A major muni buying opportunity

Transcription:

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Mike Scarchilli (00:03):

Hi everyone and welcome to The Bond Buyer Podcast, your essential resource for insights into everything municipal finance. I’m Mike Scarchilli, Editor-in-Chief of The Bond Buyer. And today we’re diving into the complex and ever-changing world of municipal bond markets. In this episode, Bond Buyer executive editor Lynne Funk sits down with Peter DeGroot, managing director and head of the investment bank’s municipal research and strategy team at J.P. Morgan, a top ranked strategist in the municipal bond space. Peter shares his expertise on the state of the muni market as it grapples with a confluence of factors from fluctuating interest rates to supply and demand dynamics. In their conversation, Lynne and Peter explore a range of topics, including why Peter believes the next few months may offer the best buying opportunity for bonds this year, the potential impacts of shifting investor behavior on market liquidity, and what the upcoming election might mean for tax policy and the muni market. This episode is packed with insights on how to navigate today’s unique market environment. So without further ado, let’s jump into this engaging discussion.

Lynne Funk (01:11):

Welcome everyone. I’m delighted to welcome to the podcast today, Peter DeGroot, who is managing director and head of the investment bank’s municipal research and strategy team at J.P. Morgan. His team publishes market analytics and commentary for investors and issuers in the public finance market. Peter has been voted among the top ranked muni bond strategists for more than 15 years, and as the top ranked strategist for more than 10 years based on the annual institutional investor survey. I can say for one that I read your work every morning, Peter, so welcome. It’s really great to have you.

Peter DeGroot (01:54):

Thank you.

Lynne Funk (01:56):

Alright Peter, just one quick housekeeping note for our audience. The views expressed on this podcast are the views of Peter DeGroot and not necessarily that of J.P. Morgan. So Peter, let us with that, get into it. This is kind of a really interesting time to be talking about the market and we have a lot to cover. We are recording this on September 24th. We’ve got one 50 basis point rate cut being digested. Munis have been underperforming corporates, govies. Ratios are cheapening, supply is ballooning, reinvestment dollars are low and this is leading you to argue that in the next two months it could offer the best opportunity to buy bonds of the year and possibly of the rate cycle. So could you talk about this?

Peter DeGroot (02:45):

Yeah, well first of all, thanks for having me on the podcast, much appreciated, and I think you laid that out very well, right? We’re actually at a very interesting point in time in the market in that we think we’re on the precipice of a protracted easing cycle that the Fed kicked off with that 50 basis point cut and at least historically speaking, that has led to inflows into the municipal bond space, into municipal mutual fund space. So that’s good though, right? So that in and of itself very strong positive. Six of the easing cycles dated back to 1992 have all resulted in flows into the municipal bond space over that time. So you expect to be in a period where of rising seas lift all boats. However, to your point, we’ve had year-to-date record supply, tax-exempt issuance. So this has capped ratios whether or not truly ratios to treasuries or ratios corporates at the highest levels today, right around the cheapest, highest levels of the year.

(04:03):

And I guess the other point you made is that our expectation is that this supply will increase dramatically between now and the election at the same time as reinvestment capital is at the trough for the year, or at least tied up for the trough over the year. In these next two months, we’re expecting, or rather next six weeks or so approaching the election, we’re expecting to see reinvestment capital of only about $6 billion and net and rather tax-exempt supply rose tax-exempt supply in the range of $11 to 13 billion. So we’re expecting that the combination of that very onerous net supply scenario along with what we expect to be the highest base yields over this full tightening cycle, which rather this full easing cycle expectation is that in addition to the 50 basis point cut that we just received, that we get another 200 basis points of easing between now and mid 2025. So expected terminal rates somewhere around the 3% range and again, leading to a significant inflow cycle in the municipal bond space.

Lynne Funk (05:26):

I want to talk about relative value. We talked about yields, talked about cheap ratios. Current muni to U.S. Treasury ratios certainly have improved. You say you anticipate them to cheapen further as this influx of supply hits the market in the next six weeks. Do ratios matter as much right now as compared to actual yields? How much are a factor are both of those to individual investors and I guess how much should they matter going into later in the year as potentially rates fell?

Peter DeGroot (06:00):

Yeah, great question, right, so ratios the question of going on ratio matters depends upon who you are, what type of investor you are. So in the current environment where as you said you see ratios at year to date cheap levels, a certain local buyer will be very aggressive in the market based on those ratios. So for example, corporate buyers, P&C and banks to a certain extent, life insurance buyers. When municipal yields are high on a relative basis to corporates, they are obviously further attracted to the asset class. And another sort of point that I believe we’ll be getting into later on is at current tax rates, the market has got to get a lot cheaper in the current environment than it was when corporate tax rates were in the 30% range. So yeah, they certainly matter for corporate buyers. For individual buyers, not so much, right?

(07:10):

For individual buyers who generally buy and hold, investors purchase securities based on taxable equivalent yield and their own tax scenario on a go forward basis or at least as far as they can project. So ratios may not be that important, particularly where they’re at today. However, what ratios hit extreme levels like we’ve operated for a good period in 2022, particularly in the shorter portion of the curve where municipal ratios for AA paper were under 60% of the U.S. Treasury year. So in an environment like that, and we saw a lot of this happening at that time, investors may switch between the tax-exempt bond market and Treasuries for example, given that taxable equivalent rates on Treasuries were more attractive for a large portion of the investing community during that rate.

Lynne Funk (08:07):

Right. And you said AA there not AAA at 60%

Peter DeGroot (08:12):

At sometimes? Yeah, yeah, sometimes.

Lynne Funk (08:15):

Yeah, no, I just was emphasizing that point, right. So let’s actually go to the supply picture because I think that it’s kind of surprised a lot of folks to the upside well over $350 billion at about 30% up year over year as of I believe that my total there is as of last Thursday, which would’ve been, this is important, sorry, September 19th. Anyway, you at J.P. Morgan have revised your initial full year gross issuance forecast higher by 15% to $460. What do you think right now You did that a little while ago. Do you think it should be higher still?

Peter DeGroot (09:02):

In a word? Yes. So we’re current, your total about $350 billion now is up to about $363 billion in total supply. Again, record tax-exempt volume, taxable supply, not so much. But if you look at current year date actuals plus our forecast, which is very generous over the next call it three months of the year we’re annualizing closer to about $480 billion. So within the ballpark but still looking a bit higher, that would be very close within a couple of over outsized weeks of hitting the prior record of about 498 billion or so in 2021, 2020 rather. The difference was in 2020, and by the way, 2021 was a comparable year in terms of supply. The main difference is that in those years we had a tremendous amount of refunding taxable advance for funding of tax-exempt debt to the tune of average supply for taxable bonds of about $150 billion in those two years.

(10:24):

Whereas again, this year will struggle to get to $50 billion in total supply. And I think it’s important to talk about some of the drivers, some of the things that we think are pumping supply up to the levels that we’re at. Certainly some of this is front loading in advance of the election. The other, when you look particularly in the sectors that have got higher supply, a lot of those sectors are sectors where issuers can come. Either the tax exempt bond market or the tax markets such as healthcare. So lower tax exempt borrowing costs relative to taxable borrowing costs. And then we’ve also had significantly muted issuance over the last three years or so given pandemic related aid. And then I think that’s all compounded like issuance within the whole space I think will affect us going forward as well is that over the last three years, a lot of folks talk about the 20 plus percent inflation that we’ve seen in recent years and that seeds at supply,

Lynne Funk (11:29):

Right? And I think it’s compelling that it is the tax-exempt new-money and I think we’ve also seen a lot of these really, if you think about inflation, I assume it’s part of the problem or part of the reason for these really large deals well over a billion plus that we’ve been seeing this year in particular, which is an interesting aspect of this market for sure. Do you think, I’ve heard sort of anecdotally that next year, particularly if rates do fall, that we could see a resurgence of refundings in 2025?

Peter DeGroot (12:08):

So this being a resurgence of taxable municipal refunding, advanced refunding of tax-exempt debt circa 2020 and 2021,

Lynne Funk (12:18):

If the policies that are in place, right tax policies are, which they will be in 2025 at least part of the year

Peter DeGroot (12:26):

Agreed and we’ll all find out together.

Lynne Funk (12:29):

Yes. Alright, well we’ll switch gears here a little bit and I’d like to talk about

Peter DeGroot (12:36):

That is a good point though if you don’t mind. Just sort of in 2020, 2021, the level of taxable, the taxable advance for funding in the left hand, the yield on 20-year AA taxable municipal bonds was about at 2.93%. And that level allowed for the significant advance for funding of tax-exempt debt into with taxable bonds. So that was responsible for the large increase in supply where we are today about 4.90%. So we’re about 200 basis points from levels that we think would really engage that larger taxable issues again, so pretty safe distance. We could get competitive if we do get competitive with that level over time, if we not only get to that 2.50%, but stay there for a longer period of time while the net cycle is warming, but a fair distance in terms of level of taxable rates today and where we need to get to before we get more taxable issuance in the market.

Lynne Funk (13:55):

Right. Makes sense. Simple mathematics there. Right. So let’s talk about who owns these bonds. I think muni ownership in this market, we know it’s primarily retail, but with the shifts kind of, we talk about the mutual fund complex, we’ll get into that more, but there has been the shift out of mutual funds and into SMAs and ETFs and that concentration of retail shifting into that space. You estimated at J.P. Morgan that perhaps more than half of household ownership is currently held in SMAs. So I guess the first real question is do you expect SMA growth to continue? How do you see that affecting retail and the market at large?

Peter DeGroot (14:39):

Yeah, so I do sort of anticipate that sub-managed accounts will continue to siphon capital from individual brokerage accounts. And I think that’s for several reasons that to me won’t be going away anytime soon. I think that separately managed accounts can offer sort of this sense of overall portfolio management as opposed to individual security purchases done approach account. And they also should and do take into account individual’s tax situations, fees are low and have been low for some time, and then for two other reasons they would, or at least most of the large shops have got a decent credit research infrastructure. Therefore those resources can benefit even individual, even smaller individual SMAs as they’re spread out over the broader community investors. And then finally, if you bulk up a lot of the SMA transactions into large buy and sells, you take advantage of tighter spreads in that portion of the market. So for a few different reasons, I think the SMA construct here to stay, continue to grow ETFs just in terms of ease of use, accessibility, sort of diversification, low fees, I think that also will continue.

Lynne Funk (16:13):

Okay. So shift over back to mutual funds. We started this talking, you started talking about how you see inflow should be continuing what as of the Thursday the 19th, there’s 12 consecutive weeks of inflows per LSEG. Given your call for a second 50 basis point fed cut in November and expected potential muni outperformance performance from maybe the lower supply figures in November and December post-election. Can you talk about how you see the mutual fund complex looking through year end and maybe even perhaps into 2025?

Peter DeGroot (16:55):

So we do actually think that that inflow cycle that we’re expecting that you laid out, we do actually think that that is going to be chiefly responsible for outperformance in the municipal bond space and in the yieldier sector. The municipal bond space that we’ve seen, again, as we said historically in all the easy cycles we’ve seen since 1992, we’ve seen the inflows have ranged in shallower cycle more shallow rate cutting cycles up to about 13%. And then in more protracted and deeper easing cycles, we’ve seen inflows of 25% of a one. Our expectation is by year end we’ll be somewhere in the area of $50 to $80 billion in terms of flows from the $25 billion that we’re at today. And we think over the full cycle we could see in flows on the order of what we’ve seen in 2019 through 2021, which was about $80 billion a year. So depending upon how well we actually remain in this cycle and up before we sort of shifted to more tightening mode, we think could see some pretty consider loads over the period.

Lynne Funk (18:19):

That’s great. So we actually are going to take a short break, but we’ll be right back and we’re back with J.P. Morgan’s, Peter DeGroot. Peter, we left off talking about mutual funds. Can we talk about performance as it is right now? What are the best performing sectors in your view, housing? AMT? What are you seeing out there?

Peter DeGroot (18:47):

Sure. Well, just looking across the index at sector performance on average per year, we see industrial revenue bonds as having the best performance. So again, I don’t know that we mentioned it earlier, but within this $25 billion inflow cycle that we’ve seen thus far, high yield has been a great benefactor of that receiving about $13 billion or so in capital. And that $13 billion in capital laid across a very thin supply in the high-yield municipal bond market. So we did see this sort of run for yieldier paper, if you will, in the market. And thus the lower quality, more idiosyncratic sector of the IG market IDR bonds with a return of about three 5%, well above the 2% return ish wide IG space. And then also other sectors, healthcare, housing, tobacco also outperformed thus far this year at a pretty good clip.

Lynne Funk (19:53):

Right. And I guess I imagine as yields fall even lower, like you said earlier, they will continue to outperform. Do you have any structures that are kind of interesting these days that you’re seeing in the market, lower coupon, shorter calls, what are you seeing out there?

Peter DeGroot (20:09):

Yeah, very good question. And we’ve seen this sort of be slower to develop than we expected in our 2024 outlook. We call for all things that you point out underform, including low coupon structures here to four, that’s, I don’t know if that’s been a little middling, but our expectation is that 4% coupon bonds, actually 3s as well when they come back in, both will outperform higher-coupon structures, 5s and 5.25s, pretty significantly here. Before that has not been the case. We, and again, sort of following on that theme of inflows, we believe that all things that have been left behind from a structural standpoint will ultimately catch fire towards, certainly before the end of this inflow cycle. So structures, short call bonds, lower coupon securities, AMT paper, we expect that after the supply of a solid, let’s call it current structure securities is exhausted from the market, those securities that have underperformed will actually perform very well.

Lynne Funk (21:27):

That’s interesting. We have heard you have and kind of seen some talk of kickers and all sorts of interesting stuff. I like that you say that things that have been left behind, which is definitely true.

Peter DeGroot (21:41):

I’d be remiss if I didn’t mention that one of the portions of the curve that’s been left behind is the 10-year spot, which is very unusual, right? It’s typically that’s focal point of demand. Retail gravitates toward that. Year to date, however, the 10-year portion of the curve is underperforming by around 20 basis points. Our expectation is that by year end, from a current performance perspective, that will be the top performing IG portion of the market. So if we think the IG sector on a whole is going to return about 2.85% on the year, we think the 10 year spot produces about a 3.5% return. And we also like about the 20 year spot. So talking about structure, that’s the curve structure recommendation that we think will perform best going forward.

Lynne Funk (22:36):

I feel as though this industry in public finance right now, the credit outlook is rather sunny. It’s rosy, the federal aid that has been pumped into the system. Do you see any sectors of credit concerns out there?

Peter DeGroot (22:56):

Yeah, so it is very interesting that the sectors that we might have sort of raised a little bit of concern about in the 2024 outlook are those that have outperformed the most, that’s healthcare, higher ed, tobacco, and we understand the reasons why they’ve outperformed. And if you look at the ratings migration, we’re not too far off in terms of the ratio of upgrades to downgrades for those sectors actually for healthcare and higher ed at least had the lowest ratio thus far this year.

So from a credit standpoint, we’re not wrong, but I don’t think that necessarily equates to performance in the sector. I think that we’re really most concerned about downgrade risk, not catastrophic risk. Right. This is munis. I think that the energy that folks spend in terms of their credit due diligence on those two sectors certainly pays off. So on complexes, the very large structure of credit analysts can do well by picking better securities in those high-yield sectors and potentially outperform their peers and benchmarks by utilizing their larger credit bench. And I think that ultimately if folks focus on the larger in terms of healthcare, like the larger, larger multi-regional large healthcare systems that have infrastructure to do things like take additional investments, make additional investments in technology and distribution, I think that those particular issuers will do well. And the same goes for the university sector, larger private institutions, large endowments, it’s credited up I think though both sectors.

Lynne Funk (25:10):

This is kind of a good segue, I think into, well two things, taxable bonds and Build of America bond redemptions. You followed these BABs redemptions rather closely. What have they done to — and the dearth of taxable muni supply in general — What does that mean for taxable muni performance and demand there?

Peter DeGroot (25:37):

Yeah, so as we said before, we expect taxable municipal issuance going to struggle to get to $50 billion this year.

(25:48):

That announced $25 billion in potential BABs refundings, right? About $13 billion actually executed. So yeah, low supply pulling bonds out of the market in refundings all have driven performance considerably in the taxable municipal bond space. But we entered this year, AA 30 year-ish taxable muni bonds were 25 basis points wide of similar structured corporates. Today those yields are eight basis points lower. So yeah, it’s been quite a performance run for taxable munis. We’ll see if we ever get that 200 or so basis point rally in longer dated taxable municipal bond yields, which again would drive taxables.

Lynne Funk (26:45):

Okay. I think about the BABs and taxables in general, I just think about P&C, the demand components of who’s out there, who’s going to buy them and how that actually has affected that buyer base. But let’s move,

Peter DeGroot (27:03):

Sorry, go ahead. So today at least wasn’t the case for most of the year. Today at least those investors are now switched into the tax-exempt expense. Why? Because they said, ‘oh, you have cheapened up and they’ll likely bulk up on those securities over the next, at least the next six weeks until you have the election.

Lynne Funk (27:24):

Right? Right. So speaking of the election volatility surrounding it, would you, I mean this is looking, I don’t want you to predict the future, but just any factors you want to highlight surrounding this upcoming election, how it might affect the market leading up, coming after? What do you want to share with this audience here?

Peter DeGroot (27:50):

Sure. Well yeah, again, as you put it, predictions or all out the window, we’ll find out together in early November. This scenario is, there’s a long writing on it from the perspective of the municipal bond market in terms of naturally tax policies are pretty different between the two camps. What we do know now is that in 2025, TCJA tax breaks for individuals, TCJA tax policy or individuals will largely expire. So there is certainty there, but naturally there is big concern that if either party were to effectuate a sweep, then there would be dramatic changes or at least dramatic changes proposed to current tax rates. So on the one hand, if we have large increases to taxes at the wealthy and corporations, that’s very additive to municipal market demand. On the other hand, if we have tax breaks for corporates and there is a lot of conversation around how that would be paid for and whether or not the municipal tax exemption might be potent to that debate as it has historically. So yeah, there’s certainly a lot riding on it from a tax perspective going forward and how that might affect the municipal market. And then just basically from the perspective as we’ve been speaking, we expect that issuers are going to chance supply in or the election, we’re concerned about potential volatility related to that election and then we expect supply to sort of pick up at a decent pace afterwards.

Lynne Funk (29:51):

Okay. So Peter, we’ve covered quite a bit. Is there anything that I didn’t ask you that you think was important to touch on?

Peter DeGroot (30:03):

I think you’ve been very thorough. Yeah, no, we about covered,

Lynne Funk (30:11):

Yeah, I even left off a few questions so we could do it again. I even left off a few questions so we could continue the conversation again sometime soon. Maybe post-election, revisit some of these things.

Peter DeGroot (30:26):

I’ll be here, I’ll be here. Yeah, great conversation. Thank you

Lynne Funk (30:31):

Very much. Alright Peter, really appreciate your time. I know the audience appreciates it as well, and like I said, to be continued. Thank you so much.

Peter DeGroot (30:42):

Thank you a great day.

Lynne Funk (30:42):

You too.

Mike Scarchilli (30:43):

We hope you enjoyed this episode. A big thank you to Peter DeGroot for joining us and sharing his insights on what’s driving the municipal bond market in these uncertain times. Here are a few takeaways from today’s conversation. One, Peter believes we could be on the brink of a strong buying opportunity in the muni market as supply increases and interest rates ease, investors may find attractive entry points in the coming months. Two, the evolution of investor behavior from mutual funds to SMAs and ETFs is reshaping the landscape, potentially providing more stability, but also creating new challenges for liquidity management. And three, the upcoming election could have major implications for tax policy, which in turn would impact M bond demand. Whether it’s changes to corporate tax rates or the expiration of individual tax cuts, the market will be watching closely. Thanks again for listening to this Bomb Buyer podcast. This episode was produced by the bomb buyer. If you enjoyed this episode, please hit like and subscribe on your favorite podcast player and please rate us, review us and subscribe to our content@www.bond buyer.com/subscribe. Until next time, I’m Mike Scarchilli signing off.