Macro Markets Podcast Episode 55: Municipal Bonds for the Long Run….and a Bond-Friendly CPI Update
Allen Li, Head our Municipal Bond Sector Team, reviews trends, opportunities, and idiosyncratic risk in municipal bonds. And U.S. Economist Matt Bush discusses the implications the soft June CPI release.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of thought leadership for Guggenheim Investments. And I'll be hosting today. We are recording this episode on July 11th, 2024. Now, even though we are through the July 4th holiday, it certainly doesn't feel as if we are heading into any kind of summer slowdown. The economy, while still relatively strong, is in transition, and monetary policy will soon follow suit. At least we think it will. We have active war zones in multiple locations around the world, and consequential global elections are playing out in unexpected ways. Not surprisingly, markets have been very active. With this backdrop, it seems an ideal time to discuss municipal bonds, a sector that is an income workhorse for many investors.
So, sharing his insights today with us is Allen Li, a managing director and head of our municipal sector team. In his role, Allen is a portfolio manager on our Municipal Income fund and oversees the group responsible for tax exempt and taxable munis, an important sector in many of our strategies. But before we get to Allen, I've asked Matt Bush, our U.S. economist, to join us, and give us an update on the inflation fight in the U.S. Matt, thanks for joining us today.
Matt Bush: Great to be back on Jay.
Jay Diamond: Now, Matt, we just got the June CPI statistics today. Tell us about the release and some of the important developments in the numbers.
Matt Bush: We saw the June core CPI index rise just 0.06 percent month over month, which was well below the median forecast which saw a 22 basis point increase. And with this low monthly number, the three-month annualized rate of inflation fell to just 2.1 percent. So really encouraging numbers kind of on a top line basis. But I think more good news came from the details of the report. The most important development was a substantial slowing in housing inflation, with both rent and owner's equivalent rent falling to monthly paces on par with those seen all the way back in 2019 after some really elevated inflation readings for this category the past couple of years. So, if this decline holds, it would be a faster slowdown in housing inflation than most forecasters, including us, had in their forecast. And given that housing inflation has such a large weight in the inflation basket, a revision downward in housing inflation forecasts could meaningfully bring down overall inflation forecasts. That being said, you know, the OER data in particular, owner’s equivalent rent, has been noisy the last couple of months. And so while leading measures suggest that this cool down in housing inflation should stick, the Fed and other forecasters will probably want to see a few more months of data to be sure it's a durable slowdown. And then beyond rent, there was good news elsewhere in the report. The so-called super core inflation category, or services excluding housing, was negative for a second month in a row, helped by a large drop in airfares along with a soft reading in recreation services. So overall, very good news on the inflation front from the June numbers.
Jay Diamond: So, thanks for that recap, Matt. What is your takeaway from the data, particularly as it relates to the Fed's possible reaction function?
Matt Bush: So again, overall, I think today's data was unequivocally good news for the Fed's inflation battle. The only caveats to that there were a few large declines in a couple of categories that probably won't be repeated going forward. Again, airfares saw a big drop. Hotel prices saw a pretty big drop. So today's numbers may overstate true underlying inflation a bit. And relatedly, the core PCE numbers that the Fed does care more about probably won't be quite as good as the six basis point month over month increase that we saw today. Initial estimates put it somewhere closer to 20 basis points, which is still overall good, just not quite as glaringly good as the CPI data. But again, the overall breadth of the inflation slowdown, the fact that housing inflation is finally slowing in line with what real world conditions are showing, will go a long way to giving the fed the confidence they need. And we think this makes a cut at the September meeting quite likely.
Jay Diamond: So the market reacted very positively and maybe overreacted to this news. Matt, looking further down the road, what is your outlook for the economy and Fed policy going forward?
Matt Bush: We continue to see a cooling both in economic growth and inflation. The latest job numbers we got confirmed that we are seeing a slowdown in the labor market. [Fed] Chair Powell actually called it a pretty significant cooling in the labor market. And so as job growth and wage growth come down, that's going to weigh on incomes and ultimately on consumer spending, which we think will push real GDP growth somewhere in the one and a half to 2 percent range by the end of the year. And similarly, today's inflation data gives us confidence in our forecast that inflation should be back near target by early 2025. So from a Fed perspective, our forecast is for rate cuts in September and December, followed by a quarterly pace of rate cuts until the fed funds rate is down to the three and a quarter to 3.5 percent range in early 2026. So that's our baseline outlook. You know, just as importantly, I think, is that the risks to this outlook are skewed to the downside, meaning it's more likely that growth, inflation, and the fed funds rate will be below this baseline forecast than above it. Economic conditions look pretty okay right now, but there's meaningful risks out there that could cause a faster economic slowdown, particularly if the Fed is too slow in bringing some economic relief via rate cuts.
Jay Diamond: Great, Matt, thank you so much for dropping by with that update, I appreciate it. And now I want to welcome back Allen Li to the podcast. Allen, thanks again for joining us today.
Allen Li: Thank you, Jay. I'm very happy to be here.
Jay Diamond: Let's start by talking about the operating environment for municipal bond issuers. How has the current rate environment and the macroeconomic backdrop affected issuers and their creditworthiness?
Allen Li: During the COVID economy, municipal credits had the double tailwind of fast growing tax receipts and multiple rounds of fiscal stimulus. So that allowed issuers to build up general fund buffers and rainy day reserves. Now that we are four years past the pandemic, stimulus money has mostly been spent and tax receipts are in retreat. So overall credit quality has plateaued I would say. Issuers still have healthy reserves and revenue levels are higher than before the pandemic.
Jay Diamond: So how have these conditions affected the market value of municipal bonds and trading activity in the market?
Allen Li: Sure. So in terms of total return, tax exempt munis are essentially flat through early July. If we look at the municipal to treasury yield ratios, most portions of the triple A curve, whether it's the five year, the ten year or the 30-year spot, they are near their average ratios for the last 12 months. So right now, both the five year and ten year triple-A munis are trading around 64 percent of Treasurys. Longer tenors are slightly cheaper at an 84 percent ratio for a 30-year spot. Again, at the one year average, but above where the shorter bonds are. On the taxable side, taxable munis have done pretty well this year actually, up above 50 basis points in total return. Now they do have longer duration. So they tend to lag when rates sell off as they have done for most of 2024. However, a dearth of taxable supply has provided technical support to the market. And taxable spreads are generally 14–20 basis points tighter on the year.
Jay Diamond: Oh, great. So, as you started to talk about, technicals are always an important factor in muni land. So what is happening on the supply side in terms of issuance, and how does this year compare to an average year of issuance?
Allen Li: We're having a mini boom in issuance this year. We're on pace for about $460 billion of new issues in 2024. That is running 26 percent ahead of 2023 and about 12 percent above the five year average. Now, issuances were below $400 billion in 2022 and 2023 as municipalities dealt with rate shock. Now, this year's spike is driven by a desire to get ahead of potential election related volatility in November, and also by the coiled spring effects, having delayed capital projects for most of the last two years.
Jay Diamond: So it sounds like supply is coming in very strong. How has demand held up for munis?
Allen Li: So on the demand side, we've had pretty good inflows from retail investors. Municipal mutual funds have netted about $9 billion so far in 2024, while ETFs have taken in another $2.5 billion. So we have seen $11.6 billion of net inflows into open end and ETF vehicles this year. On the other side, institutional investors, like banks and insurance companies, have been net sellers. Institutions have materially lower tax rates than retail investors. And right now they can find better after-tax yields away from tax-exempt munis.
Jay Diamond: And they're also finding willing buyers, when they go out into the market, it sounds like.
Allen Li: That’s correct. I would say secondary conditions are pretty supportive of municipal valuation right now. There are very few forced sellers, if any, in both tax-exempts and taxables.
Jay Diamond: You mentioned before expectations about rates going forward. So our Macroeconomic Research and Market Strategy team is now estimating, and they have for a while actually, that we’ll see two rate cuts this year. So how do you think opportunities in the muni market will evolve as a result if this were to occur?
Allen Li: So based on our macro team's view on rate cuts, I think investors should extend duration and lock in yields right now. The long end of the tax-exempt curve, I mentioned earlier, happens to trade at a higher ratio than the front and intermediate portions of the curve. So buyers are getting paid a term premium to go out longer.
Jay Diamond: And do you expect lower rates to bring more hesitant issuers to come in, at lower borrowing costs?
Allen Li: I do, I think at least on the refunding side of the equation, lower rates obviously increases the net present savings calculations for issuers who are looking to take out existing debt. So that should actually help more issuers to come to the market.
Jay Diamond: People think about the muni market, and maybe incorrectly, that it's kind of this uniform market and talked about as one entity. But, in fact, it's full of different kinds of issuers and idiosyncratic stories. Are there any particular story bonds or story ideas or credit issues that you're following right now in the market?
Allen Li: Sure. So at a big picture level, given the gradual drawdown of stimulus funds, we're keeping an eye on how states are budgeting for the upcoming fiscal year 2025, including looking at what their assumptions are for revenue growth and how they're planning to use their rainy day funds. Since 2021, only six states have reduced income tax rates. We think tax receipts will have a difficult time outperforming the overall economy. Now at the sector level, we actually have a differentiated view in health care, where a lot of investors tend to look for incremental yield. There is a consensus, from just reading rating agency reports, sell side research, and other buyside marketing— there's a broad consensus for a preference for large, multi-site multi-state hospital systems because of their scale and greater profitability. However, I think those large systems will face increased regulatory pressure going forward. Both the New York Times and Wall Street Journal have written about a relatively low percentage of charity care at these large, nominally not-for-profit systems and also have written about the price inflation post-consolidation by these large systems. Ironically, these systems are preferred by consensus thinking, as big hospitals that are run at high profit margins with dominant market share. We think those large systems are more likely to invite greater antitrust scrutiny going forward, become regulatory targets. So that's something that we're keeping an eye on.
Jay Diamond: Given all that we've talked about, where are you finding value in the market right now? And what are you avoiding?
Allen Li: So for institutions, I think taxables, especially high grade taxable housing bonds issued by state housing agencies, you know, are very attractive. They tend to come to market at pretty wide spreads, because they're not indexed and they're callable. But after adjusting for their small size and callability, I think investors are still being fairly compensated versus index-eligible non-call taxable names. For individual investors, I would say still stay in tax-exempts because the taxable equivalent yields still exceed what people can achieve in IG corporates, Treasurys, and other fixed income asset classes. Given what we just discussed about healthcare earlier, I would look for smaller healthcare systems with average margins but potential top-line organic growth, and a steady or growing charity mix, possibly having the status of a safety net hospital that gives them greater cost sharing or populations at the state level and also federal transfer payments as well.
Jay Diamond: You mentioned this before about volatility in the presidential election season. What impact do you think the election will have on munis, and how should investors think about positioning themselves for either outcome?
Allen Li: So, if Democrats come out ahead in November, I expect to see continuing support for municipal credit via steady federal transfer payments. If Republicans come out ahead in November, there is an outside chance that tax exempt issuance gets curtailed as part of the pay-for that are being used, that would be used to reduce the federal deficits. There is a very small chance, but it always comes up every four years. Also something to keep in mind. But either way, regardless of the outcome in November, I think that tax rates are unlikely to decline, thus preserving or even enhancing the value of the tax -exempt coupon in municipal debt.
Jay Diamond: Allen, you've been very generous with your time today. But before I let you go, do you have any takeaways that you would like to leave for our listeners?
Allen Li: In the short term, we are still experiencing very strong seasonal technicals that will go on for at least a couple more months. The market this year has digested higher treasury rates and supply growth very well. So I think the technical support will continue to be a tailwind for the rest of summer. Now, for longer term, we take a step back. Municipal debts, more than any other fixed income asset class, is about staying steady and staying invested. If we look at long term returns of the Bloomberg National Municipal Index, the annualized return over the last 25 years is about 4.5 percent, which almost perfectly lines up with the index average coupon of 4.6 percent. That is not a coincidence. Interest income drives long term returns in municipal debt. Now, poor liquidity means it's very difficult for most investors to time the market. We're unlikely to sell at top and then buy them all back at the bottom. The market is calm, is steady most of the time, just like right now. So the best course of action for most of the time is to maintain exposure.
Jay Diamond: Terrific. Well, thanks again for your time, Allen. Please come again and visit with us soon. And my thanks to both Matt Bush and Allen Li. And thanks to all of you who have joined us for our podcast today. If you like your hearing, please rate us five stars. Now, if you have any questions for Allen or Matt or any of our other podcast guests, please send them to Macro Markets at Guggenheim investments.com, and we will do our best to answer them on a future episode or offline. I’m Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, please visit us at Guggenheim investments.com/perspectives. So long.
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This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and or a legal opinion. Always consult a financial, tax and or legal professional regarding your specific situation. This podcast contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and nonproprietary research and other sources.
Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. No part of this material may be reproduced or referred to in any form without express. Written permission of Guggenheim Partners, LLC. There is neither representation nor warranty as to the current accuracy of, nor liability for decisions based on such information.
Past performance is not indicative of future results. Guggenheim investments represents the investment management businesses of Guggenheim Partners, LLC. Securities are distributed by Guggenheim Funds Distributors, LLC.
Important Notices and Disclosures
Investing involves risk, including the possible loss of principal.
Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. The market value of fixed income securities will change in response to interest rate changes and market conditions among other things. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline. High yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility.
Investors in asset-backed securities ("ABS"), including mortgage-backed securities ("MBS"), and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
This podcast is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This podcast contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is not indicative of future results.
Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC. Securities are distributed by Guggenheim Funds Distributors LLC.
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