Pimco, a name synonymous with active pension management, isn’t the first to be associated with municipal bonds. But given the nature of most munis, it is a sector that lends itself particularly well to the selection of individual securities.
Newport Beach, California recently acquired the
Pimco Municipal Income Opportunities Active
exchange-traded fund (ticker: MINO), managed by David Hammer to complement his portfolio of established open and closed Muni funds and to complement his exceptionally successful range of actively managed ETFs.
Fiscal policy – how much the federal government spends, what it spends and how it pays for it – is driving the economy and markets more strongly than in the past and forcing equity investors to pay more attention to it. However, Muni managers have always followed government maneuvers. It seemed an appropriate opportunity to speak to Hammer, Pimcos munis boss, about the state of the sector. An edited version of our conversation follows.
Barrons: Dave, how do you see the ammo market?
David Hammer: The muni market is very fertile ground for active managers and there are three major inefficiencies that we want to exploit: credit, structure and liquidity. Over the years broker / trader liquidity has decreased which has led to a number of opportunities. [Broker/dealers] Carry $ 10 to 15 billion [in bonds with which to make a market], from $ 50 billion to $ 60 billion before the financial crisis. On the other hand, there are daily liquid Muni vehicles, which have grown from 400 billion US dollars to almost 1 trillion US dollars over the same period.
What are the effects of this?
We are more likely to see temporary valuation overruns when there is an incongruity, which means that when valuations are high, we are likely to increase our cash more than we did a decade ago.
The market looks rich right now, with a lot of demand absorbing the available supply of bonds.
To the right. It was a big inflow year for munis. The edition was modestly disappointing. And there was a positive background in improving creditworthiness.
Does that just reflect the economic recovery? Or was it government policy?
There was a combination of record-breaking fiscal and monetary support to state and local governments. This recession was different, however, as the higher earners were less affected. Income tax and sales tax collection held up better than in a typical recession. And we’ve seen house prices rise. This is important for local credit [bonds]that depend primarily on the collection of property tax, which depends on house prices.
We’ve seen more upgrades than downgrades this year. One of the larger issuers, California, turned a projected shortfall of $ 54 billion for fiscal 2021 into a surplus of $ 76 billion by 2022.
Was that just tons of capital gains taxes from Silicon Valley? Or support from Washington?
Federal support, better than expected sales and income tax surveys, and capital gains [taxes] as asset prices rose. This also includes loans that have been heavily used in recent years: the state of New Jersey, for example, announced record revenues that are forecast for fiscal 2022. The state of Illinois received its first rating agency upgrade in 25 years.
How did you do that?
Identical themes to California – a combination of fiscal support, monetary policy support, better-than-expected sales tax and income tax collection, and a house price increase.
Is that as good as it gets for a muni investor?
“Infrastructure policy is an important part of our budget outlook.”
There are still areas of concern, such as large cities. It is still unclear how quickly workers and tourism will return to pre-Covid levels. An example that we monitor is the daily subway ride in New York City. It’s still about 50% below its 2019 level.
How does that fit into your process?
There are 50,000 credits to choose from. First and foremost, we focus on avoiding downgrades and outages. We see opportunities in smaller issues that may not be covered by a larger group of investors. And we often see a complexity bonus. It is common for investors in the municipal market to think of government and municipal debt, but a very large chunk of the market comes from public-private partnerships, securitized tax payments, and risky types [of bonds] that require an understanding of local property valuations, or even companies that can enter tax-exempt markets. This is where we usually find value.
Another inefficiency that we want to exploit is structure. Most Muni Bonds are callable, with different termination dates and call prices. This often leads to mispriced callable municipal bonds.
The other risk is interest rates; Government bond yields have risen recently.
It wasn’t so bad in the Muni market. With the US Federal Reserve’s rate hikes from 2023 onwards, we have seen peak levels of monetary and fiscal policy support and peak growth. On the one hand, as interest rates rise, the value of the tax exemption increases compared to other investments, which leads to a narrowing of the spreads. The second reason is that supply tends to decrease, as the number of bonds that are eligible for prepayment when interest rates rise tends to decrease. A third reason I would like to add: since most coins are callable, their sensitivity to changes in interest rates is less than that of a non-callable government bond with the same maturity.
Would all of those 4.5% and 5% coupon redeemable bonds that were sold a few years ago become vulnerable to effective maturity if they weren’t called when yields rose?
Well, 4.5% and 5% coupons are not; With 30 year AA Muni yields in the 2% range, they have quite a bit of protection. However, we would like to point out that over the past year some 2.5-3% long-dated coupon bonds were created in the market. These are structures that we have avoided; they face potential renewal risks and will underperform if interest rates rise.
What are you looking for in Washington in terms of fiscal policy?
Infrastructure policy is an important part of our budget outlook. The bipartisan infrastructure bill, which provides $ 550 billion in new funding for traditional infrastructure – existing roads, new roads and bridges, existing water and sewer systems – will be paramount to the Muni market. These are areas that have faced an infrastructure deficit in recent years and we should see an increase in supply in these parts of the market over the next few years. Other parts of the market will be less affected. Airport and port investment plans are often approved five to ten years in advance; It’s more likely that these new infrastructure dollars will be used on projects that were planned anyway. There could also be a prepayment repayment along with a repayment of a taxable subsidized bond like the Build America Bond program created in 2009 and 2010.
Obviously, none of this is safe until final infrastructure legislation is passed – if it is ever the case.
How does this affect our prospects? In the case of relatively high ratings, the option of returning tax-free advance refunds would lead to a more immediate increase in supply; this is another factor that justifies a more defensive positioning. Infrastructure considerations have a much longer timeframe based on the local need to go through a formal permit process including environmental assessments.
It is unlikely that we will see any major impact from the new infrastructure funding until the second half of 2022 at the earliest. We believe this is more likely to be the case in 2023 and 2024. Our baseline scenario is a 25% increase in net annual supply of tax-exempt bonds – a very different phenomenon from what investors have seen in corporate or government bonds, where there is a big spurt in issuance. Muni’s output has been fairly stagnant for the past 10 years.
The other aspect of President Joe Biden’s program is proposed tax increases for high earners. How does this affect the muni market?
That is tailwind to demand, and I want to point out both the potential for higher income taxes and the potential for higher corporate taxes, which would make sense for banks and insurance companies, which own about 30% of the outstanding tax-exempt bonds.
If you just look at the Muni returns today, a tax-exempt bond with a 2% return has a tax-equivalent return of around 2.75%. For a high-yield municipal bond with a simple yield of 3.25% to 3.5%, this corresponds to a tax-equivalent yield of 5.5% to 6%. Even with the current tax rates, Munis are quite attractive after taxes.
Especially where the high-yield market for companies is.
That doesn’t reflect their relative failure rates. High yield munis tend to default about 25% as often as high yield corporate bonds. It’s a much higher quality asset class.
After all, Dave, I have this closed-end fund thing. What are the options there?
Well, I manage our closed-end funds. You are currently benefiting from the fact that many holdings are bonds that were bought in a higher interest rate environment. Closed-end funds all use some form of leverage and benefit from a very high level [yield] Curve; they borrow at a low rate and reinvest at a higher rate. Both are currently tailwinds. However, most closed-end funds have a very long duration profile. When rates go up, that can be a bit of a headwind.
This applies to almost every asset class. Thanks Dave.
Write to Randall W. Forsyth at [email protected]