Morgan Stanley Research analyst Mark Schmidt and Investment
Management’s Craig Brandon discuss the heightened uncertainty in
the U.S. municipal bonds market.
Read more insights from Morgan Stanley.
For a full list of episode disclosures click here.
----- Transcript -----
Mark Schmidt: Welcome to Thoughts on the Market.
I'm Mark Schmidt, Morgan Stanley's Head of Municipal Strategy.
Craig Brandon: I'm Craig Brandon, Co-Director of
Municipal Investments at Morgan Stanley Investment Management.
Mark Schmidt: Today, let's talk about the
biggest market you hardly ever hear about – municipal bonds, a $4
trillion asset class.
It's Monday, May 5th at 10am in Boston.
Mark Schmidt: If you've driven, flown, gone to
school or turned on a tap, chances are munis made it happen.
Although munis are late cycle haven, they were not immune to the
latest bout of market volatility. Craig, why was April so tough?
Craig Brandon: So, what we say in April, it was
sort of the trifecta of things that happened that were a little
different than other asset classes. The first thing that happened
is we saw a significant increase in treasury rates – and munis
are generally correlated to treasuries. We're a very high-quality
asset class, that's viewed as a duration asset class. So, one
thing we saw were rates going up. When we see rates going up, you
generally see money coming out of the market, right? So, I think
investors were a little bit impacted by the higher rates, the
correlation to treasuries, the duration, and saw some flows out
of the market.
Secondly, what we saw is conversation about the tax exemption in
Washington D.C. What that did is it caused muni issuers to pull
their issuance forward. So, if you're an infrastructure issuer,
you are issuing bonds in the next year to year and a half; you're
going to pull that forward because if there's any risk of loss of
the tax exemption, you want to get these bonds issued today. So
that's basically what drives technicals. It's supply and demand.
So, what we saw was a decrease in demand because of higher rates;
an increase in supply because of issuance being pulled forward.
And the third part of the trifecta we refer to is the
conversations about the economy. So, I would put that, it's sort
of a distant third, but there's still conversations about maybe
credit weakness driven by a slowing economy.
Mark Schmidt: Craig, your team has been through
a lot of tough market cycles. Given your experience, how did the
most recent selloff compare? And why was it not like 2008?
Craig Brandon: I started my career back in 1998
during the long-term capital management crisis. I lived through
2008. I lived through the COVID crisis, and you know, really when
I look at the crisis in 2008 – no banks went out of business
three weeks ago, right? In 2008 we were really sitting on a
trading desk wondering where this was going to end.
You know, we had a number of meetings with our staff, over the
last couple weeks explaining to them why it was different and
how. Yes, there was some volatility here, but you could see that
there was going to be an end to this, and this was not going to
be a permanent restructuring of the market. So, I think we felt
comfortable. It was very different than 2008 and it really felt
different than COVID.
Mark Schmidt: That's reassuring. But with
economic growth set to slow sharply, how does your credit team
think the fiscal health of America's state and local governments
will hold up?
Craig Brandon: Well, remember state and local
governments, and when we're talking about munis, we're also
talking about other infrastructure asset classes like water and
sewer bonds. Like, you know, transportation, bonds, airports.
We're talking about toll roads.
They went into this with a very strong balance sheet, right?
Remember, there was a lot of infrastructure money spent by the
federal government during COVID to give issuers money to make it
through COVID. There's still a lot of money on balance sheets.
So, what we do is we're going into this crisis with a lot of cash
on balance sheets, allowing issuers to be able to withstand some
weakness in the economy and get through to the other side of
this.
Mark Schmidt: Not only do state and local
governments have a lot of cash, but they're just not that
impacted by tariffs, right? So why did muni yields perform worse
than U.S. treasuries over the past couple of weeks?
Craig Brandon: Right. It really… We're
technically driven, right? The U.S. muni market is more retail
driven than some other asset classes. Remember – investment grade
corporates, treasury bonds, there's a lot of institutional buyers
in those markets. In the municipal market, it's primarily retail
driven.
So, when you know, individual retail investors get nervous, they
tend to pull money out of the market. So, what we saw was money
coming out of the market. At the same time, we saw an individual
increase in more bonds, which just led to very weak technicals,
which when we see that it eventually reverses itself.
Mark Schmidt: Now I almost buried the lede,
right? Why invest in munis? Well, they're great credit quality,
but they're also tax free. In fact, muni bonds have been exempt
from federal taxes for over a century. You have a lot of
experience putting together tax bills, and right now people are
worried about tax reform. Do you think investors should be
concerned?
Craig Brandon: Listen. I'm not really losing a
lot of sleep at night over the tax exemption. And I think there's
other, you know, issues to worry about. Why do I say that?
As you mentioned Mark, I spent the early years of my career
working for the New York State Assembly Ways and Means Committee.
I spent seven years negotiating budgets and what that did is it
gave me a window – into how, you know, not only state budgets,
but the federal budget gets put together.
So, what it also showed me was the relationship between state and
local elected officials and your representatives in Congress and
your representatives in the Senate. So, I know firsthand that
members of Congress and members of the Senate in Washington have
very close relationships with members of the state legislatures,
with governors, with mayors, with city council members, with
school board members – who are all delivering the message that
significantly higher financing costs that could potentially
happen from the loss of the exemption, could be meaningful to
them.
And I think members of Congress and members of the Senate and
Washington get it. They understand it because they were all there
when it happened. The last time the muni exemption came under
fire was back in 2012; and in 2012, a lot of members of Congress
were in the state legislature back then, so they understand it.
Mark Schmidt: That's reassuring because right
now, tax equivalent yields in the muni market are 7 to 8 per
cent. That's equal to or greater than the long run rate of return
on the stock market. So, whether to invest in the muni market
seems pretty straightforward. How to invest in the muni market?
Well, with 50,000 issuers, that's a little complicated. How do
you recommend investors get exposure to tax-free munis right now?
Craig Brandon: Well, and that is a very common
question. The muni market can be very confusing because there are
just so many bonds out there. You know, over 50,000 issuers,
there's over a million individual CUSIPs in the muni market.
So as an individual investor, where do you start? There's
different coupon structures, different call structures, different
maturity structures, ratings. There's so many different variables
that go into a decision in investing in muni bonds.
I can make an argument that you could probably mimic the S&P
500 with 500 different stocks. But most muni indices are over
50,000 constituents. It's very difficult to replicate the muni
market by yourself, which is why a lot of people, you know, they
let professional money managers, do the investing for them.
Whether you're looking at mutual funds, whether you're looking at
separately managed accounts, whether you're looking at exchange
traded fund ETFs, there's a lot of different ways to get exposure
to the muni market. But with the huge amount of choices you have
to make, I think a lot of individual investors would just let a
professional with the experience do it.
Mark Schmidt: And active managers let you
customize portfolios to your unique tax situation and risk
tolerance. So, Craig, a final question for you. How do munis fit
into a diversified portfolio?
Craig Brandon: Munis are generally the stable
part of most people's portfolios. Remember, you don't have a
choice of whether you're going to pay your taxes or not. You have
to pay your taxes, you have to pay your water bill, you have to
pay your power bill. You have to pay tolls on highways. You have
to pay airport fees when you buy an airline ticket, right?
It's not an option. So, because the revenue streams are so
stable, you see most muni bonds rated AA or AAA. The default rate
for rated munis is significantly below 1 per cent. It's something
in the ballpark of about 0.2 per cent*. So, with such a low
default rate – listen, we're technically driven, as I said. You
see ups and downs in the market. But over a longer period of
time, munis can give you generally stable returns, tax exempt
income over the long term, and they're one of the more stable
asset classes that you see in your overall portfolio.
Mark Schmidt: That sounds boring, and I mean
that in the best possible way. Craig, thanks so much for your
time today.
Craig Brandon: Thanks, Mark, happy to be here
Mark Schmidt: And thank you for listening. If
you enjoy Thoughts on the Market, please leave us a review
wherever you listen and share the podcast with a friend or
colleague today.
*“US Municipal Bond Defaults and Recoveries, 1970-2021” – Moody’s
Investor Services
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