Michael Zeuner (00:08.13)
Hi, everyone. This is Michael Zeuner, one of the managing partners at WeFamily Offices. Thanks for listening to the Wealth Enterprise briefing. I’m joined again today by Sam Sudame, our global head of Macro. And we’re gonna talk about, we’ve been talking a lot about fixed income and interest rates lately, and we’re gonna talk about a corner of the fixed income market that we haven’t talked about, but where we and others think that there might be a very interesting opportunity to focus on for in particular U.S. taxable investors, and that’s the municipal bond market. So Sam, welcome. Thanks for joining. And why don’t you start us off by telling us what’s been happening in the municipal bond market in the context of rising interest rates, and then we’ll get into where you see the opportunity lying.
Sam (00:56.742)
Sure. So I’m very positive on the Muni bond market. The return versus risk is currently quite attractive, in my opinion. And the reason is tax equivalent yields in high quality municipal bonds are near decade highs, supported by strong underlying fundamentals. And what we’re seeing right now are that Muni bond yields are very favorable compared to the last 20 years.
Both absolute and relative terms and across maturity yields, meaningfully over the past year, year and a half. So the tax equivalent yield for an investment grade Muni is about double its 10-year average. You know, over the last 10 years it’s been about 4%. Now it’s about 8%. And we see that in the high-yield Muni space as well. And the two major reasons why yields are higher. First,
The overall cost of money is higher. And we’ve spent our last few podcasts talking about the cost of money in general. But then for munis, on top of that, it’s higher supply is also a major contributor to those higher yields. And the benefits of higher yields, first, you know, the yields right now offer good total return potential going forward. And, you know, what drives future return.
A lot of it is driven by the current yield. And second, just like we talked about in our previous podcast, you know, ye these higher yields provide a yield cushion if rates were to rise further.
Michael Zeuner (02:35.853)
Sam, let’s let’s drill down because I think the obvious answer about the cost of money with rates just going up, I mean, I think that’s clear. But when you talk about higher supply, I mean, that’s one of the things we talked about in the corporate bond market is that there’s just so much debt that’s being raised, issuers have to be offering higher yields, all else being equal. Wha why is that also happening in the muni market? What’s underneath that?
sam (03:00.699)
Yes, you know, in our previous podcast, we talked about the demand for money, corporations, US government, international governments, but it’s also by United States municipal entities as well. And supply has been really strong and is at record level of issuance. And the reason for that is municipalities are now shouldering more of the spending that the federal government did.
And much of the new issuance has surrounded education in hospitals. So think about in the recent bills there there were cutbacks to Medicare or Medicaid, excuse me. Well, that difference has to be made up by local governments. And you know, it is important to note that munis fund the underlying infrastructure in society: education, healthcare, roads and bridges, water and power.
And as a result, it funds essential services. You know, there’s a greater demand for power generation. Well, it’s munis that go out and raise the money for that power generation. So there’s a lot of needs at the local level.
Michael Zeuner (04:09.945)
So I was gonna say that that sounds like a investment thesis not linked to the AI trade, which is potentially a good diversifying opportunity, but then you just put out there that there is a linkage to the AI trade to the extent that that some of these this capital is being raised to fund power and utility development.
sam (04:32.027)
Sure, so you know the the AI theme is so strong, its tentacles extend broadly into almost every asset class. Munis are no exception, but the amount of or exposure to it is less. So for instance, in education, healthcare, roads and bridges, that does not have much of an AI component to it. So there is a lot of that sector that isn’t as directly linked.
Although it is indirectly linked, as we talked about, with the cost of money, that demand for capital. So it does have its indirect exposure to it. You know, one interesting link could also be that’s a little subtle, is that there is you know a growing pushback about AI data centers. And one of the reasons why is because many AI data centers have gotten tax rebates or tax benefits for building it in a certain area.
While property taxes have gone up significantly. So many people are seeing that their property taxes are going up while AI’s data centers are getting a break. So there is somewhat of this pushback still building because of AI.
Michael Zeuner (05:44.44)
And Sam, I wonder I wonder in terms of the sustainability of these rates, I guess your your point is that even if rates go higher, because if if one thinks about the US federal government and its fiscal situation to the extent that it needs to start cutting expenditures, cutting the deficit in order to keep federal, you know, treasury rates under control.
the extent that that’s driving the increase in the 10 years, the fisc the federal fiscal sustainability, that could put more of a burden on municipalities, which could take rates up further. So for an investor who’s wants to be thoughtful about interest rate risk, I guess you your point was that given where rates are, there is some built-in protection to any principal erosion from a further rise in interest rates. Do I do I have that right?
sam (06:40.729)
Yes, and actually you touched on an extremely important point, which is really looking at Muni credit fundamentals. So while the US government is double A plus, the Muni index is triple A, right? It’s unusual to see the regionals be at a higher credit rating than the sovereign. And the reason for that is most states must balance projected revenue with expenditures. So they have stricter balanced budget requirements.
Which really limit the amount of deficit that they can carry over. In contrast, the US government runs very high annual deficits, and the US net debt to GDP is 100%. And what you see right now is the municipal tax collection has been extremely high. You know, property taxes have been bringing in a lot of money because you know median home values in America are up about 50% over the last four years.
Supporting property tax receipts in most geographies. We also have higher sales tax revenue based on you know pretty much solid consumption. And then for those states that charge a state income tax, that has also been rising very nicely. So overall, you know, compared to pre-pandemic levels in 2019, in the United States, the total annual tax receipts have increased about 38% for municipalities.
Michael Zeuner (08:09.401)
So whether you look at credit quality, whether you look at fundamental, you know, trends in you know, fiscal spending by the US government and its impact on local municipalities, your your perspective is that munis represent an opportunity at this point. Now, when we always talk about fixed income, Sam, one of the things that we very much emphasize is paying attention to what’s known as duration.
or interest rate risk or how much exposure to long-term interest rates, which are much more volatile in terms of the impact on price than short shorter term bonds. how do you look at duration in the muni market and how do you think about it?
sam (08:54.603)
Same way that we think about it when we talk about fixed income investing in general. So when we look at you know the muni bond market had a pretty strong downturn in September because overall interest rates went up, they still have duration risk. Now, when we look at valuation, it’s called a muni treasury yield, and this is where we would caution our listeners. That valuation metric is
Quite attractive going farther out, but when you go farther down the curve, the maturity curve, you’re taking a lot more interest rate risk. And investors could have been hurt like they were in September. So the same advice that we have in fixed income, keep the duration short because the yields are attractive and you don’t need to take much interest rate risk.
Michael Zeuner (09:45.785)
So that that lesson definitely applies. And I I would assume, Sam, your perspective is that this is not about moving all of your fixed income exposure into municipals. This is just about adding municipal exposure as another factor and diversifier within a fixed income portfolio. And of course, this all depends on an individual’s individual tax rates and situation and state, and they need to check with their tax advisors on all of that. But broadly speaking,
the opportunity that you present in the muni market is one investors should be taking a closer look at. and that wouldn’t have been the case several years ago.
sam (10:25.285)
That’s right. So it’s another tool in the toolkit to help generate income in a client’s portfolio. You know, it’s it’s actually really interesting. So maybe a little bit of background for our listeners. You know, the Muni bond market is quite big. It’s four to five trillion dollars. And for such a large asset class, it’s actually surprisingly inefficient. Because when we look at the number of issuers in corporate bond market, there’s 1600 issuers, and that’s a lot of issuers.
The Muni issuers, there are about 60,000 Muni issuers. When we look at the number of bonds out there, in corporate bonds, the number that are outstanding is between 10 and 20,000. That’s a lot of bonds to cover. In the municipal world, it’s between one and one and a half million, which means there is no one who can analyze all the bonds, each bond out there. So it’s surprisingly inefficient.
And the investors, the underlying investors, tend to be mom and pop investors. And you know, they don’t tend to do a lot of the deep credit analysis. So you can find good return risk opportunities in the Muni bond world.
Michael Zeuner (11:36.217)
So a skilled manager might be might be the place to look to to put some money to work. Okay. We’ll leave it there, Sam. Thanks for your perspective. and we’ll look forward to talking to you again soon.
sam (11:47.771)
All right, thank you, Michael.
