Jim Murphy and Charlie Hill: ‘The Value Proposition for Municipal Bonds Has Rarely Been Stronger’

Summary

Podcast Summary: The Long View – Jim Murphy and Charlie Hill on Municipal Bonds

Episode: *Jim Murphy and Charlie Hill: ‘The Value Proposition for Municipal Bonds Has Rarely Been Stronger’
Release Date: November 12, 2024
Hosts: Dan Lefkovitz and Christine Benz
Guests: Jim Murphy and Charlie Hill from T. Rowe Price's Municipal Bond Investment Team

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Introduction to Guests and Municipal Market Overview

In this episode of The Long View, hosts Dan Lefkovitz and Christine Benz welcome Jim Murphy and Charlie Hill from T. Rowe Price's municipal bond investment team. Jim leads the team and manages several high-yield municipal strategies, while Charlie, with over three decades at T. Rowe Price, oversees short and intermediate-term municipal bond funds. Morningstar's manager research has lauded T. Rowe Price’s municipal bond capabilities, awarding several of their strategies gold medalist ratings.

Recent Performance of Municipal Bonds

Jim Murphy begins by highlighting the volatility in the municipal bond market over the past few years. He recalls a period of relative calm from 2015 to 2020, characterized by low interest rates and uninteresting spreads. However, the onset of the COVID-19 pandemic in March 2020 introduced significant volatility, with cash and treasuries soaring as other assets were crushed.

“We’re past this very significant Fed rate reset. So rates are at 10 to 15-year highs,” Murphy notes [04:02]. He emphasizes that the current environment offers a strong value proposition for municipal bonds, with high real yields and robust credit quality bolstered by improved fiscal health in state and local governments post-COVID.

Impact of Recent Rate Cuts

Charlie Hill discusses the implications of the recent 50 basis point rate cut—the first since 2020—and its effects on the muni yield curve. He explains that the inversion in the municipal curve, where shorter-term bonds yield more than longer-term ones, has lessened but still exists.

“The overnight municipal rate has come down from about 3.3 to 3%,” Charlie explains [04:48]. He outlines how these rate changes influence investor behavior and the overall yield environment, noting the interplay between treasury yields and municipal bond rates.

Researching a Fragmented Municipal Market

Navigating the expansive and fragmented municipal bond market is a challenge that Jim Murphy addresses with enthusiasm. He describes the market as “a large market of small issuers” and underscores the importance of thorough credit research and active management.

“We think it really lends itself to bottom-up analysis,” Murphy states [07:08]. He highlights the value of having dedicated researchers and maintaining boots-on-the-ground presence to uncover high-quality, off-the-beaten-path municipal bonds that offer reasonable yields.

Mutual Funds vs. Individual Bonds

Charlie Hill delves into the perennial debate between investing in mutual funds versus individual municipal bonds. He outlines the advantages of mutual funds, including professional management, holistic portfolio assessment, and the ability to manage interest rate and credit exposure effectively.

“If you hire a professional to do it for you, they take a holistic view of your entire portfolio,” Charlie explains [09:38]. He contrasts this with individual bond investing, where managing tax loss recognition and maintaining portfolio risk can be cumbersome for individual investors.

Investment Flows and Current Trends

The conversation shifts to investment flows within the municipal bond space. Charlie Hill reports a positive trend with approximately $25 billion in inflows year-to-date, reversing nearly $140 billion lost over the previous two and a half years.

“Flows have recently turned positive in the ETF and mutual fund space,” Charlie observes [13:39]. He attributes this rebound to investors returning to fixed income as equity markets become less attractive and recognizes the importance of rising interest rates in revitalizing demand for municipal bonds.

Impact of Upcoming Elections on Municipal Bonds

With the U.S. presidential election on the horizon, Jim Murphy discusses potential implications for the municipal bond market. He anticipates a divided government outcome, which could influence corporate tax rates and the Alternative Minimum Tax (AMT).

“If Vice President Harris gets elected, we could expect higher tax rates across the board,” Murphy contemplates [17:09]. He suggests that increased demand for tax-exempt income from higher tax rates would bolster the municipal bond market.

Charlie Hill adds that the fate of the AMT could significantly impact investor behavior, particularly concerning tax-exempt income.

“The AMT relief sunsets at the end of 2025 unless they reach an agreement,” Charlie notes [19:45]. He emphasizes the importance of monitoring legislative changes that could affect municipal bond attractiveness.

Geographic Considerations in Municipal Investing

Geography plays a crucial role in municipal bond investing. Charlie Hill discusses the challenges associated with states like Illinois, which have historically struggled with fiscal issues. He contrasts this with Sunbelt states experiencing population growth and increased issuance needs, particularly in Texas and Florida.

“We are spending as much time as we can really looking at some of these coastal regions more carefully,” Jim Murphy adds [40:00]. He highlights the nuanced opportunities arising from population shifts and the resulting infrastructure demands in growing states.

Credit Quality Assessment in Municipal Market

Assessing credit quality is vital in the municipal bond market. Jim Murphy explains that quality spreads in munis are positively correlated with interest rate movements and are currently healthy.

“Quality spreads are about... one standard deviation tight to where they've been in the recent past,” Jim assesses [27:04]. He underscores the strong fiscal health of state and local governments, supported by improved income statements and balance sheets.

High Yield Municipal Bonds

High yield municipal bonds offer enhanced income potential with manageable risk. Jim Murphy clarifies that high-yield in the muni space refers to higher-than-average yields rather than true junk bonds.

“The municipal market is a very, very high-quality market with a very low default rate,” Jim asserts [46:08]. He advises using high-yield municipal bonds as a yield enhancement within a broader, higher-quality bond portfolio, balancing additional income with limited default risk.

ETFs, Mutual Funds, and SMAs in Muni Investing

The discussion moves to the various investment vehicles available for municipal bonds. Charlie Hill explains that while ETFs provide passive management and liquidity, actively managed mutual funds offer superior income through targeted research.

“The extra income that you get through an active manager... will accrue to the benefit of the mutual fund or active ETF holder,” Charlie states [50:13]. Jim Murphy emphasizes the growing demand for actively managed ETFs and mutual funds, anticipating a shift towards these products over the next five years as investors seek active management’s added value.

“We're going to meet the client where they want to get their tax-exempt Alpha from,” Jim concludes [50:23]. He notes that while ETFs are gaining traction, mutual funds remain the primary avenue for active municipal bond investment.

Conclusion and Final Insights

As the episode wraps up, the guests reflect on the resilient and opportunistic nature of the current municipal bond market. Jim Murphy underscores the strategic positioning of municipal bonds given the current interest rate environment and strong credit quality.

“The exemption just feels a heck of a lot more valuable to individual investors at higher rates,” Jim remarks [23:31]. Both Jim and Charlie convey confidence in the municipal bond market’s prospects, driven by favorable fiscal conditions, rising yields, and sophisticated management strategies.

“It's been an absolute pleasure,” Jim concludes, thanking the hosts for the insightful discussion [51:43].

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Notable Quotes:

• Jim Murphy on market volatility: “One day in the stock market could be a year in the muni market in terms of volatility.” [01:35]
• Charlie Hill on rate curve inversion: “The inversion still exists today, although it's not as pronounced as it was back in the summer of 2024.” [04:48]
• Jim Murphy on research advantages: “If you can do that, then you can really add value in real time.” [07:08]
• Charlie Hill on mutual funds vs. individual bonds: “Another item obviously is going out and doing the due diligence on individual credits.” [09:38]
• Jim Murphy on election impact: “If Harris gets elected, we could expect higher tax rates across the board.” [17:09]
• Charlie Hill on AMT implications: “It might have a terrible impact if it gets reinstated, but we'll see.” [19:45]
• Jim Murphy on tax-exempt status: “We think it was very clear to us that they were so massively over-leveraged.” [40:00]

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This episode provides a comprehensive analysis of the current state and future prospects of the municipal bond market, emphasizing the enhanced value proposition due to rising interest rates, strong credit quality, and strategic management. Jim Murphy and Charlie Hill offer expert insights into navigating a complex and fragmented market, making this episode valuable for investors seeking reliable, long-term tax-exempt income opportunities.

Transcript

[Jim Murphy]

At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial, Inc. Jackson National Life Insurance Company, Lansing, Michigan and Jackson National Life Insurance Company of New York, Purchase, New York.

[Disclosure Announcer]

Please stay tuned for important disclosure information at the conclusion of this episode.

[Dan Lefkovitz]

Hi and welcome to the Longview. I'm Dan Lefkovitz, Strategist for Morningstar Indexes.

[Christine Benz]

And I'm Christine Benz, Director of Personal Finance and Retirement Planning for Morningstar.

[Dan Lefkovitz]

Our guests this week are Jim Murphy and Charlie Hill of T. Rowe Price's municipal bond investment team. Jim leads the team and is portfolio manager for several high yield muni strategies. Charlie, who has been at t. Rowe since 1991, manages several short and intermediate term municipal bond funds. Morningstar's manager research team rates T. Rowe Price's municipal bond capability highly with several strategies carrying gold medalist ratings. Jim Charlie, thanks so much for joining us on the Longview.

[Charlie Hill]

Thank you.

[Jim Murphy]

Thanks for having us.

[Dan Lefkovitz]

Yeah, absolutely. Jim, let's start with you. The past few years have been something of a roller coaster for the municipal bond market. Maybe a bit more drama than many investors looking for steady tax free income would desire. We had the pandemic and then 2022, the, the rate hikes with recoveries of course in between. But maybe you could kind of talk us through the past few years in the muni market from your perspective.

[Jim Murphy]

Yeah, great. You know, my, my old boss, Hugh McGurk used to say that, you know, one day in the stock market could be a year in the, in the muni market in terms of volatility. But yeah, that, that really changed. When you go back, I like to think about some of the periods we went through and I would say starting with the period of 2015 to 2020, it was a period of real calm in the mu market, kind of Groundhog day where rates were very low quality spreads were very uninteresting. Inflation at the time, a lot of the discussion was inflation was dead, kind of vacillating up and around over under of 1% with the Fed having real concerns as much about deflation as inflation. And then March of 20th Covid hits and it's been quite a volatile ride since. So Covid basically the market was run for the hills. Anything that was not cash or treasuries got crushed. And then we moved into 2021 where we had a massive swing back on the Back of the Fed swinging a heavy ax to bolster the markets post Covid. And then 2022 and most of 23 where we had an enormous interest rate reset in response to inflation. I think that transitory is a word that will probably be struck from the Fed script moving forward. But now here we are in 24 and I think we've returned to maybe a period of more normalcy. And now I always look for the falling safe over my head when I use that expression. But things feel, you know, a lot more normal for the market. And I think that as we were talking about before we jumped on, the value proposition for the asset class has really rarely been stronger in my time of doing this where we're in a sweet spot. We're past this very significant Fed rate reset. So rates are at 10 to 15 year highs. So we can actually in income products offer real yield for our investors. And also, you know, that dovetails nicely with credit quality in the municipal bond market being very, very strong as well. Whether you liked it or not as a taxpayer, Federal support for the states through Covid left the states. The byproduct of that left the states and local governments in great shape from a fiscal perspective. Balance sheets strong, pension fundedness improved a lot even for poster children of former bad fiscal behavior like New York and Illinois. So we've seen significant credit upgrades. So it's pretty easy to like what we're seeing as bond investors, certainly after living through a pretty bumpy ride.

[Christine Benz]

That's really helpful stage setting and we'll follow up on some of the themes that you just referenced. But Charlie, I want to turn to you and ask about the recent rate cut. We recently had a 50 basis point rate cut which was the first since 2020, and potentially more rate cuts expected in 2024. So the muni yield curve has been inv like the treasury curve. Can you talk about what the impact of this recent rate cut has been for the muni market?

[Charlie Hill]

Sure. So the inversion in the muni curve was very much focused on the very front end of the curve where overnight municipal money market investments were yielding more than 1, 2, 3, 4 year bonds. That inversion still exists today, although it's not as pronounced as it was back in the summer of 2024. So some of that inverted steepness has come out of the market. The rest of the muni curve is actually fairly steep. If you start with the five year at around a 2.4%, you go out to 30 year debt a little bit under 3.7%. So 130 basis points from five year bonds to 30 year bonds is actually historically a pretty steep yield curve in the muni space. As far as what the impact immediately of the fed cutting rates 50 basis points from 5.3 roughly to 4.8, the overnight municipal rate has come down from about 3.3 to 2.97 to 3.3 to 3%. So what you're earning on your cash is obviously coming down the front end of the muni market, the front end of the treasury curve. A lot of this had obviously already been built into the marketplace before the FOMC met and cut the interest rates last Wednesday. And since that time, going into the unemployment report last Friday, rates had moved up anywhere from say 10 to 15 basis points. Moving out the treasury curve and then post the payroll report, we're up another 20 to 30 basis points depending on what part of the curve you're looking at. So in the very big picture, if we step back and we'll talk about the treasury market, treasury yields declined from about 4 and 3/4% to 3.6 right before the Fed cut rates. And since then rates have moved from 3.6 to roughly 4.1% in the aftermath of the Fed cut and the non farm payroll number.

[Dan Lefkovitz]

Well, taking a step back, Jim, it might be helpful. This is a massive market. For those who aren't familiar, it's often referred to using terms like fragmented and opaque. How do you go about researching such a large and fragmented market?

[Jim Murphy]

Yeah, you know, that's the great fun of, of the market is we always say that it's a large market of, of small issuers, it's sprawling. So you mentioned, you know, Beth Foose and when we spoke with her last week, we talked about it, it's kind of one of the, one of the last bastions of really inefficient bond market. So you know, we, we really view ourselves as credit investors. We invest very heavily in credit research and we're active managers. So we're trying to add value with that research. So when you have a large sprawling market like the muni market with varying degrees of sophistication in terms of market disclosure, we think it really lends itself to bottom up analysis. And that includes, you know, having boots on the ground folks that can do timely research, folks that can absolutely navigate the heterogeneous world of municipal bond disclosure. So if you can do that, then you can really add value in real time. And that also includes getting out in the world and meeting management teams and marrying a quantitative approach to the qualitative work as well. So it's a lot of fun. And the average issue size of most municipal deals is probably somewhere in the 50 to 75 million dollars range. So you can just add a lot by finding these little off the beaten track nuggets of high quality credit at reasonable yield. So that's kind of what makes the job a lot of fun, is the inefficiency and the ability to extract that for the benefit of your clients.

[Christine Benz]

We appreciate the shout out for our colleague Beth Foods and Manager Research. She has been covering fixed income funds for a long, long time and is really good at it. Charlie, wanted to ask you about the fund versus individual bond question, which seems especially alive and in the wake of 2022, where I think many investors just think they're better off holding individual bonds to maturity where they'll, you know, they believe they'll be made whole at the end of their holding period. Can you talk about that decision? I think even a lot of advisors put their clients in individual bonds versus muni bond funds or, you know, other types of products. So can you talk about that decision and maybe what you think investors are giving up if they opt for individual municipal bonds?

[Charlie Hill]

Well, I mean, it's a great question. It's an age old question that people love to pose to a mutual fund manager, obviously. Right. Let's support the business that you're in. A few big picture things are that when you hire a professional to do it for you, they take a holistic view of your entire portfolio and look at the interest rates, exposure and credit exposure of the entire portfolio. And one thing that we try to do is make sure that we have kind of an asymmetric lean towards interest rate exposure. If rates go down, we want the portfolio to appreciate in value. And if interest rates go up, the value of the portfolio doesn't go down faster than it otherwise would. So you, you kind of want an asymmetric payout depending on which way interest rates go. And I think if an individual populates a bond fund or a bond portfolio, they don't necessarily know the overall risk that that portfolio has. Another item obviously is going out and doing the due diligence on individual credits. And where you hire a professional manager, you do that. And you know, we've had, or I have had at least in my career a number of times where high quality credits have gone south. And I go back to my early years at T. Rowe Price when Orange county defaulted. Bob Citron was the manager of Orange county finance. In 1994, he was managing the Cash basically buying mortgage backed securities. And when GreenSpan raised rates 300 basis points, his mortgage portfolio blew up. And here you had a aa very high quality general obligation issuer that was suddenly in trouble. You know, we've seen that happen with other high quality issuers or large issuers like the state of Illinois or New Jersey, and we've even seen the state of California get in trouble from time to time. So I think having having somebody, you know, do the research and pay attention to the credit quality, various investments is important. Another thing that I think doesn't get really appreciated is as you point out, if you buy an individual bond, you know you're going to be paid off at maturity. Well, if interest rates go up and you have a loss in many of your bond holdings, that loss is something that you can reduce your tax liability with if you realize it. And it's an asset at that point. It's really an asset that if you monetize that loss and use it to offset other gains that you might have in your equity portfolio, you can make it work for you. And an individual with a portfolio of 20 securities, for instance, I doubt is going to go out and execute tax loss swaps to realize losses on the individual bonds and then go back into other bonds where we do that in institutional size across a number of funds and separately managed accounts all at one time. And you really see our transaction, the amount of transactions increase dramatically when we're in a situation of being able to realize losses for our clients and rebook into higher yielding securities that will then pay the investor a higher stream of tax exempt income going forward. So I feel like between the overall professional management of the rate risk, obviously the credit research, and then tax loss recognition, those three accounts I think are very supportive for farming it out to a mutual fund or an etf.

[Dan Lefkovitz]

Well, it'd be interesting to hear what you've been seeing in terms of investment flows into your products. Munis sort of have the reputation of being a retail market and so flows can be volatile and sensitive to headlines. What have you been seeing?

[Charlie Hill]

Flows have recently turned positive in the ETF and mutual fund space. I think we're at roughly $25 billion worth of inflows year to date and 13 or 14 consecutive weeks of inflows, and that follows the better part of two and a half years of kind of anemic growth. 2022, when the Fed started raising rates, the industry lost about $123 billion. 2023, another 16 billion. And we've been kind of flatlining into 2024, and we've had a recent uptick in issuance. I think if you step back and think about what has happened, the rate move in 2022 was very quick in the first three months of the year, or I should say the February, March, April timeframe. And we saw a tremendous amount of cash leave the market. And if you think about where interest rates were when that money was leaving, rates had already moved up and people were reading headlines in the Wall Street Journal or whatever newspaper, seeing it on television, that interest rates were moving higher and they started liquidating bond funds. If you look at the prior three years, 2019, 2020 and 2021, you had inflows of about $250 billion over that three year period. Coming into a market where interest rates were very low and the municipal bond asset class was trading at a very rich level relative to treasury bonds. So you just think about the individual investor that is choosing to kind of chase returns when interest rates are very low and then liquidating that asset class after rates have moved up in 2022 and 2023. So it's good to see that they are returning to fixed income. And I think that if you, you know, you listen to asset allocators, you think about where the equity market is today relative to where it was at the end of 2022, suddenly fixed income appears to be a much more interesting asset class to asset allocation managers.

[Jim Murphy]

Yeah, the one thing I would add to that is just this expression moves AT T bills and chill. So when a lot of that money kind of rightly departed the market in 2022, they were doing exactly what we were doing in portfolios, which was taking tax losses. We, as an industry fully expected a lot of that money to kind of roll back into the funds, but it's been very hard to compete with a 5 and a quarter percent money market rate. I think what Charlie was just talking about, the fact that inflows are starting to really pick up in the tax exempt space, has a lot to do with the fact that maybe that party is coming to an end in money market rates and adding duration makes a lot of sense.

[Christine Benz]

In front of that, Jim, I did want to ask you about the upcoming election. We're taping this on October 10th. We have an election coming up less than a month away. So I wanted to hear about what you're watching in terms of the election, in terms of the presidential election, Congress, national and state elections, what are the potential implications for your market?

[Jim Murphy]

Yeah, I think the tail risks are really what we're looking for to try to understand. It seems a lot of our in house research and folks that we talk to outside seem to point to more divided government. And it feels like, you know, smart money is saying that the House might flip towards the Democrats, the Senate might flip towards the Republicans. I think watching the Senate race here in Maryland is really interesting. Maryland is a pretty dark blue state, but we have a very popular centrist former governor in Larry Hogan that really might be the linchpin of swinging the Senate back. The Republicans, the presidential race is a coin flip. So I think what we're playing for is divided government, which means whoever gets elected, whether it's Trump or Harris, they'll get maybe one bite in their first year at the policy apple. We think that if Trump gets elected, he will certainly try to make permanent the Tax Cut and Job act of 2017, maybe try his hand at lowering the corporate tax rate even more. I think this time around he will stay away from health care. He lost pretty convincingly last time. And then if Vice President Harris gets elected, I think one of the things she's campaigning on is a big change to the corporate tax rate. And I think it's fair to say if Harris gets elected, we could expect higher tax rates across the board. So that, at least for the muni market, means more demand for the exemption. And after the Tax Cut and jobs act of 2017, we saw a pretty considerable downshift in demand from both banks and insurers for the tax exemption that munis offer. And so if the corporate tax rate went up to 28%, we should expect to see banks and insurers coming in and buying munis at a far more torrid pace. One other thing we're watching as investors too, is what happens to the alternative minimum tax. So that was largely fixed in the Tax Cut and Job Act. We had millions and millions of middle income Americans in high tax states being drawn into the amt, which it was never designed for. And that was fixed with the Tax Act. If that's allowed to expire, our math says that we might go from somewhere around 50,000 individuals to over 7 million being pulled into the AMT. AMT, which would be a pretty major headache for the government.

[Dan Lefkovitz]

Charlie, did you want to weigh in at all on the election?

[Charlie Hill]

I think the AMT question for us is the biggest thing. And the AMT relief sunsets at the end of 2025 unless they reach an agreement and leave it in place. And it's kind of interesting, even though fewer people are subject to amt right? Now AMT spreads have kind of remained relatively wide throughout the entire period from 2017 until today. It's kind of one of the last places in the high quality investment grade market where you can actually pick up some spreads. So the change didn't really have an impact. So I don't know if it'll have a terrible impact if it gets reinstated, but we'll see.

[Dan Lefkovitz]

Jim mentioned the exemption. Is there any risk that the tax exempt status for municipal bonds could be changed?

[Jim Murphy]

I don't think so, no.

[Charlie Hill]

Okay, that's a one word answer.

[Jim Murphy]

I mean the Build America bond program was an attempt at that during the Obama administration and it's kind of like a fielder's choice. It became overcomplicated. And I think most people that we know down in Washington believe that the municipal bond market, as much as everybody likes to say, oh, you know, crumbling infrastructure or failing infrastructure in this country, they fail to mention that from a bottom up perspective. Most state and local decision makers know where to put the bridge, they know where to build the airport, they know where to build the hospital. And the exemption is the grease for the wheels of all of those good infrastructure decisions that are made at the state and local level.

[Christine Benz]

I wanted to ask whether the sun setting of the TCJA potentially at the end of next year, I guess 2025, does that embellish prospects for Munis? Does it make it more likely that people will gravitate to that tax free income that munis offer?

[Jim Murphy]

Yeah, if the highest tax brackets move upwards and the corporate tax rate goes up, then yes, at the margin. That should create more demand for the exemption would be my expectation.

[Charlie Hill]

Yeah, I was just. Christine, I was just going to say that I think the demand for tax exempt income right now is very high. I mean you've had, has this act also cut corporate rates? It made municipal bonds less attractive to banks and insurance companies. So we've seen them liquidating municipal holdings for the past seven years. And on the other side of that, issuance has been very high. We're going to have hit a record in issuance this year. And yet in all of this, banks, corporations liquidating issuance being high, the demand has been insatiable except for times of periods of very high volatility where there might be a lot of negative price action in the fund and ETF space. The rest of the time, the demand from whether it's mutual funds, ETFs or separately managed portfolios has been extremely high. And I think the wealthy people seeking tax exemptions understand where rates are today relative to the last 15 years. And they see it as a great opportunity to lock in to a certain amount of good high quality income prospectively as many of us, including myself, look towards retirement. So I don't know that the sunsetting of the act will have as big an impact as just the uptick in rates that we've experienced over the last two, three years and the opportunity it has provided. I think that's the bigger thing in the room right now.

[Jim Murphy]

Yeah, I would just add that exactly to Charlie's point. The exemption is it just feels a heck of a lot more valuable to individual investors at higher rates.

[Charlie Hill]

Right.

[Jim Murphy]

If you're sitting in a money market earning zero or earning, you know, you get $10 a year in interest, well, who cares, right? But all of a sudden you have money market rates at five and a quarter percent and you know you're getting 500 or $600 a month in interest showing up, you know, you're paying taxes on that. It just, it makes the whole dynamic more interesting for people to invest in tax exempt income.

[Dan Lefkovitz]

I know the key statistic in muniland is that MTT ratio, the muni yield versus the treasury yield. Can you sort of explain what drives that ratio and how you use it?

[Charlie Hill]

I mean, so it is, it's very simply, you take a Treasury maturity of your choice. We can talk about the five year right now. So the five year treasury is at 3.9%. A five year municipal high quality bond is around 2.4%. You divide the 24 into the 39 and you come out with about 61, 62% of treasury. So that's the ratio that we quote. And I think in generally calm markets, that ratio can kind of exist at a level that's plus or minus one or two ratio points for a long period of time. In periods of high volatility, especially negative volatility, counterparties will cheapen the municipal market if they need to in order to bring in other entrants. So we saw this big time in 2008, in the spring of 2008 where there were massive liquidations of levered mutual funds and you started to see 30 year municipal bonds trade at levels that were 120 and 130% of 30 year treasuries. So the ratio day in and day out, we use it to kind of gauge where a specific maturity should be relative to what the treasury market has done. So if the treasury market moves a few basis points, we apply the existing ratio, today's ratio, to the new treasury level. And kind of estimate what the what the new muni rate would be. But the other way that people use it is as it gets very cheap or the counter very rich. You'll see people who don't normally pay attention to the municipal market poke their head up and start to get involved.

[Jim Murphy]

At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial, Inc. Jackson National Life Insurance Co. Lansing, Michigan and Jackson National Life Insurance Co. Of New York, Purchase, New York.

[Christine Benz]

So Jim, I want to ask you about credit spreads which you mentioned earlier in the conversation. It's obviously something you monitor and you indicated that Covid was actually good for municipalities in a lot of ways in terms of improving their fiscal health. But maybe you can talk about how you are assessing credit quality in the municipal bond market, especially relative to other areas of fixed income.

[Jim Murphy]

Yeah, you know, it looks fairly healthy, Christine. It's probably not as wide as 2022. Quality spreads in munis tend to be positively correlated with the direction of rates. So when rates are falling, quality spreads typically tighten. And that's kind of the retail element of our market where individuals will reach for medium and lower quality as rates go down. Just that I need my 4% kind of mindset. So there's a lot of technical in there and there's also a lot of fundamental, I would say right now, based on the last five years, quality spreads are about, we would say about one standard deviation tight to where they've been in the recent past. That feels okay to me, especially if you overlay that mindset to let's say a period of 2001-2006 where rates were a lot higher. We had a very constructive credit environment. Like now, quality spreads look quite healthy in that regard. So it feels good. When you dig under the hood and you take a look at just the fiscal health, you see that income statements and balance sheets are very healthy at the state and local level. So it justifies paying a little bit more for let's say an A rated credit. You know, at the wides over the last couple years probably has been as wide as 100 plus 120 to a AAA net maybe now at 75 to 80%. From a longer term historical perspective, that's just fine.

[Dan Lefkovitz]

Well, it'd be really interesting to hear about how you're approaching today's market and where you're finding Opportunity from a sector perspective, from a geography perspective, our colleagues on the manager research team say healthcare is a sector that you like.

[Jim Murphy]

Yeah, healthcare has always been an area of specialization for us. I think we invest a lot in our ability to do credit research there. And I think it's a very misunderstood part of the tax exempt market. We always say the muni market, which implies all state and local gos. But the tax exempt market, two thirds of which are revenue bonds and not for profit hospitals are a very, very big part of that. If you look at just our nation's network of hospitals, a very very high percentage of them are not for profit. So interesting about that is unlike for profit hospital systems, these systems are not forced to dividend their earnings to shareholders. So what happens is you have businesses that generally generate anywhere between a 5 to 10% EBITDA margin or free cash flow margin. And that money after providing the healthcare services to their constituents, those profits go right into the balance sheet of those hospitals, which is great. Okay, for periods like Covid or periods. We have a hospital down in Tampa right now, BayCare Health, where they've got. It's a double A credit that's got two times cash to debt outstanding, which means you can survive a lot of income statement volatility in that environment or payer mix volatility, which is exactly kind of really. The healthcare industry took two gigantic body blows in three years. One with COVID and then two with pretty rampant employee inflation for healthcare workers during 2020 22. We're on the other side of that now. And it just. Most of these credits benefit from limited competition, very resilient income statement strength and balance sheets that typically cover their debt outstanding by a multiple. So frankly, I think the rating agencies often get it wrong in healthcare. The municipal market too, like because so much demand comes from the SMA business and the retail side of the business, a lot of people will just simply say, hey, no healthcare, no transportation, no this, no that. I just want really nice, clean, safe water and sewer bonds and local. And you're really missing out on terrific extra income and spread in these sectors that are very safe and are often misrated in our view.

[Christine Benz]

So Charlie, how about the flip side of that? Are there any sectors that you are generally avoiding for whatever reason and maybe you can expound on what the reason might be?

[Charlie Hill]

Well, it's really, it's just the opposite of what Jeb just talked about. You know, the local and state and local general obligations bonds, water and sewer pre refunded bonds, the handful of very high Quality sectors in our market that offer no additional spread or carry relative to what you can get in some of the revenue bond sectors. I mean, it's just the counter to buying healthcare. You're not going to purchase the stuff that trades at a very rich level. So those are the areas that you end up underweighting them in order to overweight the revenue bond sectors that we do a lot of research on. And just to further Jim's point, I mean, another example of a healthcare bond, the largest position in one of my portfolios is Innova Health in Northern Virginia. It's a $5 billion a year operation and they have $7.5 billion in cash and investments on the balance sheet. And they have got three and a half times more cash than they have debt. And we look at a hospital like that, that's giving me 50 basis points more than a high quality water and sewer bond or a high quality local general obligation bond. And you think about the professional management, the corporate style management that you're getting out of a hospital, the balance sheet that you're buying, and you ask yourself, I mean, why in the world would you not pick up that incremental yield over a local general obligation bond or a water and sewer credit.

[Jim Murphy]

Yeah, another, another one in the market, Children's Hospital of Philadelphia, I mean the Double A hospital, it's one of the top children's hospitals in the country. And you know, it's, you know, they've got two plus times cash to debt. It's just if you're a really careful fixed income investors and you pay a lot of attention to the balance sheet and a lot of novices in this space will pay a lot more attention to the income statement. And we just think you have to.

[Dan Lefkovitz]

Do both your portfolios have some exposure to corporate backed munis. Could you explain what those are first of all and why you like them?

[Jim Murphy]

Yeah, traditionally corporate backed munis, the heading would be industrial revenue bonds or pollution control bonds. So you'd have a lot of certain types of corporate credits that could issue in this market, largely like let's say take utilities for example. So a utility, maybe 30% of their base electricity generation comes from coal. As much as we want to get away from coal in this country, it's hard to do, but maybe they can issue 100 or 150 million of tax exempt debt to put in a scrubber for that coal plant. So the code will allow for corporations to often issue debt for pollution control. We've seen that with paper companies, we've seen it with Steel companies like US Steel is a big issue. We used to see international paper a lot. And airlines, airlines have the ability to issue on a tax exempt basis, typically when they're lessors at airports, at state owned airports. So we do get a decent amount of issuance coming from corporations, which is a really neat thing for a firm like ours that has a very robust research advantage not only in munis, but across taxable and high yield investments and even equity investments. So we partner with those folks very directly. I would never ask a hospital analyst to tell me what they think of U.S. steel. I would go right down the hall to our U.S. steel analyst and talk to him about that. So it's a pretty cool thing. Now we used to have even more, as much as 20% of tax free high in corporate backed debt. When rates got to that Groundhog day environment, really, really low, the value for corporations of issuing in the exempt market versus the taxable market became less. And now we're starting to see more corporations come back into the muni market. Because when borrowing costs are so low, what's the difference between issuing at a 180 or a 140 to the corporation, but now at 4 and 5%, they could probably save 100 basis points by issuing on an exempt basis. But with that, the responsibility of the corporate entity is to prove to the IRS that they are issuing this debt for bonafide tax exempt purposes too. So there's a little bit of a, of a hurdle there that they have to go through as well.

[Christine Benz]

We wanted to ask about geography. We're talking to you today from Illinois. Both Dan and I are in the Chicago area. It's obviously long been a problem child. From a fiscal perspective though you referenced that things have improved a little bit. So maybe you can talk about how you think about state specific regional issues as you go about putting together muni portfolios. And maybe you can weave in how you think about population shifts that we're seeing, where people are moving away from some of these higher tax states towards Sunbelt states. And then also sort of the related question about the Sunbelt states and some of the climate change impacts that they've had, where it seems maybe have more of a need to do rebuilding and address some areas that have been hurt by some of these big storms that we've been seeing.

[Charlie Hill]

You know, as far as state issues, I think, you know, you're talking to us from Illinois and Illinois has obviously had issues over the years. I think, you know, it's very difficult to come in and buy a Local go or a healthcare credit or a water and sewer credit. Even if the state general obligation debt is trading at a widespread or even distressed level, you know, it's hard to give yield to go into other bonds within a state ignoring what the general obligation debt is doing. And we saw that in the 2007-2010 timeframe in the state of California, where Cal revenues declined precipitously during the global financial crisis, spreads widened considerably and as such, other spreads in other California exempt debt also widened. So I think your, your opinion, your outlook for the state general obligation debt does make a difference. It doesn't necessarily, it's not necessarily, you can't necessarily draw a direct line to another credit being weaker, but you can definitely draw a line to the perception of other credits within a state getting a little less attention than they otherwise would. As far as the migration question, I mean, we've seen out migration in California, Illinois, New Jersey, New York for a number of years now. And in migration to Texas and Florida. I think specifically with Texas and the other side of it hurting the states where populations are leaving, the amount of debt that we're seeing issued from the state of Texas just to handle the educational needs and other infrastructure needs within the state has increased issuance out of Texas tremendously. So, you know, to the extent that California may be hurt or Illinois may be hurt from out migration, you're not seeing the corresponding issuance pressures that you're seeing on some of the states that have a lot of the net in migration on the Sunbelt state questions and rebuilding. You know, and I hate to throw Puerto Rico into the mix, but a couple of hurricanes really brought a tremendous amount of money into Puerto Rico. And I would imagine to the extent that we're going to see considerable rebuilding needs in North Carolina and Florida, that will only create many booms in those areas of the country once they get their feet back on the ground.

[Dan Lefkovitz]

Jim, did you want to add anything?

[Jim Murphy]

That was well said, but I think we are spending as much time as we can really looking at some of these coastal regions more carefully and understanding that maybe we're supposed to demand a little bit of a yield premium on a place like Miami versus Atlanta. And so I think we're doing that. I think the market is in the early stages of doing that. And I would echo what some of the second, third derivative effects of this migration shift. We invest in charter schools. So you look at places like Arizona, Texas and Florida that have all been growing. And so charter schools have been a really, really interesting, nice outlet for the public school system. And a lot of times if you're in a pretty static population growth environment or a declining and you drop the charter school into one of those areas, there could be some real friction because the public school system in that charter might be fighting for the same tax dollars. Well, that's absolutely not the case in Texas. In fact, in Texas you see that once a charter school gets to a certain critical mass of students and financial solidity, the PSF permanent school fund will actually come in and wrap that system and allow them to borrow at even lower rates. So there are some really interesting second and third tier nuances to this migration shift, but we watch them closely and try to take advantage of them.

[Dan Lefkovitz]

Well, you mentioned Puerto Rico earlier. You also mentioned the famous Orange County, California default. City of Detroit was another bankruptcy, high profile bankruptcy in the meaning market. Do you see any major risks like that on the horizon today? And it also might be interesting to hear how you've moved in and out of Puerto Rico. It looks like you've got some exposure to Puerto Rico now in your portfolio.

[Jim Murphy]

Yeah, you know, it's, it's on just the, you know, are there any Puerto Ricos in the offing? No, I mean, I don't, that was a $70 billion problem. And the thing about the municipal market is most of these very big thematic distressed credit problems. I'm not talking about the one off project finance deal or trains down in Florida. These are slow moving train wrecks. The beauty of having research is we really got the Puerto Rico question right, let's call it from 2010 to 2020 15. It was very clear to us that they were so massively over leveraged, as soon as the market started to starve them from capital, they were going to have a big problem, which is exactly what happened and what had been the case. And Charlie mentioned Orange county prior to something like Puerto Rico and Detroit was a lot of big municipalities somehow got bailed out at the last minute and averted any type of real substantive loss to the investor. Post GFC places like Detroit and Puerto Rico, the populace in Washington said enough with the bailouts and allowed these places to fail. Which as a credit investor I think is very healthy. Like we got. It was so disappointing to get something like that right and then just have some white knight come at the end and bail these places out. So we think it was, we got Puerto Rico right. We had very little exposure to Puerto Rico when that happened. And if you take the blueprint of Detroit, what happened? They passed PROMESA down in Washington, which is a bill that allowed for the commonwealth to actually reorganize under a bankruptcy like framework and fix their problems. And with that they imposed upon them a financial oversight board that was going to hold and has held local officials and leadership accountable to their finances. So a when you get it right and you don't have any and then it defaults and it goes down, you get rewarded for not owning it. From a performance perspective and then from an opportunistic, certainly high yield perspective, to be able to look at that distressed debt with a much more sober eye of how are they going to recover. And frankly, Puerto Rico has done a pretty good job of right sizing their debt profile. And the fomb has imposed upon them fiscal discipline. And as Charlie mentioned, a lot of revenue has hit the island both from hurricane relief and Covid relief. So you have this really nice beneficial credit tailwind happening in Puerto Rico at a time when they right size their debt profile. So yeah, we reengaged in most of the boxes, when I say boxes, the general obligation credit, the sales tax credit, which is known as cofina. We had owned the water sewer system which never defaulted. So that was a good situation. The only real disappointment that we see with Puerto Rico today is a real obstinance to face and fix the problems at their electric utility company, which is called prepa. For some reason they are really fighting very, very hard where the debt is really not the big problem in Puerto Rico. For prepa it's the cost of fuel. But they seem to be just in a very aggressive, legalistic way, be taking that out on bondholders who did nothing but loan them $6 billion of money. So that's the last part of Puerto Rico that needs to get fixed and we're hoping for a good resolution there as well.

[Christine Benz]

Jim, I wanted to ask you about high yield munis in particular. This is a specialty area or your main specialty area there. Obviously it's attractive from an income perspective, but the trade off is low credit quality and the potential for problems like some of the ones we've been discussing. How should investors think about risk and reward in the high yield muni space? And then a related question is how to think about the role such a fund or such an investment might play in a portfolio. Do you think it's best used to augment higher quality exposure? Maybe you can can discuss that too.

[Jim Murphy]

Yeah. Well, thank you. There are some really interesting nuances to muni. We always start with the fact that the municipal market is a very, very high quality market with a very Low default rate. So the use of the words high yield is very different than true junk. In the corporate market, only about 5% of the municipal market is actually below investment grade. So when we use the term high yield, it's really more higher yielding. If you looked at the portfolio that I run, the average credit quality is in the mid triple B range. So said differently, there's not enough good junk to invest in. So if you look at a high yield fund like ours, it's a little bit more conservatively postured. You're really looking to enhance your income without a lot of additional default risk is kind of the way we try to to manage the fund. It's a lot of fun because you do get into less vanilla credits and more into some rocky road credits. But in terms of positioning in a broader portfolio, I think it's very appropriate, depending on the investor's age and risk tolerance, to use it as a yield enhancement vehicle to the higher quality part of their portfolio. Many of our clients use high Yield is like 10 or 15% of their muni allocation, which you know, I think makes a lot of sense. I'm a little, I'm eating my own cooking, I own a lot more of it myself. But it's a pretty safe house on a very safe street. But certainly you have to understand the styles of the different managers in the space as well. There are some that that are very aggressive in using leverage and tender option bond programs or some that that carry very, very high percentages of non rated debt. We try to stick to what we know.

[Dan Lefkovitz]

Well, unfortunately we only have time for one more. I wanted to ask you about ETFs which I think have been getting a lot of flows in the muni space. Along with SMAs which you mentioned earlier, I believe you manage funds, ETFs and SMAs. I'm curious if you can talk about the relative merits of the three vehicles. It would seem that with ETFs in this space, the tax benefit of the ETFs wouldn't be as pronounced murph.

[Charlie Hill]

I'll take that one. So we have recently started an intermediate ETF that is managed very similar to one of the intermediate bond funds that I manage. When I think of ETFs I generally think of passive management styles. There are two very large ETFs out there, the MUB and the Vtuber. And the main difference between the passive ETFs that are available today and an active mutual fund or an active ETF is just the different types of sectors and credits that they will Invest in the ETFs generally do not buy healthcare, they do not buy airports, they don't buy amt, they don't buy certain lower rated names in the, in the toll road space or the life care space. So they are giving yield relative to what an active manager can deliver to a shareholder. They are very useful for someone who wants to step out of a mutual fund and take a tax loss in a mutual fund, maintain exposure to an asset class, wait for the 30 day holding period and then step back into an actively managed mutual fund or a more actively managed etf. So I think they definitely serve a purpose. I think the ones that I'm speaking of are very well managed, but over a longer period of time. The extra income that you get through an active manager that employs research to deliver a little bit of excess income over time, that excess yield is going to accrue to the benefit of the mutual fund or active ETF holder.

[Jim Murphy]

Yeah. And from a, you know, a management perspective, if we weren't t row price munis, but we ran our own muni shop. Charlie and I talk about this all the time. We work in the Alpha factory.

[Charlie Hill]

Right.

[Jim Murphy]

We, we want to generate the best risk adjusted returns that we can in the Muni space. The packaging of that Alpha, you'd want to. The market is asking us for three things. Mutual funds, ETFs, SMAs. So far be it from us to tell the market they're wrong. We're going to meet the client where they want to get their tax exempt Alpha from. So that's what we're trying to do. But Charlie makes a great point. Thus far ETFs have been the purview of largely passive. And what we're hearing from our clients is that there is real demand for reasonably priced active in the ETF space and we're certainly trying to move in that direction as well. Right now I'm looking at the split inflows this year. About 28 billion of new money has come into the Muni market this year. 20 of that has been in the open end mutual fund space and 8 billion in ETFs. So there's this perception that oh my God, ETFs getting all the money. Well, they're really not because right now most of the best active managers are still in the open end mutual fund space. I think that's going to change over the next five years and we certainly want to be a part of that change.

[Dan Lefkovitz]

Well, we appreciate you inviting us onto the Alpha factory floor today. Thank you so much. Jim and Charlie.

[Jim Murphy]

Thank you Dan and Christine, it's been an absolute pleasure. You know, call us anytime. We appreciate everything you do for our clients, so thank you.

[Christine Benz]

Thank you so much. We appreciate that.

[Dan Lefkovitz]

Thank you for joining us on the Longview. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts. You can follow us on Socials, dan.

[Christine Benz]

Lefkovitz on LinkedIn and @ChristineBenz on X or Christine Benz on LinkedIn.

[Dan Lefkovitz]

George Cassidy is our engineer for the podcast and Carrie Gretch produces the show Notes each week. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us@thelongview morningstar.com until next time. Thanks for joining us.

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