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3 Superior Managers on Today's Muni Bond Market

Elizabeth Foos

Elizabeth Foos: Hi, I'm Beth Foos, senior analyst of fixed-income strategies here at Morningstar. At the 2019 Morningstar Investment Conference, we sat down with three superior portfolio managers to talk about the state of the municipal bond market today.

Peter Hayes: Finding value in today's muni market is really a function of your investment goals. Given the tremendous performance so far that municipals have had year-to-date, total return might be less of a component of the year's returns. So, it's really income. And where we're finding income, I think, is certain sectors like transportation and healthcare, et cetera, particularly high BBBs, low As. That's the best risk-reward proposition to maximize income given we expect lessened price going forward for the rest of the year.

Carol Flynn: Currently, in the muni market, we have a relatively flat yield curve and credit spreads are tight. So, it can be a challenge to find great value. Where we are finding good value, however, now is in AMT bonds. Historically, the spread for AMT bonds has been about 20 to 25 basis points and it remains there today. We have expected that after tax reform with so many fewer people being subject to AMT, that those spreads would compress. Since we haven't seen that yet, we are buying AMT bonds in anticipation of a spread compression. Also, in a couple of sectors where we are seeing some value with select not-for-profit hospitals, we can pick up incremental yield relative to comparably rated securities and other sectors. And in the high-yield space, we have seen some charter school deals, which have provided some good value as well for the risk that we are taking.

Robert DiMella: It's a little harder today to find value because there's a lot of money, as everybody know, chasing the municipal marketplace. So, you have to be a little more diligent in actually uncovering where the value is. Yield curve in the municipal marketplace is a little flatter. So, we've actually been pivoting our portfolios at MainStay actually more toward the five- to 15-year part of the yield curve. We don't think clients have to go out to 30 years any longer. It was a great space to be for the last couple of years. So, value on the yield curve is between 15 and say -- you know, five and like 15 years. From a credit perspective, similar patterns are going on. Credit spreads are tightening down. There's not as much value by still staying out on the credit spectrum. So, therefore, in all of our portfolios at MainStay we are actually kind of quality-ing up the portfolios. It's about time you, kind of, did that after several years of spread compression happening in the municipal marketplace, and I think that sets up clients' portfolios much better for the foreseeable future as far as the value trade is concerned.

Peter Hayes: The risks in today's market are really a function of here we are late-cycle. A lot of the flows are going into high-yield and long duration at a time when interest rates have fallen and credit spreads have compressed. So, one of the risks is just understanding what you own. Are you taking too much duration risk in your portfolio? Are you taking too much credit risk in your portfolio? We prefer to find down the curve value, income, et cetera. It's also a function of there's some risky credits in the market. Obviously, the entitlement issue, the pension problem in the U.S. is a big one. So, you need to be selective around credits that you own.

Carol Flynn: In the muni market right now, things are very strong. It's a good environment for liquidity. It's a great market for borrowers to come to market because we've had such strong fund flows coming into the market this year. So, one word that really comes to mind with regard to what do we need to be attuned to and watch out for is complacency. We can't take this current market environment for granted. We have to be mindful of the fact that liquidity is very strong right now because of fund flows. But if we continue to see strong economic data that might raise Treasury rates, that could impact fund flows, and we need to be positioned with good liquidity in case that happens. And also, with regard to credit, we need to make sure that we're being disciplined and that we are continuing to do our full due diligence on credits, so that the risk we are taking is appropriate for our shareholders.

Robert DiMella: I think the risk in the municipal marketplace is really tied to the fact that we believe we are in a late cycle. Whether you believe the late cycle is at a pause and the economy is going to continue to move along, or we actually could roll over and the economy could start slowing down again. The fact of the matter is, it's late cycle with what the shape of the yield curve is doing and credit. And so, therefore, risks are associated with a cycle pattern. And so, therefore, again, staying down the credit spectrum you've got to be really careful you actually can get out of, like, the weaker areas. Real estate, for example. Commercial real estate-backed municipal bond strategies in our opinion are not where clients should be at this stage of the cycle, given the headwinds that could present themselves in that sector of the municipal marketplace. And so, you’ve got to be really wary of where you are in the cycle pattern, quality-up the portfolios, pay attention to that. We don't there's any impending like legislative movers that are actually going to impact the municipal marketplace right now. But clearly, the municipal marketplace is very politically oriented. You do have to pay attention to not only the federal government but also what the state and local governments are doing. And just looking for signs of any type of cracks with regards to the relative strength in the economy and the tax collection revenues that have been going on for the last several years, let's start paying attention to when that could actually start peaking and cause some problems. Don't see it yet, but I think diligent investors should really be paying attention to that.