December 21, 2022
Could munis rebound in 2023? After underperforming for much of the year, municipal bonds could be poised for a turnaround in 2023. In our latest podcast, we provide an overview of the asset class.
David Hagee: Hello and welcome to Conversations with Commerce Trust, our show about the markets, investment themes, and economic insights that matter to you. I'm your host, David Hagee, Chief Investment Officer with Commerce Trust. Today we're going to be discussing the municipal markets, looking at the tumultuous year that they've had and planning for investment opportunities with Brian Musielak, our Director of Fixed Income Portfolio Management here at Commerce Trust, and also a manager of our municipal bond mutual fund complex. Welcome to the podcast, Brian.
Brian Musielak: Thanks, David. Glad to be here.
David: Yeah, it's been a wild year inside fixed income. How's it going inside the municipal bond marketplace?
Brian: Well, it's been less bad, let's just say that. So, when you look at it, particularly if you focus on total returns, obviously with the increase in interest rates, we've had negative total returns. So, if you're invested in a bond fund, you can see that that's readily available, or even individual bonds, you'll know from your statements that as interest rates go up, the values of those bonds go down. So, when you compare them to the taxable side, we've gone down less. In terms of total return, yields haven't gone up quite as much. I think most taxable bond intermediate duration funds are in that double digit loss category, anywhere from 10 to 12%. In the muni (municipal bond) space, you're looking at negative returns closer to six to 7%. But obviously when you look back historically, it's been probably one of the worst years in that space or in bonds, again, if you measure from total return, that we've ever seen.
David: Well, I think in 2022 less bad counts as a victory for us. I think it'd be helpful for our listeners to have a bit of a definition around municipal bonds. Who can issue, what they look like, and kind of where they fit into the marketplace.
Brian: So, it's always been categorized as a sleepy asset class, right? In order to qualify to issue tax exempt debt, issuers have to be a public entity, state, local government, school district, non-for-profit profits can also access the markets. So, you've got private universities, non-for-profit hospitals also have access, but also too, in order to qualify, the proceeds or what you use the debt on. So, if a hospital's going to issue debt, or even the City of Clayton was going to issue debt and they would like to have it tax free, they have to make sure that that debt issuance goes to public use, so in a more broad category. So, the market is about $3.4 trillion in size, so you're looking at probably a third to maybe a half the size of the corporate bond market. So, what's much smaller, but the biggest difference is it's much more fragmented. So, there's thousands and thousands of municipal issuers ranging in size from the smallest taxing districts that could be created that are eligible to issue tax exempt debt to the largest states such as a California, New York or Texas that have the ability to issue debt.
So, when you look at the landscape, while we (Munis) may be half the size or a third of the size of the corporate market, just in total outstanding, the sheer number of issuers in the municipal market dwarfs that of what we see in the corporate market.
David: So, at its core, the municipal market can be defined this way: that you have municipalities that can issue at lower cost, lower interest rates to be able to fund projects for the common good, but then investors also get the benefit of having federally tax-exempt interest coming to them. And then depending on the state they live in; they might get some tax benefit in the state that they're in as well. So, a win-win, but you're accepting a little bit less interest. How should we think about those taxes? Is there a way that you analyze the tax advantages of municipal bonds?
Brian: Sure, sure. So, obviously the biggest component is the federal exemption. That's where you get the most bang for your buck. So, if you think about the buyers or investors of municipal debt, they tend to be individual investors that find themselves in the higher marginal tax rates. So, if you look at our tax structure right now, the highest marginal rate is 37%. On top of that, we do have the Medicare tax or what some called the Obamacare tax at 3.8%. So, the highest taxpayer, the individual taxpayer can have a marginal rate of 40.8%.
And so, when you're thinking about municipalities and issuing that tax exempt debt, that's the key measure we're using in terms of the relative value. What is that going to be? So, for an example, if you were to buy a bond that has a yield, a tax-free yield of three and a half percent, which you can get around 10 years in our market right at this point, so 3.5% on a taxable equivalent basis, that gets close to 6% on a taxable equivalent basis.
So, if you think of it another way, if I were going to buy a bond at 6% that's taxable, say a treasury or a CD, then you're going to lop off 40% of that roughly to pay the government. So that would be the equivalent yield at three and a half percent. So, it's very appealing right now when you look at the tax-exempt markets, say, relative to treasuries. This gets into another discussion. But if you think about those long-term Treasury yields, I think most of our clients have probably either read in the Wall Street Journal, heard on CNBC that Treasury rates are flat to even inverted, meaning that longer term rates are actually lower than shorter term rates.
That's not the case in the municipal market, so you still get incremental yield the further out in term you go. So again, getting back to that 10-year comparison, you can buy a tax-free bond at 3.5% tax-free in the muni space, would get you a 5.9%, call it taxable equivalent yield, and then you look at where the 10-year treasury is today at about 3.6% that's taxable. So that's a lot of numbers thrown at you, but generally at a high level, what we're saying is munis are very attractive to those individuals that find themselves in the highest tax rates.
David: And Brian, you talked about earlier that it's a bit of a sleepy place in the marketplace, or at least is characterized that way. Of course, that's because they have less defaults and the reason they have less defaults is because they have the power of taxation. But let's talk about maybe some more exciting times inside the municipal bond marketplace.
Brian: Yeah, so obviously, going back to the financial crisis, municipalities from a budgetary standpoint were severely impacted. And it followed a typical pattern where you have a recession, which tax revenues are going to go down, expenses are going to go up and you're going to have a deficit. But as you mentioned, David, the power of taxation goes a long way in terms of how that's fixed over time. And as we've seen in the past, even though the numbers were much greater during the financial crisis, the budget deficits were much bigger, it took about three fiscal years, maybe four fiscal years for them ultimately to close the gap. And so, while we saw a little uptick in the default rate, we certainly saw a lot more credits getting downgraded, which doesn't mean default, that just means they’re of lower quality, which makes sense when you get in an environment like that. But ultimately, as we found out that munis have always done, they're very battle-tested when it comes to these environments, that they ultimately fix that.
David: You know, and I'll say, inside the municipal bond space, there are some weaker municipalities out there, say, some cities that are a bit over-levered here, and certainly some states that appear to be a little bit weaker. As you assess the current state of the municipal bond market, what are your thoughts as to the overall health?
Brian: As we sit here today, the overall health is very good. We expect, even if we get into a slowdown next year or even a mild recession, we think municipalities will hold up very well. And a big component of that, of course, is the fiscal stimulus that's been put in the system last couple of years. State and local governments got an estimated $500 billion of federal stimulus that went into their coffers. Much of that had strings attached in terms of how it was spent, but nonetheless, a lot of that is still sitting there.
David: So, given that we talked briefly about 2022 performance and how challenging it's been in the rising interest rate environment that we've experienced, looking ahead, what are we thinking are the trends inside muni finance and more specifically inside the muni market?
Brian: Well, I think a couple of things. One is you know the positive that has come out of this is we've got higher yields than we've had since 2018. So, when you look at the opportunity set in terms of investing, right, we're looking backwards and licking our wounds over the performance of bonds we've held, certainly bonds that we bought in the last couple of years. And I think that that'll go a long way in terms of investor demand. The other thing as we look out, even with the infrastructure spending, we get asked this a lot. Okay, infrastructure's coming in for the federal government. Are we going to see a lot of issuance from the muni space? And I think overall, we do expect a little bit of an uptick in issuance, but if we look at over the course of the next year, we think there's actually going to be more bonds coming due or maturing over the next year.
If you include all the coupon payments associated with, then it's going to be issued, meaning you're going to have what's called negative net supply (a large pool of investible dollars with a limited number of new municipal bonds being issued.) So there's more bonds being issued, more cashflow being generated from those redemptions, then there will be supply of new issues. And we've had that for a couple of years. It's been really the one space where you can look to actually see some deleveraging going on. And I think that from a market technical standpoint, that's going to go a long way in terms of supporting munis, particularly relative to say taxable bonds such as corporates and treasuries.
Now, the muni market is going to follow treasuries, so really dependent upon where treasuries are going. We do think with the potential slowdown next year that maybe by the end of the year you could see lower interest rates, lower treasury yields. If we do see that, I think munis will outperform again relative to treasuries.
David: Thanks for the great discussion, Brian.
For more information about munis and their marketplace, you can download our market perspectives at www.commercetrustcompany.com. Thanks for joining us on Conversations with Commerce Trust. I'm David Hagee. We'll talk again soon.
Important material disclosures regarding the content of this program follow, Commerce Trust is a division of Commerce Bank. Generally, non-depository investments offered in connection with Commerce Trust and its affiliates are not guaranteed, are not FDIC insured, and may lose value.
Opinions and other information provided are effective as of the date of the recording and presented for the purpose of general education information or illustration only. Neither Commerce nor any of its affiliates, officers, employees, or agents have made any recommendations to buy, hold, or sell securities, or given any advice as to the terms, beneficial interests, or profitability of any investment strategy or market activity. And information provided may not be relied upon as such.
You as the investor, are fully responsible for any investment transaction you choose to enter into, including determining whether such investment is appropriate in light of your investment objectives and personal circumstance. And you shall not have relied on any of the proceeding or following information from Commerce as the basis for any investment decision. This material is not intended to replace the advice of a qualified attorney, tax advisor, or investment professional.
In considering whether to trade or invest, you should inform yourself and be aware of the risks. Past performance is no guarantee of future results. And the information in the commentary provided is subject to change based on market or other conditions. Diversification does not guarantee a profit or protect against all risk.
Commerce Trust does not offer tax, legal, or specific estate planning advice. And while we may provide information or express general opinions from time to time, such information or opinions are not offered as professional tax or legal advice. Commerce Trust does not provide advice relating to rolling over retirement accounts.
Commerce Trust is not a municipal advisor under Section 15B of the Securities Exchange Act and therefore does not offer advice or recommendations concerning bond proceeds or other municipal advice, subject to this section. Any data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
December 8, 2022
Commerce Trust is a division of Commerce Bank.
Could munis rebound in 2023? After underperforming for much of the year, municipal bonds could be poised for a turnaround in 2023. In our latest podcast, we provide an overview of the asset class.
David Hagee: Hello and welcome to Conversations with Commerce Trust, our show about the markets, investment themes, and economic insights that matter to you. I'm your host, David Hagee, Chief Investment Officer with Commerce Trust. Today we're going to be discussing the municipal markets, looking at the tumultuous year that they've had and planning for investment opportunities with Brian Musielak, our Director of Fixed Income Portfolio Management here at Commerce Trust, and also a manager of our municipal bond mutual fund complex. Welcome to the podcast, Brian.
Brian Musielak: Thanks, David. Glad to be here.
David: Yeah, it's been a wild year inside fixed income. How's it going inside the municipal bond marketplace?
Brian: Well, it's been less bad, let's just say that. So, when you look at it, particularly if you focus on total returns, obviously with the increase in interest rates, we've had negative total returns. So, if you're invested in a bond fund, you can see that that's readily available, or even individual bonds, you'll know from your statements that as interest rates go up, the values of those bonds go down. So, when you compare them to the taxable side, we've gone down less. In terms of total return, yields haven't gone up quite as much. I think most taxable bond intermediate duration funds are in that double digit loss category, anywhere from 10 to 12%. In the muni (municipal bond) space, you're looking at negative returns closer to six to 7%. But obviously when you look back historically, it's been probably one of the worst years in that space or in bonds, again, if you measure from total return, that we've ever seen.
David: Well, I think in 2022 less bad counts as a victory for us. I think it'd be helpful for our listeners to have a bit of a definition around municipal bonds. Who can issue, what they look like, and kind of where they fit into the marketplace.
Brian: So, it's always been categorized as a sleepy asset class, right? In order to qualify to issue tax exempt debt, issuers have to be a public entity, state, local government, school district, non-for-profit profits can also access the markets. So, you've got private universities, non-for-profit hospitals also have access, but also too, in order to qualify, the proceeds or what you use the debt on. So, if a hospital's going to issue debt, or even the City of Clayton was going to issue debt and they would like to have it tax free, they have to make sure that that debt issuance goes to public use, so in a more broad category. So, the market is about $3.4 trillion in size, so you're looking at probably a third to maybe a half the size of the corporate bond market. So, what's much smaller, but the biggest difference is it's much more fragmented. So, there's thousands and thousands of municipal issuers ranging in size from the smallest taxing districts that could be created that are eligible to issue tax exempt debt to the largest states such as a California, New York or Texas that have the ability to issue debt.
So, when you look at the landscape, while we (Munis) may be half the size or a third of the size of the corporate market, just in total outstanding, the sheer number of issuers in the municipal market dwarfs that of what we see in the corporate market.
David: So, at its core, the municipal market can be defined this way: that you have municipalities that can issue at lower cost, lower interest rates to be able to fund projects for the common good, but then investors also get the benefit of having federally tax-exempt interest coming to them. And then depending on the state they live in; they might get some tax benefit in the state that they're in as well. So, a win-win, but you're accepting a little bit less interest. How should we think about those taxes? Is there a way that you analyze the tax advantages of municipal bonds?
Brian: Sure, sure. So, obviously the biggest component is the federal exemption. That's where you get the most bang for your buck. So, if you think about the buyers or investors of municipal debt, they tend to be individual investors that find themselves in the higher marginal tax rates. So, if you look at our tax structure right now, the highest marginal rate is 37%. On top of that, we do have the Medicare tax or what some called the Obamacare tax at 3.8%. So, the highest taxpayer, the individual taxpayer can have a marginal rate of 40.8%.
And so, when you're thinking about municipalities and issuing that tax exempt debt, that's the key measure we're using in terms of the relative value. What is that going to be? So, for an example, if you were to buy a bond that has a yield, a tax-free yield of three and a half percent, which you can get around 10 years in our market right at this point, so 3.5% on a taxable equivalent basis, that gets close to 6% on a taxable equivalent basis.
So, if you think of it another way, if I were going to buy a bond at 6% that's taxable, say a treasury or a CD, then you're going to lop off 40% of that roughly to pay the government. So that would be the equivalent yield at three and a half percent. So, it's very appealing right now when you look at the tax-exempt markets, say, relative to treasuries. This gets into another discussion. But if you think about those long-term Treasury yields, I think most of our clients have probably either read in the Wall Street Journal, heard on CNBC that Treasury rates are flat to even inverted, meaning that longer term rates are actually lower than shorter term rates.
That's not the case in the municipal market, so you still get incremental yield the further out in term you go. So again, getting back to that 10-year comparison, you can buy a tax-free bond at 3.5% tax-free in the muni space, would get you a 5.9%, call it taxable equivalent yield, and then you look at where the 10-year treasury is today at about 3.6% that's taxable. So that's a lot of numbers thrown at you, but generally at a high level, what we're saying is munis are very attractive to those individuals that find themselves in the highest tax rates.
David: And Brian, you talked about earlier that it's a bit of a sleepy place in the marketplace, or at least is characterized that way. Of course, that's because they have less defaults and the reason they have less defaults is because they have the power of taxation. But let's talk about maybe some more exciting times inside the municipal bond marketplace.
Brian: Yeah, so obviously, going back to the financial crisis, municipalities from a budgetary standpoint were severely impacted. And it followed a typical pattern where you have a recession, which tax revenues are going to go down, expenses are going to go up and you're going to have a deficit. But as you mentioned, David, the power of taxation goes a long way in terms of how that's fixed over time. And as we've seen in the past, even though the numbers were much greater during the financial crisis, the budget deficits were much bigger, it took about three fiscal years, maybe four fiscal years for them ultimately to close the gap. And so, while we saw a little uptick in the default rate, we certainly saw a lot more credits getting downgraded, which doesn't mean default, that just means they’re of lower quality, which makes sense when you get in an environment like that. But ultimately, as we found out that munis have always done, they're very battle-tested when it comes to these environments, that they ultimately fix that.
David: You know, and I'll say, inside the municipal bond space, there are some weaker municipalities out there, say, some cities that are a bit over-levered here, and certainly some states that appear to be a little bit weaker. As you assess the current state of the municipal bond market, what are your thoughts as to the overall health?
Brian: As we sit here today, the overall health is very good. We expect, even if we get into a slowdown next year or even a mild recession, we think municipalities will hold up very well. And a big component of that, of course, is the fiscal stimulus that's been put in the system last couple of years. State and local governments got an estimated $500 billion of federal stimulus that went into their coffers. Much of that had strings attached in terms of how it was spent, but nonetheless, a lot of that is still sitting there.
David: So, given that we talked briefly about 2022 performance and how challenging it's been in the rising interest rate environment that we've experienced, looking ahead, what are we thinking are the trends inside muni finance and more specifically inside the muni market?
Brian: Well, I think a couple of things. One is you know the positive that has come out of this is we've got higher yields than we've had since 2018. So, when you look at the opportunity set in terms of investing, right, we're looking backwards and licking our wounds over the performance of bonds we've held, certainly bonds that we bought in the last couple of years. And I think that that'll go a long way in terms of investor demand. The other thing as we look out, even with the infrastructure spending, we get asked this a lot. Okay, infrastructure's coming in for the federal government. Are we going to see a lot of issuance from the muni space? And I think overall, we do expect a little bit of an uptick in issuance, but if we look at over the course of the next year, we think there's actually going to be more bonds coming due or maturing over the next year.
If you include all the coupon payments associated with, then it's going to be issued, meaning you're going to have what's called negative net supply (a large pool of investible dollars with a limited number of new municipal bonds being issued.) So there's more bonds being issued, more cashflow being generated from those redemptions, then there will be supply of new issues. And we've had that for a couple of years. It's been really the one space where you can look to actually see some deleveraging going on. And I think that from a market technical standpoint, that's going to go a long way in terms of supporting munis, particularly relative to say taxable bonds such as corporates and treasuries.
Now, the muni market is going to follow treasuries, so really dependent upon where treasuries are going. We do think with the potential slowdown next year that maybe by the end of the year you could see lower interest rates, lower treasury yields. If we do see that, I think munis will outperform again relative to treasuries.
David: Thanks for the great discussion, Brian.
For more information about munis and their marketplace, you can download our market perspectives at www.commercetrustcompany.com. Thanks for joining us on Conversations with Commerce Trust. I'm David Hagee. We'll talk again soon.
Important material disclosures regarding the content of this program follow, Commerce Trust is a division of Commerce Bank. Generally, non-depository investments offered in connection with Commerce Trust and its affiliates are not guaranteed, are not FDIC insured, and may lose value.
Opinions and other information provided are effective as of the date of the recording and presented for the purpose of general education information or illustration only. Neither Commerce nor any of its affiliates, officers, employees, or agents have made any recommendations to buy, hold, or sell securities, or given any advice as to the terms, beneficial interests, or profitability of any investment strategy or market activity. And information provided may not be relied upon as such.
You as the investor, are fully responsible for any investment transaction you choose to enter into, including determining whether such investment is appropriate in light of your investment objectives and personal circumstance. And you shall not have relied on any of the proceeding or following information from Commerce as the basis for any investment decision. This material is not intended to replace the advice of a qualified attorney, tax advisor, or investment professional.
In considering whether to trade or invest, you should inform yourself and be aware of the risks. Past performance is no guarantee of future results. And the information in the commentary provided is subject to change based on market or other conditions. Diversification does not guarantee a profit or protect against all risk.
Commerce Trust does not offer tax, legal, or specific estate planning advice. And while we may provide information or express general opinions from time to time, such information or opinions are not offered as professional tax or legal advice. Commerce Trust does not provide advice relating to rolling over retirement accounts.
Commerce Trust is not a municipal advisor under Section 15B of the Securities Exchange Act and therefore does not offer advice or recommendations concerning bond proceeds or other municipal advice, subject to this section. Any data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
December 8, 2022
Commerce Trust is a division of Commerce Bank.
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