A Deep Dive into the Municipal Bond Market
The municipal market is not a homogenous market as many investors perceive. It is a rather fragmented one with many issuers and buyers with different needs. There are over 80,000 municipal issuers and 1.5 million CUSIPS that can be difficult to navigate. Since 2008 the loss of monoline insurance and legislative initiatives like Dodd Frank and SALT have also increased the complexity and volatility of the municipal marketplace. This has all combined to open up opportunities for relative value trading and tactical investing.
To dig deeper into this marketplace and explore some of its hidden risks and opportunities, we were introduced to James Pruskowski, Chief Investment Officer at 16Rock Asset Management – a NYC-based boutique asset management firm dedicated to the municipal bond market. Before joining 16Rock, Mr. Pruskowski was a Managing Director & Global Chief Investment Officer for Municipal Bonds, Institutional & Wealth Management at BlackRock. We asked questions to better understand their nontraditional perspective as proactive and tactical municipal investment managers.
Hortz: Can you give us a brief overview on municipal bonds?
Pruskowski: Municipal bonds - both general obligation bonds secured by the issuing municipality’s pledge to repay and revenue bonds secured by a specific source of revenue like tolls - serve a vital role in building and maintaining a wide range of state & local infrastructure such as schools, hospitals, airports, universities, highways, and water and sewer systems. When an investor purchases a municipal bond, they are lending money to finance public projects that are often monopolistic in nature (water, electricity) and essential in purpose. For this reason, in general, municipal bonds score highly on ESG and Impact scales or criteria.
Municipal bond interest payments are traditionally exempt from US federal income taxes and sometimes state & local income taxes. US taxpayers, including family offices, high-net-worth individuals, as well as corporations like insurance companies, typically focus on tax-exempt municipal bonds. Non-US tax paying entities like endowments, foundations, as well as foreign investors and pension investors typically focus on taxable municipal bonds because they trade at a higher yield than tax-exempt municipal bonds, often the same yield as corporate bonds.
Hortz: What should investors know about investing in municipal securities that they may not be aware of?
Pruskowski: US municipal bonds are not as well known around the world as say corporate bonds. The tax-exempt variety is often dismissed on the global stage because of its low yield, however, tax-exempts can provide all investor types with attractive and scalable real returns. The tax-exempt market offers a wider variety of top-rated credits (relative to corporate bonds) with comparatively lower overall default rates, better recovery rates, and municipal credit ratings transition less than most other asset classes. In short, the credit picture is strong and diverse.
The taxable bond variety has grown in recent years. They offer yields that are similar to corporate bonds, however, they have become increasingly attractive to many global buyers due to their regulatory capital efficiency (i.e., Solvency II). Financial regulation is constantly evolving around the world and reshaping the way investors approach the capital markets and taxable municipals have found many valuable use cases.
The tax-exempt variety also has many use cases as the asset class is often used to support retirement lifestyles, defease liabilities and is an important source of performance for multiple-strategy funds.
Hortz: How would you characterize your investment approach versus traditional municipal bond SMA management?
Pruskowski: All too often we see municipal investment processes with an automatic approach that stems from a convenience of process. Industry providers these days appear to be putting more emphasis on brand awareness and streamlining production rather than best execution at the individual bond level. We feel what gets lost is out-of-the-box thinking and the ability to adapt quickly to rapidly changing investment regimes.
The goal of our investment approach is to identify inconsistencies and reconcile that into best ideas and industry-leading performance. Each of our Portfolio Managers has decades of municipal market experience and deep domain relationships with the street which we believe translates into superior information flow.
Hortz: What other variables are involved in analyzing municipal securities besides coupon, issuer and ratings?
Pruskowski: We aim to optimize bond selection with a proprietary set of criteria that extends beyond just relative value. It is inherently easier for investors to get comfortable with a top-rated issuer with a strong balance sheet and stable cash flows, but often what gets overlooked are other key attributes such as index eligibility, regulatory capital-efficiency, tax multiplication at the Federal, State & Local level, impact investment qualities and various other structural features like premium/discount and optionality around calls and coupon, to name a few.
Politics can also have an outsized impact on supply and demand. For example, the Trump tax reduction act reduced the ability of an issuer to advance refund a municipal bond which has reduced annual supply by about 5% to 10%. Alternatively, changing federal and state tax can impact demand.
Our risk management is designed to provide independent, top-down and bottom-up oversight to help identify investment risk and opportunities. We produce quantitative analysis to support portfolio construction and have ongoing surveillance of key risk variables such as political, climate, liquidity, credit, event, tax, policy, credit, sector and interest rate risk. Performance is the key driver of success. Our focus is on consistency and informed investment results. We seek alternative sources of return when client guidelines dictate, to achieve directionally similar results.
Hortz: How does your research process inform your prevailing view of market conditions, sectors and where value or risk may be?
Pruskowski: Our research process is designed to provide structure and consistency around our views. We seek to enhance the subjectivity that comes from having a traditional quantitative and qualitative based approach. Quantitative analysis includes financial analysis of the issuer and qualitative analysis consists of factors such as political, climate, public support and growth potential.
Our process is designed around flexibility and adaptability that is required to deliver top-tier performance. All of the Portfolio Managers are responsible. We are constantly second guessing what everyone else is thinking and building portfolios that afford to be flexible while acutely focused on optimizing investment objectives. That flexibility is what affords rotation of sectors and credits when valuations change to produce quality performance.
We continuously monitor exceptions with a proactive sell discipline. Our ongoing surveillance process is designed around a relative value scorecard review on a real-time basis. We compare market clearing yield and spreads at the point of new issue acceptance and focus on secondary market trading, volume, price and spread changes.
Hortz: Can you give us examples of the types of relative trading opportunities that you can find in the municipal marketplace?
Pruskowski: Portfolio construction is driven by our investment strategy, best ideas and highest convictions. We diversify our investment strategy into nine style buckets to deliver low-correlated outcomes and top-tier investment results. From a trading perspective, today’s environment of heightened volatility presents opportunities to rotate in various sectors and credits. There is good value to be had in new issue concessions, from a flow perspective and demand differences that exist within the market. Municipals at times can trade rich or cheap and having the flexibility to adapt quickly to constantly evolving investment environments is key.
One tangible example of relative value is how certain states may trade. In the past several years, California paper has gone from being one or two standard deviations “cheap” to the AAA-rated municipal yield curve to being one or two standard deviations “rich” as the state credit has improved.
Hortz: How does 16Rock see municipal bond management differently than other municipal managers?
Pruskowski: We cater to the modern needs of institutions and high-net-worth individuals around the world. Our passion is to help clients translate their desires and aspirations into sophisticated outcomes that exude order. Our team leverages decades of experience to construct highly curated portfolios. We offer tailored managed account solutions, transition management services and, through our alternative investment capabilities, products designed to deliver absolute return excellence.
Within managed accounts, we seek to provide outcome-oriented solutions designed specifically for each client. Our expertise spans across many styles, maturity, credit, constraints and objectives. Some examples of styles include tax-exempt municipals, taxable municipals and or impact investing in other dedicated or crossover portfolio construction. This includes customization across the entire yield curve and credit spectrum for a wide variety of constraints and objectives, such as tax sensitivities, regulatory, accounting, investment income, total return, book yield and/or modified total return.
We also provide what we refer to as Transition Management services, which we think is an under-utilized opportunity. To this end, we can work with a high-net-worth individual to efficiently transition his/her portfolio from one tax jurisdiction (i.e., New York) to another, (i.e., California). A separate use case is when a corporation wants to transact in the municipal market anonymously to say increase a position in municipals, or as we have seen recently with some regional banks like First Republic, liquidate municipal bonds. The final case is for an opportunistic market participant like a hedge fund to “rent a desk” for a trade.
Hortz: Can you comment more on the opportunities for investors looking for an asset class with impact?
Pruskowski: U.S. Municipal Bonds finance public schools, roads, water, sewer systems and other vital infrastructure projects that lend themselves to the UN Sustainable Development Goals. UN Sustainable Development Goals (SDGs) are a collection of 17 global goals set by the UN and are a call to action to end poverty, protect the planet and ensure that all people enjoy peace and prosperity. 16Rock team identifies opportunities within the U.S. Municipal Bond market that align investments with UN SDGs to build municipal portfolios that extend client goals to specific impact targets.
Sustainability considerations in municipal bonds are typically associated with physical risk with climate. Measure the effects of changes in mortality rates, labor productivity, heating and cooling demand, changes on expenditures, agricultural productivity and expected annual average loss from hurricanes. 16Rock analyzes demographic areas and screens for bonds that target regions that have low economic loss from climate change and events that still offer strong credit profiles.
There are also social opportunities in terms of investing with impact in undercapitalized areas. Investment practices that focus on client interest in racial equity, community engagement, sustainable employment, preventative healthcare, mental health, affordable housing and social justice. 16Rock analyzes demographic areas and screens for bonds that target under-supported communities that still offer strong credit profiles.
Hortz: What are your thoughts and concerns about the muni market right now? What do you see as some of the biggest risks and opportunities?
Pruskowski: We think there is a narrow path to a soft landing for the US economy and volatility is likely to remain elevated. The environment is one of caution, but also presents some of the best risk-reward profiles in decades for municipal bond investors. We believe there will soon be a regime shift toward lower interest rates as the Federal Reserve is at or near a peak terminal rate. While inflation may or may not be slow to come down, we see it transitioning from supply/demand imbalances to a tax on the US consumer.
From a top-down perspective, there are downstream credit consequences to the municipal asset class due to the lingering effects of economic, social behaviors and climate. There will also be other challenges with pension and retirement healthcare leverage as products of heightened exposure to equity markets and demographic shifts. We see the rating cycle at a peak and acute challenges popping up in select sectors and non-essential purpose debt such as in private education and senior living sectors. There are good reasons to shift portfolio construction from cyclical to defensive in terms of credit exposure.
While acute challenges are likely to exist in select sectors and non-essential purpose debt, value can be found in monopolistic systems such as water and sewer with rate-setting autonomy and a diverse customer base. Other diversified systems such as multiple state highways and healthcare systems offer value and can spread risk across geographies. It is important to invest in issuers with proactive and disciplined management with strong financial and operating performance.
From a technical and valuation perspective, demand as measured by fund flows is slowly returning after a dismal 2022. Today’s environment is one of the net negative supply that we expect to continue. High interest rates trump rich ratios in tax-exempt given the multiplier effect of US tax and compounding benefits of wider credit spread. Taxable municipals also offer tremendous value at or near corporate equivalent yields and provide greater diversification potential across the yield curve in higher-quality assets.
Hortz: Any advice or recommendations you can share with advisors on working with munis in their client portfolios?
Pruskowski: Municipal bonds have many applications around the world. They are a vital solution for savings and retirement as they can be for performance generation and regulatory capital efficiency. Careful consideration must be given when working with clients to understand their investment goals, objectives and constraints. Opportunities are driven by the market’s broad and persistent demand, routine supply of credit, favorable capital treatment and having infrastructure characteristics at corporate equivalent yields.
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