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  • Muni Nation

    Asset TV Masterclass: Municipal Bonds

    Jim Colby, Portfolio Manager
    August 03, 2017
     

    James Colby, VanEck Vectors Portfolio Manager and Senior Municipal Strategist, participated in Asset TV's recent Muni Bond Masterclass video panel, hosted by Asset TV's Gillian Kemmerer. Colby joined municipal bond industry experts Terry Hults of AllianceBernstein, Suzanne Finnegan of Build America Mutual, and John Miller of Nuveen.

    Jim Colby's comments are excerpted below.

    GILLIAN KEMMERER: Welcome to Asset TV's Municipal Bonds Masterclass. Municipal bonds have dominated headlines in recent months with an influx of crossover buyers and pockets of credit concern impacting the fate of the sector. Investors are grappling with a legislative agenda that could make its mark on this space, but with no sense of the timeframe in which those changes may be enacted. What does the opportunity set look like right now and what do investors need to know? Today, I am joined by a panel of experts who will share their insights.

    Muni Market's Evolution in the Past Decade

    KEMMERER: Let's start with Jim Colby. How has the municipal market changed, either in terms of composition or opportunity set, over the past few years?

    JIM COLBY: Looking back at the last 10 years, I would say that the financial crisis [2008-2010] really opened up the marketplace to new concepts and new ideas. Municipal bonds have been a tried and true performer, and a core holding in many asset models. Now we have innovation, and I'm not just talking about derivative structures. I'm talking about true innovative structures in the marketplace which are pleasantly, I think, offsetting in terms of where opportunities exist not only on the yield curve and the credit spectrum, but for different types of investors. We have a range of different types of fund structures from closed-end funds to UITs [unit investment trusts], to now ETFs [exchange traded funds], which is the part of the market I represent. I think we now have a collection of asset opportunities that lends itself not just domestically, but here's the big change, even internationally. We see interest in the municipal bond space, specifically the Build America Bonds program, which was an offshoot of the financial crisis, that has opened up a whole new venue of potential investing opportunities in Europe, in Asia, and we see that continuing.

    KEMMERER: Are you saying that the opportunities in the muni bond market in terms of fund structure have really changed?

    COLBY: Absolutely. I mean it's an opportunity because the disruption of the market to some degree has created a comparative value analysis, if you will. We are not just saying here is tax exempt income to the buyer. We're saying, compare what they are delivering compared to corporates. Compare what they are delivering to equities over a long period of time. And these comparisons have been very favorable to munis in the past decade.

    Recent Muni Market Performance

    KEMMERER: Let's look at performance specifically from Q4 of last year through the first half of 2017. We saw some interesting movements in munis in response to the election. Jim, how would you characterize the past couple of quarters of muni performance?

    COLBY: Along with the election for the Republicans in November came a concern that tax reform was in play in a big way. What impact this would have on the municipal marketplace was very uncertain. I think this led to the outflows that occurred in the municipal space, through probably the mid part of December and through the end of the year. That uncertainty was in great part mitigated by the slowness that occurred in terms of Trump's administration putting forth measures that would get enacted in that timeframe that he had hoped for. So with the potential of tax reform impacting munis, I think that we returned to a more orderly municipal market in the first quarter.

    KEMMERER: Interesting. It seems that munis have reacted to the slow pace of legislative growth faster than other asset classes, which might still be riding a little tail end of that wave of the election.

    COLBY: I would say that's a fair analysis.

    Muni Supply Demand Dynamics

    KEMMERER: Jim, coming to you, how do you look at the demand supply imbalance in munis right now?

    COLBY: I think it's very favorable for our marketplace, and it is a dynamic that we have been pointing out to our clients, and that we've written about, over the last three years. And the supply demand imbalance has occurred for slightly different reasons in each year. For example, in January, one of our leading strategists in the industry did predict an enormous wave of refinancing, contributing to nearly $500 billion in terms of new issuance this year. But then I had a conversation with him at the end of the first quarter, and asked him, "Well, what's happened?" He said, "No refinancing." With refunding volume down, that is a big part of the supply picture. At the same time, demand is strong; it keeps reappearing in the form of new investors looking at the marketplace and looking for "relative value opportunities". And also with the amount of roll off that's occurring – bond calls, coupon payments, bond maturities – this month, with June 30 and July 1, for example, going to be very significant dates, there is an enormous amount of cash coming back in to client accounts for reinvestment opportunity.

    Muni Opportunities Based on the Yield Curve

    KEMMERER: Let's discuss market technicals. How has the shape of the yield curve changed, and what are some of the best entry points?

    COLBY: At VanEck, we have built portfolios that are positioned to provide client opportunity for different outcomes in the marketplace. We subscribe to two key thoughts. One concerns the intermediate part of the municipal curve which is supported not only by individual investors but by substantial institutions in this country ― they could be insurance companies, big property and casualty companies, and banks in particular. In the 7-12 year intermediate part of the curve there is a great deal of issuance and that coincides with a greater demand from those institutions. And as John was just saying, high yield has been for quite some time, on a comparable basis to corporate high yield, well above its long-term mean in terms of the nominal yield deliverable. From a technical point of view, when you do the math to represent apples to apples, taxable equivalent returns for munis versus other asset classes, are still favorable. And that's what drives both the intermediate part of the curve opportunities as well as high yield.

    The GO-Revenue Bond Debate

    KEMMERER: Jim, what are your thoughts on the general obligation versus revenue bond debate?

    COLBY: We look at the muni universe in a slightly different fashion because our management process focuses on matching up our ETF portfolios against specific indices, and an index will reflect what's in the marketplace. And if it's, say, a 65/35 division between general obligation and revenue bonds and more granular than that of course, we're certainly trying to do two things. Number one, we're trying to reflect what the index reflects. Number two, we do care about what's happening with Detroit, with Puerto Rico, with Illinois in particular because, as we look at what might occur two weeks or two months from now, it will have a big impact upon the structure of the index. And the index doesn't pay out returns, but our portfolios do. If we are even slightly overweight in a sector in a revenue situation or a GO like the State of Illinois and it drops below investment grade status, then of course we have to adjust. We do a similar analysis to manage all our ETF portfolios, but with a bit of a wait and see approach given that we are not supposed to manage proactively.

    KEMMERER: Jim, let's talk about Illinois. When you look at the possibility that Illinois might get downgraded, what's the process you go through to look at your indices and the composition or your portfolios, and re-jigger them? Will Illinois automatically go into your high yield index?

    COLBY: Given the makeup of our high yield index, we carry triple B-rated securities, as a condition of meeting New York Stock Exchange requirements as well as the SEC, in terms of fulfilling the need for what is liquid or represents liquidity in high yield. Illinois is also part of our investment grade index, the bottom rung. As I mentioned, we're looking at the relative weighting in the index of Illinois GOs, of its political subdivisions. And doing our best to match up to those weightings with a hopeful eye that something positive will materialize in Springfield. Right now it is anybody's guess, and I am an outsider looking at the big picture. For two years now we have seen no legislative compromise to create any certainty around what the outcome will be.

    State Pension Liability

    KEMMERER: Jim, unfunded pension liability is an absolutely enormous issue in the U.S. What's your outlook? And is any state getting it right in a way that other states can model?

    COLBY: That's a question for some very focused analysts. States, including Connecticut, New Jersey, Kentucky, Pennsylvania, and now Illinois, are all laboring under intense scrutiny in a way that they have not experienced in prior years. I can remember going back some 25 years or so and hearing about the unfunded pension liabilities in some of these states. At that time, it got very little focused attention because economically states were doing well in other areas. There were revenue streams that covered up some of those issues, or legislatively the executive branches had the ability to say, "Well, all right, we'll set that aside for another year, allocate the money into different resources." I do think, however, that it is a grave concern when we're growing at less than 2% CPI year over year. Yes, there's job creation, but it's not as economically productive as it might otherwise be, which translates into slower revenue growth, which means that the POPs ― the Pension Obligation Performers ― are going to struggle with a lack of ready available cash in order to do what they are supposed to do internally within their own states, as well as fund their pension requirements.

    KEMMERER: Jim, what are some of the opportunities that you see right now along the yield curve?

    COLBY: Unquestionably, the intermediate part of the curve has almost never ― and I know as soon as I say something like this that somebody will prove me wrong ― flattened or inverted, which means that you're getting the benefit by being positioned in that part of the curve of opportunity, what we call roll down. The maturity of bonds that are 10 years right now, next January are going to be 9-year bonds. All things being equal, that means some incremental performance opportunity accrues to that part of the curve. For high yield, I do think that there are opportunities that are generally not recognizable to the average investor embedded in the different sectors. The long-term profile of high yield, low default rates in the muni market, higher recovery rates when defaults do occur than in the corporate sector. And the high taxable equivalent returns compared to other asset classes really are what recommends munis.

    KEMMERER: With munis, we have tax free income, liquidity, and security. Jim, last but not least, where do munis fit into a larger investment portfolio?

    COLBY: ETFs are a product that are relatively new on the scene, nearly 10 years old probably this September. Investors should ask, what do I need to anchor stability in my portfolio? While munis, as we discussed are clearly a preferential option, the ETF structure provide a structure that is low cost and transparent. ETFs trades on the exchange so that at any time, any moment, you can go buy $100 worth of a stock instead of spending $5,000 to buy one particular municipal bond, which is the typical trading unit for these bonds.

    KEMMERER: Thank you all for taking time to paint this really interesting picture of the municipal market. From the Asset TV studios in New York, I am Gillian Kemmerer, and this was the Municipal Bonds Masterclass.

    Watch Video Asset TV Masterclass: Municipal Bonds

    James Colby, VanEck Vectors Portfolio Manager and Senior Municipal Strategist, participated in Asset TV's recent Muni Bond Masterclass video panel, hosted by Asset TV's Gillian Kemmerer. Colby joined municipal bond industry experts Terry Hults of AllianceBernstein, Suzanne Finnegan of Build America Mutual, and John Miller of Nuveen.

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