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The great muni reset · UBS Trending

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  Municipal bonds have certainly had a strong start to the year,
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  but they're making headlines.
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  There's elevated volatility
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  record supply and some shifting valuations.
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  Is now the time to rethink your muni strategy.
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  We're going to talk about that and a whole lot more right now.
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  On UBS trending.
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  Hi everybody and welcome to UBS
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  Trending I'm Anthony Pastore here in our New York studios.
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  And coming to us from the West Coast is my friend and colleague
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  from PIMCO, Dave Hammer,
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  who is the lead Muni Bond portfolio manager there.
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  Dave, always nice to have you join us here.
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  And even virtually in the studio.
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  It's great to see you. Thanks for joining us.
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  Hey, Anthony, thanks for having me.
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  Any time.
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  Dave, look, it's it's been a really interesting
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  time for Muni bonds.
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  As I mentioned in the intro,
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  we've had this strong start to the year.
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  Supply is up, strong year to date performance.
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  But there has certainly been
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  a lot of volatility going on right now in the markets.
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  How is that potentially
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  impacting muni bonds as you see them right now.
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  Yeah.
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  Volatility has been the name of the game this year so far.
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  You know the first two months were exceptionally strong periods,
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  massive inflows coming back into the muni market
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  as the Fed lowered rates
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  and the market was pricing in further cuts.
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  January and February were two of the biggest inflow months
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  into the muni market since 2007.
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  But that is sharply reversed here.
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  Since the Iran war started
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  in the month of March, interest rates in U.S.
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  treasuries are up 40-50 basis points
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  on the front end of the curve.
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  Muni yields, which were actually quite rich versus
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  treasuries, in February, are up as much as 75 basis points.
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  And as we look back, March of 26 was the worst performance month
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  for the asset class since 2022, down about 2.5%.
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  So, valuations have been adjusted significantly.
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  You know, last piece is just repricing
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  recession risks on, you know, was proven to be
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  a really big energy shock.
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  It does put the Fed in our view, in a very difficult position.
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  Inflation is moved up
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  maybe by as much as about a percentage point.
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  But the economy's in a very different spot
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  today than it was in 2022.
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  It, it likely,
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  is to see further slowing,
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  in the economy, a softer labor market.
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  And what it means to us is that the Fed
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  may still have to lower rates,
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  but it pushes those rate cuts further out into the future.
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  There's a chance they have to do more.
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  And the economic impact means rising recession probabilities.
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  Here at PIMCO,
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  We've upgraded our recession
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  probabilities from about 10 to 15% to 30 to 35%.
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  Thank you.
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  Dave, I'm glad you pointed that out because we, at CIO
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  here at UBS,
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  we haven't raised any kind of recession flags just yet.
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  But we also agree that we expect the Fed will still cut
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  probably twice, but we are pushing it out further in the year
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  likely, you know, September, December.
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  probably 25 basis points each.
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  But again,
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  uncertainty really is kind of the word of the of the times
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  that we're in right now with the Iran conflict.
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  But I want to kind of talk more
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  about the valuations with you, because right
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  now, CIOs being maybe a little bit cautious on Muni
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  likely because of the strong outperformance
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  that munis have shown.
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  But where do you think
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  how do you position
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  the asset class right now for like for forward looking returns?
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  What are you seeing there.
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  Yeah.
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  Look I mean historically starting
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  yields are a pretty good
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  indicator of forward expected returns in the muni market.
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  And they look attractive to us.
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  The IG Muni index is back up to about 3.7% tax free.
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  You'd have to earn a little over 6% in taxable markets.
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  So a really significant pickup
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  for investors in the top marginal tax bracket
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  going into munis over treasuries,
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  over corporate bonds, which we would say are also riskier.
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  And there's parts of the market
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  that are even more attractive. Bonds
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  in the 20 year part of the curve.
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  Because the Muni curve is so steep,
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  an investor can earn closer to 4.5%.
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  That's about 7.5% taxable equivalent yields.
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  And in some of the high quality
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  portions of the high yield muni market, yields approach 6%.
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  You'd have to earn about 10% tax to get a
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  6% after tax yield in our view
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  That means taking a lot more risk
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  than what you'll find in the muni market.
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  So we think it's an attractive time to allocate.
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  And investors should be taking advantage of this
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  this back up in yields.
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  We agree with you
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  that the Fed is likely to act further out in the future.
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  But but still act.
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  And we think the direction of high quality
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  interest rates is still lower over the next year or two.
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  Yeah. Thanks, David.
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  You know, and interestingly,
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  you talked about the muni curve
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  being kind of unusually steep right now.
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  But you know, there's some technical weakening.
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  We've talked about this elevated supply.
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  So given given
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  that dynamic that we're seeing right now in muni bonds,
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  what dive maybe into some of the drivers and maybe expected
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  issuance trends that are that are moving forward here,
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  especially given where we've just come from.
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  Yeah.
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  So we've come from your point really rich valuations
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  yields are moving higher.
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  Relative value is improved.
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  And we have what's probably a
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  you know
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  considerable window of weakness over the next two months.
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  You mentioned
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  supply in our view, supply is going to be quite large again.
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  The muni market used to issue 3 to 400 billion a year.
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  You know, it's likely 550 to 650 billion a year.
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  Now, part of that is inflation.
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  If you look at any construction cost index,
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  prices are up 35 to 50%.
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  So every new, CapEx
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  infrastructure investment deal
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  in the media market's going to be bigger.
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  State oracles are also broadly in a really healthy position.
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  So they feel good about borrowing.
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  There's a big federal infrastructure bill
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  that was passed a few years ago,
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  you know, that incentivizes state
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  local governments to take advantage
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  of those federal funds
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  and go out and do new CapEx, do new infrastructure.
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  And then on the curve,
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  you know, the corporate market,
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  corporate CFOs tend to react pretty quickly to steeper curves
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  unless you do a lot more five year bonds,
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  a lot less 30 year bonds.
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  It's harder for muni issuers to do that.
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  Many muni issuers are
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  bound by, by law to issue level debt service out to 30 years.
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  New infrastructure projects.
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  Oftentimes, they have to match the,
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  the profile of the debt to the useful life of the asset.
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  And that can mean a lot of 30, 40, even 50 year bonds.
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  So, the curve probably stays steep.
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  That's a good opportunity for investors.
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  Another thing adding to this window of weakness, you know,
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  the technicals aren't great.
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  Over the next few months,
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  muni investors tend to allocate less capital to
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  to muni funds when interest rate volatility is higher,
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  which it is.
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  So we think the,
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  you know,
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  the size of the inflow wave is probably slowed down a little bit.
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  And historically,
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  this is a pretty weak time of the year for the muni market.
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  A lot of muni investors pull money out of muni funds to go
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  make their,
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  tax payment between April 15th and May 15th.
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  That tends to mean wider.
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  Wider spreads, cheaper valuations.
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  But yeah,
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  I think the most important takeaway, it's
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  a really good time to opportunistically invest
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  and look for cheaper valuations, wider spreads, less competition
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  from inflows between now and the end of May.
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  Right.
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  And you know and you made a really good point.
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  This is sort of a
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  you know a popular time of year for you know, for Muni
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  bonds when, you know, we're entering this time of year,
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  they usually increase.
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  And especially if interest rates move,
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  which we are expecting them to.
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  But let me ask you, Dave, is we're sort of wrapping up here,
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  if you look at some of the high conviction ideas that you have
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  in your implementing
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  your PIMCO portfolios, you know, because right now at UBS CIO,
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  we're looking at high credit
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  quality taxes and income diversification sort of benefits.
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  As we're looking to,
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  you know, give guidance to some of our clients and advisors.
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  What are your
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  some of some of your high conviction ideas right now?
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  Yeah.
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  So so we really like the steep curve an investor that extends out
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  and buys a 15 to 20 year maturity,
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  sometimes with a shorter call date, can earn about twice
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  the expected return in our view, as a non callable double A
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  bond in seven, 8 or 9 years
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  with a marginal pick up in interest rate sensitivity.
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  So that's one,
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  you know number two I'd say high conviction is timing.
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  We think given the moving rates and the relative
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  cheapening of units,
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  the next few months are a great time to allocate.
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  We really like multifamily housing risk and tax exempt form
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  depending on the risk profile.
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  This can be high quality
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  mortgage bonds that are tax free, backed by Fannie or Freddie.
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  It can be pooled securitizations
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  for affordable housing in the high yield space. This can be,
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  new issues
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  that are issued to finance affordable or workforce housing
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  that have a yield of six plus percent, a relatively low LTV.
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  So good protections for investors if the economy slows,
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  you know, but but there are areas of caution as well.
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  While, we agree credit
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  quality is good overall the tide's going out.
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  There are a lot of big urban centers
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  that have been less responsible,
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  with their their, their balance sheets.
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  And we do see big budget deficits emerging over the next year.
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  And then I'd say, last but not least, while
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  we're constructive on the high quality
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  portions of the high yield muni market,
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  the bottom third of the muni market, a lot of deals that
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  were issued in 2016 to 2021,
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  a lot of those for large scale project finance,
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  issues.
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  You know, we think default rates are rising.
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  We see a number of relatively high
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  profile debt restructurings, likely over the next year.
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  And the potential for very low recovery.
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  So in the high yield portion of the market,
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  we think it's important that investors are careful
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  and really avoid the lowest quality portions of that asset class.
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  Great.
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  What's your duration preference right now Dave.
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  We've got an intermediate
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  kind of preference right now 5 to 10 years.
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  And obviously if investor demand cool
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  cools a little bit, that could impact more longer term bonds.
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  What do you think about that.
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  Yeah.
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  So so I think taxable fixed income portfolios
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  we're modestly overweight duration
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  and really gravitating towards, you know, call that 5 to 7 year
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  part of the curve.
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  We think two year treasuries are attractive as well.
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  You know we're still close to neutral in the muni market.
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  Just because we think tactically valuations
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  will cheapen a bit more.
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  But you know we're biased to extend duration over the next,
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  you know, month or two
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  as a lot of money supply gets digested into a much weaker market.
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  And the starting point for for duration is,
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  for yields is simply a lot higher than it was a month ago.
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  Dave, thank you very much.
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  It's always good to get your perspective.
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  And always great partnering with you and,
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  the rest of your colleagues at PIMCO.
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  Thanks for joining us, Dave. Good to see you.
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  Thanks a lot, Anthony.
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  Great, great.
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  We'll see you soon. Dave. Dave Hammer again from PIMCO.
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  And for more information
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  on anything that Dave
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  and I spoke about or anything coming
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  out of our own, Chief investment office here at UBS,
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  make sure to visit our website at ubs.com/views.
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  Plus you can follow us on social media.
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  We're on LinkedIn and Facebook.
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  You can check out the dedicated Instagram account for the studio
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  at UBS Trending is how you can follow us.
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  And as always, if you have any questions about your portfolio
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  or anything that Dave
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  and I spoke about today, please continue this conversation
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  with your financial advisor.
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  Until next time, I'm Anthony Pastore.
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  We wish you a great rest of your day,
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  and remember to keep your eyes on what's trending.
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  We'll see you soon everybody.