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- [00:00]
A
Today's Animal Spirits Talk youk Book is brought to you by Franklin templeton. Go to franklintempleton.com to learn more about their whole suite of active municipal bond ETFs. That's franklintempleton.com to learn more.
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B
Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.
- [00:43]
A
Welcome to Animal Spirits with Michael and Ben. Michael, Tax Alpha is all the rage these days. You and I've been talking about it a number of different ways. I still remember when Meredith Whitney came out with her call after she kind of quote unquote, what did she. Her thing was, her claim to fame was Citigroup. Right. She's like, Citigroup's going down.
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C
She shorted it.
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A
Yeah, yeah. And then after the great financial crisis,
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C
she said, oh, for my next trick.
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A
Yes. And she predicted that there's going to be massive defaults in the muni bond market.
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C
Was it Detroit? I can't remember. Did she single out cities? I can't quite remember.
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A
Yeah, I'm sure Chicago is the one people always talk about maybe California and obviously didn't happen. There have been no huge problems. There's probably been some small ones, but this is an area of the market in municipals that I don't think there's a ton of people that cover it. Essentially, would you call it almost like the small caps of the bond market just in terms of coverage.
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C
Overlooked.
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A
Yeah, right, overlooked. But it's interesting because states actually are different than the federal government and how they have to spend and their budgets and a lot of these are revenue backed bonds and such. But this is a space that you and I aren't experts on, obviously, but certain we have clients in muni bond funds because sometimes, especially for higher income people, the tax breaks can be phenomenal. But as we get into with Ben Barber, who is the director of Municipal Bond department at Franklin Templeton, Muni bonds are not just people with really high income. Right.
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C
So he says.
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A
So he says, we talked a lot about the whole space, how to think about rising interest rates in the market, what else we talk about. Bunch of stuff. We won't step on it here. Here's our talk with Ben Barber from Franklin Templeton.
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C
Ben, welcome to the show.
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D
All right, thanks very much for having me. Appreciate it.
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C
All right, let's start here. Over the last couple of weeks, the market has increasingly become focused on the direction of interest rates up and to the right at almost every area of the yield curve. I'm curious, how does, how do interest rates impact the municipal bond market?
- [02:47]
D
Yeah, absolutely. Great, great question and a great place to start. You know, the muni market very much follows the treasury market. We like to say it doesn't follow it tick for tick. So it's not exact. There's always a lag between the muni market and the treasury market. And over time, you could actually kind of set your clock to how correlated the muni market was versus Treasuries. That correlation is broken down over the years for a bunch of different reason reasons. But overall, the muni market will follow the same general trends as the treasury market up and down the yield curve.
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C
I guess more specifically, like how reliant. I know this is a very dumb question, but hey, I never claimed I was smarter than the muni bond market. How impacted are municipalities by interest rates today?
- [03:34]
D
I would say that they're very impacted. So when we think about the two main angles of risk or the two main factors that drive price volatility in the muni market, it would be, number one, interest rates, by far and away, that's your most important factor in terms of what causes prices of bonds to move up or down. So it's number one, interest rates, number two, credit risk. So is, is the credit story of the particular borrower on a positive trajectory or a negative trajectory? And that's, that's a factor as well, that interest rates by far is the most important factor in terms of what drives price volatility of muni bonds. And so if you're thinking about it from an issuer perspective, say the city of San Francisco or New York City needs to issue debt issue municipal bonds to finance some sort of infrastructure project. They're very mindful of what's going on in the overall interest rate environment before they get out there and borrow significant money.
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A
I'm curious how you think from a macro perspective about interest rates, because Michael and I have been talking that people are framing the rate rise as, oh, this is bad, right, because it's going to be harder for people to borrow and it's going to make it more onerous for governments because interest expenses are higher. But I look at it from the perspective of a bond investor and to me, it's short term pain for more long term gain. And for years fixed income investors were saying, this is terrible, there's no yield anywhere. What are we supposed to do now? Yield is finally here, but you just had to go through the pain to get there. Do you look at this as more of an opportunity like man, these are yields we haven't seen in a very long time?
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D
Potentially, yeah, without a doubt. We look at it much more from the opportunistic side of things. If you think about what has happened, you know, over the last several years when you were at a near 0, 0 or, or near zero interest rate environment for, you know, quite a long time, there were many, many investors who just went to cash and say, you know, forget it. Rates started rising on the short end of the curve and it was a very popular trade was just to stay in cash as the, the fear of rising rates really precluded a lot of investors from pushing out the yield curve and taking on more interest rate volatility in their fixed income portfolios. Now here we are with a 10 year, that's floating somewhere around a 464.70 in 10 year treasury space. Right now it is exactly at 458, but it's been moving around in that general area. You've got 30 year treasuries north of 5%. And so investors are really, really waking up to that exact point that there's finally yield in the market. And it's a heck of a lot better than sitting in money markets, for example. And so we've seen a lot of investor movement from cash and cash equivalents pushing out the yield curve as far as they're possibly comfortable. We've got a pretty good steep shape to the yield curve. So for every year that you're willing to push out in terms of investing, you're getting compensated that much more in terms of additional yield. So yeah, we definitely look at it as an opportun, opportunistic time.
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A
And from a risk perspective, it's funny because people were really worried about a recession when the yield curve inverted. Right now the yield curve is uninverted and it's back to what I think is more normal. Ish. If there is such a thing as normal in the yield curve. Right? This is more normal, correct?
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D
Yeah, absolutely. I mean we're Talking about essentially 100 basis points of steepness in the treasury curve from twos to 30s, give or take. And so, yeah, that's a fairly normal shape to the yield curve. You want the yield curve to Be upward sloping. You want those expectations set up that way. And that's exactly where we are now. I think the fixed income market gets very uncomfortable in an inverted yield curve situation, which is where we found ourselves a couple years ago. So, yeah, this definitely feels much, much better for investors to be able to push out a little bit beyond money markets and cash equivalent type of investments.
- [07:38]
C
This week on the podcast, Ben and I were talking about how impactful the AI trade has been for capital formation. We're getting the SpaceX IPO, not exactly AI, but certainly some areas of it anthropic, might be coming later in the year, but outside of just the equity space, I can't remember the number. It was like 87% of high yield issuance, some crazy number. And a lot of the investment grade issuance also has been related to AI. I'm wondering if you're starting to see municipalities be impacted at the local level between, like where AI, where data centers are being built. Does that infiltrated your headspace?
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D
It's definitely infiltrated our thoughts. You know, we've got a very large and experienced research team that works here, you know, right next to our. Our team is basically half portfolio managers and traders and then half research analysts or large team, roughly 27 people. And so yes, the notion of AI and data centers and financing and capital structure, capital formation around financing, all this stuff has definitely taken up a lot of our headspace. We think about it from a bunch of different perspectives, but one, when you think about municipalities specifically, you're really concerned about electricity usage and water usage, space. So there are certainly positives and negatives with regard to capital formation around building all of this infrastructure. But there's also on the risk side of things, you know, a lot of water usage, a lot of electricity usage. And so municipalities are definitely having to, you know, plan, plan ahead for that.
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A
You guys have a whole suite of municipal bond ETFs that can range in and you know how aggressive they are, type of credit risk they take, or the type of duration. Are any of these like go anywhere funds that kind of can go different durations or do you have pretty strict guidelines for the types of bonds you can buy in these funds?
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D
The answer is yes to both. You know, many of our muni ETFs that we have here at Franklin Templeton are very specific, they're state specific, and they are generally market duration type of funds, mostly investment grade. So that's the largest number of ETFs that we, that we manage here. But yes, we do have a Sort of quote unquote, go anywhere. Muni etf. It's called the Franklin Dynamic Muni Bond Fund and Muni Bond etf. And the whole notion there is that we have a little bit more flexibility on the portfolio management side to move around duration, which is your interest rate volatility side of things, as well as credit risk. So we can move both of those levers as we see opportunities in the market. That's our sort of our best, you know, quote unquote, best ideas. Muni Bond etf.
- [10:32]
A
I'm curious where you're seeing that now. Like, are you moving out on the duration a little bit because those yields are higher? It seems like credit spreads for corporate bonds are pretty tight. Is it pretty similar the spreads pretty similar in munis as well. Like where are you guys finding value these days?
- [10:46]
D
We see a lot more opportunities in the muni market than certainly that I'm hearing from my colleagues on the rest of fixed income. We spend a lot of time with the other asset classes around fixed income and we continue to hear, you know, spreads are either at or very close to all time tights across many of the different fixed income asset classes. That's not true in munis. So I think from an opportunistic perspective, from a yield, you know, we think about it a couple different ways overall duration and yield curve. And so to your point, yes, we're, we're a little bit further out duration wise than we are normally. We're trying to get access to that 20 to 30 year portion of the curve, which is the steepest portion of our curve right now and quite attractive from our perspective as well as on the credit side. So we're pushed down a little bit more on the credit risk side of things. So taking on a little bit more credit risk than we ordinarily would because credit spreads from our perspective are very attractive in munis. So we have not had nearly the tightening that other asset classes have had across fixed income.
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C
You've mentioned credit risk a number of times. I'm curious, what does that mean through the lens of municipal bonds? What does lousy credit look like? I would imagine that these are not things that change rapidly. I would imagine it's a very slow moving, upgrade, downgrade cycle. So what does that all look like?
- [12:14]
D
Great question. I think one of the things that people think about with regard to the municipal market is they think about states and cities and counties as being the issuers. And that's absolutely true. However, there are dozens of other sectors within the municipal market that have different Elements of risk that some of which have nothing to do with the state or the city or the county where that bond is being issued. So there are lots of sectors around the utility sector, water and sewer, electric authorities, et cetera. There are several different sectors within higher education, whether it's private schools, public schools, you name it. There are lots of different transportation sectors around toll roads and bridges and ports, airports, even airlines can issue debt in the municipal market if they're doing infrastructure at airports. And so you're taking on an airline credit risk. There are lots of different healthcare sectors, for example, nonprofit acute care hospitals, there are retirement centers, et cetera. And these all have different types, different elements of risk and different drivers that affect the economy that will affect these sectors in different ways. And so what does credit risk look like in the municipal market? Well, you have to take it sector by sector. Default rates are very low in the municipal market overall, but they do exist most specifically down in the in the below investment grade high yield portion of munis. Even in that space, defaults tend to be much, much lower than defaults in the corporate high yield space, for example, and recoveries tend to be higher than they are in corporate defaults. It's a fascinating market. I've loved it for my decades in the municipal market because it's so nuanced. Specifically, it's pretty illiquid in terms of as you go down the credit spectrum, it's very inefficient as an asset class overall. And so that creates lots of opportunity for us as institutional managers.
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A
It seems like once every few years someone comes out with a proclamation that the states and municipalities are all screwed and good luck with these muni bonds, right? Meredith Whitney was the most infamous one back in the day. But a lot of people say this and they picked certain cities or whatever states. What do you think are some of the misnomers about this, about these types of bonds that people don't seem to understand? Because it is kind of like the US government debt where people are constantly predicting there's going to be a crisis and then one never comes. What is it about munis that people want to predict a crisis, but it seems like there just hasn't been many waves in this space.
- [14:47]
D
Well, I think there are two things that really stick out. And we had to answer this question quite a bit in the aftermath of the gfc. Thinking through, I was getting the question, I remember what's going to be first to default? Is it going to be Portugal, Ireland, Greece, Spain or the state of California? And I was Being asked this question by a lot of folks that were not, you know, experts in the municipal market. And, and it was really interesting when we kind of thought through, you know, different ways to explain the overall strength of the credit fundamentals in the municipal market. Two things really stood out to us. Number one is that states have to operate with a balanced budget. That's, that's a mandate for every state in the country, with the exception of Vermont. But every other state has to operate with a balanced budget. It doesn't mean that gaps and deficits don't get created. Of course they do. But they have to have that discipline of coming back into balance at the state level. Not true at cities and counties or other sectors that I mentioned earlier. But at the state level, which is a major, obviously major borrower in the municipal market, that discipline of having to have a balanced budget is very, very important. That's number one. Number two, in general, remember that with municipals, we're providing financing for public infrastructure, and that infrastructure will have an average useful life. Say it's a bridge or a school or a hospital. Call it 30 years average life before major reconstruction needs to be done. Municipals amortize their debt generally in line with the average useful life of whatever asset was being financed. And so that's another critical difference. When you think about the, the post GFC time and Greece and other countries in Europe having to face the capital markets at a time where the capital markets weren't terribly happy to, to lend more money. They had these walls of maturities that were impending. In municipals, you don't really have that because you are constantly amortizing your debt, meaning you're paying down your debt. So if you, you know, if you borrow a billion dollars to build a bridge, you, you won't have $1 billion that's due in 30 years. You'll be paying that off through serial maturities or sinking funds, but you're paying down that debt over time, over that 30 years. So in year 30, you might only owe 50 million left or 100 million left, not $1 billion. And that amortization of your principal of municipal bonds is critical to, to think about the overall credit strength of the municipal markets, I'd say there's two things. Number one, the balanced budget discipline and number two, the amortization in general of municipal debt in line with the average useful life of the asset. So those are two critical features.
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C
As you're thinking along these lines and building a portfolio, how do you think about different areas of the curve and different durations and attractive opportunities. How does that all filter into your process at Franklin?
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D
That's a very iterative process that we have between our portfolio management staff and our research team. Because it's sort of the beauty of the municipal market is you've got the highly quantitative side, which is just your straight up bond math, which is kind of what you're referring to, where you know, where's the value in the yield curve, where is it the steepest, where's the best, best roll down and that sort of thing. Those are critical features of just straight up quantitative bond math. On the other side, you've got the creative side of what's required to research properly. You know, these different sectors from a top down perspective and then from a bottom up perspective, thinking about individual security selection. Those are the critical features of how we analyze the municipal market. How we go about building portfolios is very specific. So if we're talking about an ETF or an open end municipal bond mutual fund, you know, both of which we manage here at Franklin Templeton, it's all going to be about the target, the goals of that specific fund that we're, that we're managing. Same sort of thing on the SMA side, the separately managed account side, where we have very customized goals for our clients. So it's all about the target. What do we have to work with, what's our risk budget stipulate for us with regard to interest rate risk. And then we go about building the portfolio based on the best value in the yield curve to get us to that duration number at the end of the day. Same sort of thing with credit risk.
- [19:01]
C
So within the same vein, how do you think about, maybe this is not your job per se, but I'm curious. You obviously talk to a lot of clients, advisors and their clients are municipal bonds, only for high income people in high tax states.
- [19:17]
D
I'm really glad you asked that question. I think that's the biggest misnomer that we've got in our market is I think the answer is that munis are attractive really for any investor in the US that's paying any sort of taxes, any sort of income taxes. It depends where you are in the curve. But it's very easy to look at the after tax analysis and say, you know, here's the yield on a muni tax free, here's the yield on a corporate or a government bond, and here's how we line up from a credit perspective as well as from a duration or interest rate risk perspective. And to take a look at the after tax Analysis and what you'll see is as you push out the curve from one to 30 years, when you get longer and longer on the maturity spectrum, the term structure munis get more and more attractive on a relative basis. So looking out in that 20, 25, 30 years of maturity, it's very difficult to compete with municipal bonds across any other fixed income asset class that you might see on an after tax yield perspective and even down in the shorter portion of the curve where munis are less attractive on an after tax basis, given the overall, you know, very, very high credit fundamental, you know, potential of munis. It's, you know, you can even find munis down on the short portion of the curve that are attractive on an after tax basis when you really compare credit to credit and try to get to an apples to apples comparison. So I think mun are for sure attractive to high income people, but even those in a lower income bracket, lower income tax bracket at the federal and or at the state level, there's quite a bit of opportunity in the municipal market.
- [20:55]
A
I'm curious how you explain because Michael and I have noticed in wealth management that especially in the last few years, the tax alpha thing is a real thing that clients are coming to us with and asking for. They understand better than ever that it's not your gross returns that matter, it's your net after taxes, after fees. That's the only thing that matters, what's in your pocket. And municipal bonds have this interesting feature that it's almost like phantom savings or phantom yield. And so you have to show this tax equivalent yield to show people put them on the same wavelength. Right, because it's the taxes that you're not paying on this income versus taxes you are paying on other types of bonds. I'm just curious how you go about presenting that idea to show these on a one to one basis to show the attractiveness.
- [21:38]
D
Yeah, we definitely have a lot of conversations with clients around tax equivalent yields. Very easy math to do. Just looking at any sort of taxable bond, whether it's corporate bond or government bond, whatever the range of taxation is, take that off of the yield to get to a taxable to get your tax equivalent basis. Or you can gross up the muni yields to get to a taxable equivalent basis. Either way you want to do it, you can get to apples to apples on an after tax basis, which is critical for that analysis. So we, we do that quite a bit. You know, the other angle of tax efficiency that is really attractive in municipals is tax loss harvesting. And here what we're talking about is if we invested today and rates go down, we all know that the price and yields are inversely correlated. So if yields go down, prices rise, you're sitting on an unrealized capital gain. We'd be very reticent to have turnover in that situation because the last thing we want to do is book a capital gain investor has to go out and pay taxes on that capital gain. Conversely, if we invest today, rates go higher and we're sitting on an unrealized loss in a separately managed account, we would be very incentivized to book that loss. That loss flows directly through to the bondholder, to the client that they can use against gains they might have in real estate or equities or whatever. But that loss can be very, very valu. Key to this whole transaction in munis is that to get around the 30 day wash sale rule, which is if you sell Cisco at a loss, you can't go back into the market and buy Cisco back within those 30 days. Otherwise it's a wash sale in munis because you have so many different attributes to what a muni bond is. You've got the issuer, the coupon, the call, the maturity, all of which can be slightly different to escape that 30 day wash sale rule. And so it's a very efficient asset class to take tax losses as well as obviously providing the very attractive yield on an after tax basis.
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C
Do you think there's any particular wrapper for the investor that is better than the others? Whether it's an SMA mutual fund, an etf?
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D
It's really interesting. We do all three here at Franklin Templeton. Very large and growing separately managed account business etf. We have lots of different stripes and varieties of muni ETFs. And the history of the Franklin Muni group of course is in open end municipal bond mutual funds. So we have loads of those, state specific as well as national, all sorts of different risk, et cetera. It comes down to client preference, which is, I think what I'm most proud about with this group is that we were able to offer all of our capabilities in municipals in all three of the major wrappers. I don't think there's a one size fits all here type of situation. I think, you know, every client is going to be a little bit different in terms of their tax sensitivity, in terms of their desires around duration and credit risk. Liquidity in open end funds obviously is daily. With Muni ETFs, it's intra daily, which is an advantage for some people. In smas, you own the individual bonds as a client. And so that's very attractive for people as well. It really depends on client goals, but really happy that we were able to provide all three of those major wrappers to clients.
- [25:04]
C
You know, we don't hear that argument too much these days, which is I like individual bonds and I hate bond funds. I'm sure that drives you nuts because we know that portfolio of bonds. It doesn't matter if you own the individual bonds or not. They're owned somewhere and it's the exact same thing. But whatever, you can't change human nature. I don't have a question, that's more of just a comment. Do you have any thoughts on that?
- [25:26]
D
Well, I do. I think it's an excellent comment because it's spot on. And I think the really interesting part of that comment is in periods of interest rate volatility, specifically in an interest rate increase in environment like 2022 was worst year on record for total return in the municipal bond market. And it was just rates were going higher and higher and higher, 250 basis points in different portions of the curve. So it was a very difficult year. From a total return perspective in 2022, very typical response from shareholders of open end funds historically was to sell the losing asset class and buy the winning asset class. And so in a year like 2022, rates rising, NAV is falling and shareholders redeem like crazy out of open end funds. That was a record breaking year from a redemption perspective from open end funds. So our open end funds were getting liquidated, getting redeemed just like everyone else's. Our SMA business, very interestingly, every month in 2022 was positive net flows in 2022. And I think what you just, just hit on was exactly it. And that is the difference in the psyche of the retail investor.
- [26:39]
C
Wow.
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D
With open end funds they can tend to be, you know, kind of flighty with SMAs, kind of. The theory is if I liked this investment at a 2% yield, I should love it at a 4% yield and I'll give more money. And so we found that the investors over lots of different cycles that we've been managing money in all these formats have been very good and responsive and really opportunistic in the SMA space.
- [27:05]
A
So you've been doing this for a long time. I've had this talk with Michael before that I think that investors are actually becoming better behaved at this kind of thing. They're not running from the burning building anymore, they're running into it. Right. Have you seen that over your career where people are more apt to put money in when you get something like that, a downturn and yields go higher and they're better understanding what this means?
- [27:25]
D
Well, I think education is critical to that exact question. And so that's why I'm very appreciative to be on this podcast today, because the more information, more education we can provide to clients, the better investors they will be. And to your exact point, you know, rates rise, we don't want people to be scared. We want them to be, you know, think on the front foot and maybe this is a better environment for them to put money into fixed income and in particular, munis. And, you know, the whole key here is we know that rates are going to move up and down. We know that that's going to cause price volatility. That's a given. And we also know, and we fully acknowledge as fixed income portfolio managers, we can't guess interest rates correctly every single time. No one can. No one ever has. And so the key is, you know, that's coming and let's take advantage of it. So rates rise a little bit. It might be a great time to tax less, harvest. It could be a great time to put more money into, you know, extend more capital, more of your asset allocation into fixed income at that moment with, with a higher rate environment. So, yeah, I do believe that investors are smarter, more well informed, but the more, the merrier in terms of education and, you know, client interaction.
- [28:36]
A
Ben, where can we send people to learn more about your funds?
- [28:38]
D
Well, Franklin Templeton has a very good website. There's a lot to do there. You can look specifically into the Municipal Bond Group. We're very happy to connect and there's lots of information online for sure.
- [28:53]
A
All right, thanks so much for your time, Ben.
- [28:54]
D
Thank you.
- [28:57]
A
Okay, thank you to Ben. Remember, check out franklintempleton.com to learn more, but all our active Muni ETFs and more, email us animalspiritscompoundnews.com Investors should carefully
- [29:07]
E
consider a fund's investment goals, risks, sales charges, and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money. Investments involve risk, including possible loss of principal. Please see each product's webpage for specific details regarding investment objective, risks, performance, and other important information. Review this information carefully before you make any investment decision. There is no guarantee that any strategy will achieve its objective. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. ETFs trade, like stocks, fluctuate in market value and may trade at prices above or below the ETF's net asset value. Brokerage commissions and expenses will reduce returns. There is no guarantee that any strategy will achieve its objective. Separately managed accounts SMAs are investment services provided by Franklin Templeton Private Portfolio Group, llc, ftppg, a federally registered investment advisor. Client portfolios are managed based on investment instructions or advice provided by affiliated sub advisors of Franklin Templeton. Management is implemented by ftppg, the designated sub Advisor or, in the case of certain programs, the program sponsor or its designee, Putnam. Funds are not exchangeable for funds distributed by Franklin Distributors, llc. Franklin Distributors, LLC Member FINRA SIPC Investment Products not FDIC insured no bank guarantee may lose value. Municipal income may be subject to state and local taxes for out of state residents. Some income may be subject to the Federal Alternative Minimum Tax for certain investors. Capital gains, if any, are taxable. Franklin Templeton, its affiliates and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and tax related statements are not intended or written to be used and cannot be used or relied upon by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax related statements, if any, may have been written in connection with the promotion or marketing of the transactions or matters addressed by these materials. To the extent allowed by applicable law, any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.