Municipal Credit Strategists Share Insights
Smith's Newport Municipal Bond Conference featured a round table discussion with three of the nation's leading municipal strategists. The conversation was witty and crosstalk while somewhat sarcastic, was always respectful.
Mikhail Foux is a Managing Director and the head of Municipal Strategy and Research at Barclays, based in New York. He focuses mainly on market trends, relative value opportunities and credit analytics.
Michael Zezas is a Managing Director of Morgan Stanley. He is the firm's Chief US Public Policy & Municipal Strategist, heads the firm's municipal securities research effort, and is a member of the municipal securities operating committee.
Tom Kozlik is the Head of Research and Analytics at HilltopSecurities. He publishes regular commentary and is a presence on social and traditional media for the firm.
Mr. Foux: "We were going into the year pretty positive on credit. Even before the elections in Georgia, I felt good about muni credit. After that, things got much better. We were positive on everything including Illinois and such. Overall, I'm not bragging, but we had pretty good calls, but it wasn't an easy thing, like fishing with dynamite." [Laughter] "We cannot say that everything went well because we were positive on malls. The mall in Syracuse [Destiny USA] recently hired a restructuring team potentially to restructure their debt. I guess you cannot win them all, but for the most part, it was good."
Moderator: Mike you just heard Mikhail bring up the malls. We've got the American Dream mall sitting over there in New Jersey. What is your call on that? They just failed to file their CAFR which of course prompted a failure to file notice.
Mr. Zezas: "I'd say both Mikhail and I could do hypothetically plenty of site visits to the American Dream because we both live in Hoboken, which is basically a stone's throw from there. My kids have been bugging me to go there for months at this point because they've heard so many things about it, but I've never gone there. I don't know if that tells you anything." [Laughter] "Here is what I'd say about American Dream, not specifically, but rather more generally, because we don't have a specific piece of research on the American Dream. You asked a question to Mikhail earlier about what's a call that's gone wrong or a call that's gone well. A call that has gone wrong for us, was we pulled the trigger on telling folks to lighten up on credit risk too early. That was a call we made a little bit earlier this year. Our primary concern about that was not that credit quality was going to deteriorate amongst high yield credits and to put American Dream in that bucket.
"Our primary concern was that the liquidity in the market was going to suffer because of what's been happening in the macro economy with inflation picking up, bear steepening of the yield curve, those are the types of conditions that historically create negative total returns, which creates volatility, and then tends to have retail investors pull money out of duration. They pull money out of bond funds. It just expresses itself more negatively in the muni market. All those things happened except for the investors pulling the money out of bond funds. Now, thinking back on it, would I have made that call differently?
"I don't know that I would because we did a backtest; those conditions historically about 70% of the time lead to outflows and underperformance. It just didn't work this time. When things happen 70% of the time, 30% of the time they don't happen. Anyway, I would still say that risk persists. Obviously, the Fed is starting to creep closer to taper talk, and muni valuations are extremely tight. I think the credit quality in the market is good, it's not going to get any worse this year, but we do worry about market liquidity and valuation going on from here."
Interviewer: Tom, you have published a lot. I mean A LOT. It's been great during this COVID to keep up with you. Fom a strategy point of view, you've highlighted the role of Washington DC.
Mr. Kozlik: "Yesterday morning, McConnell came out and just outright mentioned that there doesn't seem to be all that much support from a Republican standpoint to get anything done on the debt ceiling and that perhaps the Democrats are going to need to get something done on the debt ceiling through budget reconciliation. First of all, one of the things that I'll note is that McConnell is usually pretty measured and strategic about what he talks about. If he's making a statement like that, there are some pretty, usually deep reasons of why he's going to say anything, much less something like that.
"The way that I am interpreting that is, from a big picture perspective and with regard to budget reconciliation, I think that he knows that the Democrats don't have much of a chance of getting something done even through reconciliation. James Carville was probably right back in April at the NFMA conference saying that the Democratic party really can't be any more progressive than what Senator Manchin is prepared to do. While the August 1st deadline is extended, the CBO came out yesterday with a report about the debt ceiling, that money is going to last until maybe the beginning of October and November.
"The deadline isn't necessarily as quick as we thought it was going to be. The fact of the matter is that lawmakers are still really not going to be in Washington very much until October 1st. I think it may be just two and a half more weeks of them actually being in Washington. Between the timing and the weaponizing of the debt ceiling, potentially, like we saw in the summer of 2011, I think that is something to watch."
Moderator: Mikhail, what about your Outlook for volume and returns?
Mikhail: "We were probably a little bit low on both. We're saying, for example, high-yield should be expected to provide returns on the order of 5% or 6%, but the market is already at 7%. Unless high-yield bonds have negative returns in the second half of the year, we're probably a little bit low. Same on supply, which was predicted to be $430 billion, but it seems we're probably at the low end of investor expectations. It seems the market is probably going to beat that volume, but I don't think by much. We typically make a mid-year update and this year we upped our return expectations a little bit.
"We still think that the second-half will not be as profitable as the first half, which is when the main gains were made in the muni market. On supply, we also bumped up our expectations a little bit to $460 billion during our mid-year update. We typically quote ranges $450-470 billion. Overall, I think we still feel relatively good on munis. We still feel the second-half of the year will see much less price appreciation. There's a lot of concerns, and I'm sure we're going to talk about them, but for the most part, we're not that worried about the market, and definitely not worried about muni credit near term."
Moderator: Mike. I'm just wondering, are you making the mid-year correction?
Michael: "No. If we trace it back, in April of 2020, we really stuck our neck out and said, "You should buy this market." We did that pre-MLF because, A, we thought the Fed was going to respond. And B, we felt pretty confident about the CARES Act, that it would pass and that there would be money coming in from it to a variety of sectors.
"In particular the airport sector. I was listening earlier to my former colleague, Doug Kilcommon's analysis made during the rating agencies panel this morning. I don't know if he's still here. I don't know if he remembers that we used to be colleagues. [Laughter] I think a lot of the guidance on airports was really strong and accurate. The amount of cash balance that could really give you a, no pun intended, 'runway', to get all the way through the rest of COVID. That was a big call, but it was an easier call to make. Right now, it's a harder call to make because I can't remember a time in my career anyway, where muni credit was such a positive place. Valuations were in such a rich place. We just keep breaking through these historical barriers in terms of how low and tight risk premium can go.
"I think, unfortunately, if you're just trying to perform in the market or outperform a benchmark, a lot of what's going to happen in munis over the next 6-12 months is going to be dictated by things outside of the muni market. I touched on the inflation aspect before, but I think it really boils down to if the Fed is right about inflation. Munis are probably going to stay really boring. The valuation's going to stay tight, they're going to have modest but positive returns, and that's okay.
"If the Fed is wrong about inflation and inflation isn't transitory, and you get big prints into the Fall. Even after, for example, the supplemental unemployment benefits go away, that's the type of condition could lead to another bout of rates of volatility and a bear steepening yield curve. Just because it didn't create outflows last time, it doesn't mean it couldn't create outflows this time. That's the risk we're aware of. I would say our base case, because our economists think inflation is going to be transitory, it's the boring outcome, but the risks are very much skewed towards a valuation reset again, driven by macro factors, having nothing to do with muni credit."
Moderator: Tom, in promoting this conference, I shamelessly stole your idea about a shining golden moment versus a golden era from a report that you did a couple of weeks ago. Where are you on that?
Tom: "Back in March after the Rescue Plan Act was released, Hilltop Securities raised the number to 7 of the 11 sector outlooks by at least 1 notch. One of the things that I wanted to make clear is how substantial is the size of the Rescue Plan Act — The Rescue Plan Act was $1.9 trillion. By my account, about $650 billion of Rescue Plan Act is flowing more or less directly to state and local governments and other public finance entities. There is $350 billion from the rescue plan for state and local governments, $130 billion for schools, and then there's the money going to the high-rise sector housing, and healthcare sector, for sure.
"In March, a lot of folks were expecting that the Democrats would be able to get something done through budget reconciliation on infrastructure. Potentially as quickly as they did with the Rescue Plan Act. I wrote that public finances are on the verge of a golden age, and I stick by that prediction whether or not there's infrastructure bill. I reflect on the fact that Mikhail noted, because it's really just because the Democrats won the Georgia runoff elections that it was able to happen."
Moderator: Tom, what about your volume forecast?
Mr. Kozlik: "I'll go back to what my issuance forecast was at the end of last year, and then talk about the revision that I published last week. By the way, I've never published a revision before last week. My issuance forecast for this year was published back in November 2020, which was $375 billion. Frankly, at the time, $375 billion was actually a little more towards the higher end of the number being considered. If you think about where we were in November, there still wasn't the whiff of the fact that the Democrats had a chance to take maybe one of those seats in Georgia. If they had not taken two, we probably, politically speaking, would have been right back into a situation that we saw from March until that point of gridlock with nothing happening.
"Without the runoff election wins, $900 billion would have come out of the federal government at the end of December, maybe a sixth phase could have materialized, but there wouldn't have been direct relief for state local governments. There was a trillion dollars of money on the table for States and Local government that was riding on that election. My trillion dollar number is from the HEROES Act. There was a little over $900 billion that lawmakers were proposing to go to state local governments in the HEROES Act. It ended up being $650 billion. I was much more negative on mutual credit overall if it wasn't for the fact that we would have seen that federal relief.
"The issuance forecast that I moved to last week is $460 billion. There was about $220 billion of issuance that we've seen over the first six months of this year, and you realize that you get to $440. I don't think that it's a stretch to think that there will be activity for the next six months, it's going to be a little higher, so we go to $460. It's almost solely because there was such a significant amount of federal relief targeted to state local governments."