Aaron Applebaum is a Capital Group fixed income portfolio manager specializing in municipal bonds. In this interview, he offers his insights into munis, which went through a bout of volatility early in the pandemic but finished 2020 with strong returns. He also explains his approach to the sector — and what the near future could hold.
Near the beginning of COVID-19, there was a brief period of fright and illiquidity that led to extremely cheap muni valuations. In addition to unprecedented economic uncertainty, investors were worried that local services, such as airports and mass transit, would struggle with reduced demand and related operating revenue, which raised the risk that some municipal issuers could default on their bonds.
But federal fiscal and monetary support quickly assuaged those concerns, and markets bounced back quickly. By May 2020, a one-way market started gathering steam that led to where we are now, with front-end munis being fully priced. Many investors have been preparing for higher tax rates, and tax-exempt munis can be a natural harbor. That, combined with a global search for yield, has created extremely robust inflows into the municipal asset class. But now spreads are tight, and that’s limiting munis’ return potential in the near term.
I’m investing quite conservatively at the moment, looking for higher quality opportunities and limiting sensitivity to interest rates. I’m looking for securities that have reasonable yields and less downside risk. As a result, I’m positioned defensively. High-quality munis have been very good at preserving capital. They can play an important role in client portfolios, both by producing income and providing diversification.
We’ve gotten to where we are today partly because of fiscal and monetary policy. There’s the unprecedented degree of quantitative easing, which I call Fed “pixie dust.” It’s elevated all asset prices, whether for used cars, home values, the stock market, bonds — everything. There’s a wall of money, and it’s finding its way into investable assets.
For municipals in particular, a lot of money was sent to states and local governments. Think of the Metropolitan Transportation Authority (MTA) of New York and the airports, which quickly received assistance. That support, plus a strong economic recovery, has eased fears that a lot of entities might not survive the pandemic.
It’s impossible to disentangle that from other elements of market support. For example, some investors in the market are, unfortunately, looking in the rearview mirror. They’re seeing the great returns driven by last year’s volatility, and they’re buying munis based on that past performance.
But I can tell you, if you look at a triple-A, five-year muni right now, the yield is about half of what similar Treasuries are offering. Because munis are not taxed at the federal level, there is an implication that, all else being equal in terms of liquidity and risk, the market expects marginal tax rates to go up very significantly.
I don’t think that makes sense. If you look at the House and Senate, there’s room to have a package that moves up marginal tax rates a little bit. But I don’t think we’re going to go above Obama-era tax rates on the highest earners. Congress is having enough trouble passing an infrastructure plan.
The market, of course, is forward looking. It is likely going to start discounting Fed actions before there’s any announcement. All the market focus right now is on how the Fed will start to taper its bond-buying efforts. The Fed is being extraordinarily cautious in how it discusses those things — it wants to avoid the kind of surprise that led to the “taper tantrum” that hurt markets in 2013.
However, I think, as do many of my peers, that the Fed is positioning for a taper that will slightly exceed the pace of market expectations. And I think it will put upward pressure on rates. As a result, many of us are focused on munis with more limited duration — that is, lower sensitivity to changing rates. I’m short duration relative to my benchmarks, meaning my portfolios are positioned for rising rates. It’s not just the Fed. I’m actually optimistic that the Delta variant will be the final large-scale COVID-19 wave in the U.S. and that by the end of 2021 we will be rapidly returning to more normal social patterns. At the same time, investment in domestic supply chains and efforts to rebuild inventories should provide a solid economic tailwind in 2022. And then there’s that infrastructure package we discussed. I suspect that will put incremental fuel in the economic engine.
Most of the strong choices already played out over the past year, such as the MTA securities and the Illinois general obligation bonds. But one area I’ve been looking at is something called multifamily housing cash-collateralized bonds, which are used to help finance affordable housing projects.
One way to finance the development of affordable housing requires issuing municipal bonds during construction. Once the project is built, the Department of Housing and Urban Development will issue tax credits that the developer can monetize. These bonds mature in two or three years. And because they’re only a required placeholder for the eventual tax credits, the bonds are fully backed by Treasury collateral. These financings are small, so big financial institutions rarely underwrite them. But we’ve built relationships with many smaller sell-side shops that do, so we often get a chance to work with them and capture yield relative to traditional municipal bonds.
Ultimately, I view them as escrowed bonds collateralized with Treasuries. They can provide capital preservation with some incremental income. And they had good liquidity characteristics in the pandemic crisis of March 2020. That’s been a piece of the pie, along with their short duration, extra spread and super high quality.