and even more traditional manufacturers like Kohler and Proctor and Gamble are establishing manufacturing facilities out here.

So it’s a quickly evolving dynamic economy. Another aspect of the population is that even though we’ve doubled in size in the last 30 years, we’ve seen an increasing wealth effect between 2016 and 2021, Arizona attracted a net, the migration of $22 billion of adjusted gross income, which was third in the nation behind only Texas and Florida. The other big change that we’ve seen over the years is traditionally Arizona had a less than stellar reputation in terms of workforce education and education in general, and we’ve seen huge strides in that in the last 10 years. One of the things that I noted in some recent studies was that we’ve seen large growth in residents in their 30s and 20s over the last five years with college degrees. I think Arizona ranked third in the nation by one study, and so we’re becoming a highly educated workforce and becoming a magnet for wealth production and wealth creation. So it’s a great story that’s somewhat flown under the radar stream during that time.

Chip Barnett (06:41):
Can you compare and contrast investing in these two states?

Royden Durham (06:45):
Sure. Chip, since Tony and I are local managers, we can see trends in our local economies that others may not see using our Aquila tenants of high quality and local management, we think we ferret out values in the municipal market that others may not. With the growth in southern Kentucky, particularly down on the Tennessee border, near Nashville as a spillover, we bought some Warren County hospitals because of their huge nursing program. It has been one of the handful of upgrades in the state in the last 10 years. Prior to the May and June upgrade issue, 80% competitive. Arizona is probably 80% negotiated. Kentucky has only 5% of its issuance as geo debt while the major state issuers a lease revenue, the Kentucky State Property and Building Commission, Kentucky has always been a slow growth while Arizona hasn’t, and Kentucky only has four and a half million people.

Tony Tanner (07:52):
You know, Roy, you pointed out some great observations and probably one of the biggest observations, is the fact that our muni market structures are very different and that we have very few competitive deals and almost exclusively negotiated issues. And that’s one of the advantages we have of being local in that we were able to kind of navigate these nuanced differences. And as you pointed out there within the muni market, the regional nuances between states and regions are very important when it comes to investing in those states. In a lot of areas of the country hospital, municipal issuance and credit quality can be challenged, whereas with the outsized population growth that we have here in Arizona, there’s a continued increasing demand for healthcare. And so our hospital issuers on average tend to be very high quality issuers and present a great opportunity for me as a local fund manager. And another area is in looking at higher education and the pandemic provides a good example for that in that because of the shutdowns within public universities and schools, one of the things that we observed here in Arizona was that from the outset of the pandemic to mid-2022, Arizona was one of only eight states to actually experience public university enrollment increases. And so we operate in sort of very different economic environments, but with some fairly consistent evaluation processes.

Chip Barnett (09:36):
Okay, and we’ll be right back after this important message. And we’re back talking with Royden Durham and Tony Tanner of Aquila. Looking at broader trends, where’s the municipal bond market as a whole right now? What’s happening there that investors should be aware of?

Tony Tanner (10:02):
Well, Chip, I think one of the most important observations for muni investors now is the unusual shape of the muni yield curve in that there’s this unusual sag between sort of one and 11 and 12 years and you should normally be able to go out in those early years of the yield curve and get higher yields. The curve in fact is positively steeped, positively sloped going beyond 12 to 13 years, and so that has a lot of implications for overall portfolio management. There’s somewhat of a value demarcation along the curve in that 10 years and shorter muni ratios are a little more expensive at 70% and lower in terms of the ratio of those muni yields compared to benchmark Treasury yields. But going out further the curve 15 years and beyond, you start to the point where munis are much less expensive. The ratio of those yields to Treasury bonds is generally in the high eighties, and so it makes for a challenging environment to determine where value is. Fortunately, I believe municipalities are benefiting still from a lot of the economic stimulus from the federal government. And so credit strength overall appears to be holding up well despite the recessionary concerns out there. But if you put it all together, I think what it means is that it’s an environment and a set of raw material that are advantageous to professional managers and munis, especially compared to where we were a couple of years ago.

Chip Barnett (11:43):
Where do you see the best opportunities for buyers right now?

Royden Durham (11:46):
Well, Chip, these are the highest yields we’ve seen in decades, and four and five to five point a half percent tax-free is certainly enticing. With general uncertainty with regard to whether the economy could fall into a recession, the best values would seem to be the AA rated revenue bonds that can weather a credit crunch. In Kentucky. Issuance of school building revenue bonds over the last several months has helped me diversify that sector of my portfolio and add to it. Since the curve is shaped like a ladle, we’ve been buying out 11 to 15 years and trying to barbell with shorter paper, this helps with keeping our intermediate fund objective.

Chip Barnett (12:32):
Where do you think it is the most challenging right now?

Tony Tanner (12:35):
I think probably one of the most challenging aspects is sort of the behavioral aspect of managing munis within the fixed income landscape and talking about being able to shift your focus from the negative return environment of the past few years and Fed policy towards looking at the current state of investible yields, and especially looking at them in the context of classic 60/40 asset allocation. We’re at a point now in the Fed cycle where it appears that the paths of market yields and inflation may be diverging in a manner that could provide real yields, that is investible yields above the long run raised inflation. And that was something much more difficult to attain a few years ago when high quality 10 year muni bond yields we’re hovering around one and 2%, especially given that the long run rate of inflation has already been around 2%.

So sort of resetting perspectives and gaining objectivity to look at the state of investible yields, I think may help investors better identify opportunities to satisfy long-term income oriented investment needs. I think the other thing that’s can be challenging is in a higher rate environment, it’s pretty well known that new issue supply has been down fairly meaningfully. I think this year we’re down still 13% compared to last year. And so sourcing bonds can be a challenge in the current environment. However, within our individual states, I think we have seen some pretty significant opportunities in the secondary markets. And dovetailing what Royden had said from a structuring standpoint, we think that there’s value having good broad maturity diversification in your portfolio, and that can mean ensuring that you’re not underexposed to maybe longer portions of the curve or maybe having too much exposure or emphasis in an area of the curve that might be overvalued.

Royden Durham (14:56):
And the only thing I would add to that is in Kentucky we’re having a difficult time to barbell the portfolio because a reasonable trading size securities a million dollars or more is hard to come by with the structures on very small issues that come to market in Kentucky.

Chip Barnett (15:22):
Do you have any last thoughts or our listeners today?

Royden Durham (15:25):
Well, Tony, the only thoughts that I have in addition are basically some of the Aquila tenants, high quality, intermediate maturing maturity, have shown that they perform very well in this turbulent market according to Bloomberg indexes that 22 plus year index is down a bit over 2% year to date while the quality intermediate index is down just over 1%.

Tony Tanner (15:56):
Yeah, Roy, that’s a great observation. And if you actually go back to mid-May of 2022 when the Fed funds rate was only 1%, and look at how munis have performed since then, the majority of the time, since mid-May of 2022, they’ve been in relatively positive total return territory, and that’s been primarily a function of the consistent level of and higher levels of income that are provided. And so the phase of the Fed policy that has sort of reset asset prices seems to have reached the close to its end, and that if you look back in hindsight, the level of fluctuation the muni market has been relatively consistent with what you would expect in an environment where investible yields have now crossed 3%. The other thing I think it’s interesting to keep in mind is that the municipal bond market is unlike most other security markets that investors are familiar with, in that only about two to 4% of this market trades on a daily basis trades on a decidedly trade by appointment way. And it’s because of that, it’s an asset class that can create challenges for individual investors compared to the equity markets or the high quality corporate bond markets that are much more continuously traded. And so we believe that investors can benefit from collaborating with their financial advisors to find opportunities to work with professional muni managers to certainly exploit the opportunities that Roy and I have discussed today.

Chip Barnett (17:44):
Royden Durham and Tony Tanner of Aquila. Thank you very much for being here with us today.

Tony Tanner (17:50):
A pleasure. Thanks for having us, Chip.

Chip Barnett (17:52):
And thanks to the listeners of this latest Bond Buyer podcast. Special thanks to Wen-Wyst Jeanmary who did the audio production for this episode. And don’t forget to rate us, review us and subscribe at For the Bond Buyer, I’m Chip Barnett, and thank you again for listening.

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