Muni Yields Are Up. Is Opportunity Up With Them?

Lawrence Gillum [0:14] Hello, and welcome to this week's edition of LPL Market Signals. I'm Lawrence Gillum, chief fixed income strategist on the LPL Research team, and I'm your host this week. While September has historically been a weak month for the municipal markets, this September, we were one trading day away from having the worst monthly return for the Bloomberg Municipal Bond Index since May 1984, when the index was down 5.9%. Still, the down 4.4% return for the month was the worst month since 1987, so not too much comfort there.

And with a negative return that large for the index over a one-month period, investors are wondering if something is broken in the bond market last month. So to help answer that question, and to unpack what is taking place in the muni market, I am joined by David Hammer from PIMCO. David is a managing director in the Newport Beach office and leads municipal bond portfolio management with oversight of the firm's municipal investment grade, high yield, taxable, and separately managed account strategies.

Lawrence Gillum [1:10] He is the lead portfolio manager on PIMCO's municipal bond fund complex, including investment grade, high yield, state specific, closed-end, and interval funds as well as PIMCO's private tax warehousing strategies. I think I got all of that. David, welcome to the podcast.

David Hammer [1:27] Hey, thanks so much for having me.

Lawrence Gillum [1:29] As I mentioned, September was a very challenging month for the muni market and muni investors in particular. So really do appreciate your time this week. The timing couldn't be better. Really looking forward to your insights.

David Hammer [1:44] Yeah, happy to be here. It has been a, you know, painful month for muni investors just on the rate move, but the, you know, opportunity set that it's created is pretty exciting.

Lawrence Gillum [1:56] Yep. And we were going to unpack all of that, but let's just jump right in. So as mentioned, September was a pretty weak month for the index. And now outside of that brief period during the global financial crisis back in 2008, the Bloomberg Muni Index yield hit its highest level since 2001. So give us a sense of how you're thinking about this market in general.

David Hammer [2:17] Yeah. So, you know, I'd start with saying that it's normal when interest rates rise over a longer period of time. Muni indices, they actually tend to outperform taxable fixed income. And the reason is that at higher levels of nominal interest rates that the tax-free income you earn, it's worth more relative to taxable fixed income.

What is unique about this time period or time periods like this is when there's a liquidity vacuum in the muni market and a lot of macro volatility, a lot of supply, and U.S. retail investors are in these environments either taking money out of muni strategies or allocating less than they typically would, you tend to get really big valuation overshoots versus taxable fixed income. And that's really what's happened in the last month. The muni market went from outperforming taxable fixed income to underperforming the Barclays Agg by a couple percentage points year to date.

David Hammer [3:17] And that's created some values. So I think, you know, there's no shortage of highest-in, you know, 2000-and-something comparisons going on at the moment. You know, one thing that gives us a lot of comfort is actually looking back a bit beyond that. And if you go back to 1995 through 1999, the average 10-year Treasury yield was about 6.05%. The average 30-year Treasury yield was about 6.30%. The average investment grade muni bond index yield was 4.85%, and that was where it peaked out in the month of September.

So munis in our view have really overshot their fundamental valuations and are essentially implying a 10-year Treasury north of 6%, a 30-year Treasury north of six and change percent. And on a go forward basis now offer, you know, just about the highest yields we've seen in, you know, my 20-plus years doing this, and even going back to a little bit further.

David Hammer [4:17] The IG muni index yield today is about 4.70%. You'd have to earn a little under 8% in a taxable investment to get the same after tax return. A portfolio with a little bit of credit can earn you 5% to 6% tax exempt, and that is an 8% to 10% taxable equivalent return. Within our framework here at PIMCO, and we look over the next five years for U.S. taxpayers, you know, those really stand out as the highest risk adjusted, tax adjusted areas of potential investment. So, you know, painful getting here, but quite excited about munis on a go forward basis.

Lawrence Gillum [4:57] Yeah. And I would, you know, just echo that and add that the muni index is a lot higher quality than what you're getting out of the corporate index right now too. So higher yields, better quality, we think better opportunities set within the muni market in general. I am curious to kind of hear your thoughts on September in general. You mentioned liquidity, you know, Treasury yields backed up pretty aggressively in the month. Any concerns from a credit perspective or is this really just kind of localized with the, you know, the Treasury issues and the liquidity in the market?

David Hammer [5:32] Yeah. Well, you know, there's a million CUSIPs and 50,000 issuers in the muni market, so it's always a bit of a nuanced answer. But what I'd say is, broadly speaking, investment grade, high quality muni credit is in just about the best fundamental shape it's been in 20-plus years. And the reason is that from 2009 to 2019, after the great financial crisis, state local governments were in a mode of repairing their balance sheet.

They were dealing with the aftermath of housing prices that declined and that affected local tax collections. And at the state level, there were a lot of unfunded pension liabilities, budget deficits. And so as a result, you know, most muni issuers, they didn't issue new bonds during that time period. The muni market really didn't grow while the corporate bond market doubled in size, the Treasury market tripled in size.

David Hammer [6:24] The muni market was delevering and didn't really grow. Then in 2019 into 2020, the pandemic happened and federal policymakers looked at the shock, tried to figure out just how bad it would be for tax collections and muni issuers, ran a bunch of models that used to be very predictive that would have suggested that state and local tax collections would decline by 10 to 20%. They crafted a big federal relief bill to try to fill that hole and sent that money out to muni issuers of all types.

But what actually happened is tax collections exploded higher. They're now 40 to 50% above the pre-pandemic peak. A lot of fiscal stimulus, high income earners, not losing their jobs in the last recession, but just working from home. You know, inflation actually helped here. So we've seen a big up migration in high quality muni credit, and that puts the muni market in, you know, really the best position in a long time to weather any potential economic slowdown.

David Hammer [7:27] The caveat here is that the tide's now going out. So 2026 is the last year that federal relief flows through state and local government balance sheets. Some have used the money very responsibly. They've rebuilt reserves and rainy-day funds, but others have used it to paper over deficits. And in some of the, you know, call it the triple-B to low-A rated credit space, we see, you know, a number of issuers that over the next year or two, deficits will grow to potentially the highest on record.

So those are credits that we've been selling. And then as we step down into the high-yield muni market, really different story here, high-yield muni credit spreads are at all-time tights since 2007. So investors are receiving, you know, record low levels of compensation for stepping into high-yield munis, and that's coupled with rising default rates.

David Hammer [8:20] The senior living sector is the best example, default rates have risen to about 10% of the high-yield muni market. And then there are large-scale project finance deals. One just, you know, announced the restructuring this past week. And our view here at PIMCO is that there was a lot of really risky lending done by investors back in 2016 to 2021 when rates are low. And a lot of those, you know, poor investment decisions that are coming home to roost now.

And so high-yield munis is an area we like the beta of the asset class. We like the upper 50%, but the bottom half of that investible universe, you know, we see more losses to come and are quite conservatively positioned in some of those strategies.

Lawrence Gillum [9:07] It's interesting that you mentioned high yield muni spreads and still at pretty tight levels. It's always kind of interested me that, you know, that area, that part of the market is relatively smaller versus other markets out there, and kind of more of a niche market in terms of, you know, not a lot of crossover investors, you know, traffic in that area. I guess from your perspective, what, you know, what are the reasons why the spreads are as tight as they are in that market?

David Hammer [9:34] Just hasn't been a lot of price discovery. You know, there's a lot of securities in this market that are held by a really small group of investors. And when interest rates move and there's an illiquidity event, as there has been over the last month, the bonds don't really trade. And so I think on paper, spreads are tighter, but that's really because there's been a lack of price discovery.

You know, I think, you know, interestingly, if you were to look at some of the high yield strategies in the market that run the most amount of credit risk, have the most amount of kind of sub-investment grade risk, you'd expect over the last five years, given that spreads are tight, that they would have outperformed, but it's actually been the opposite. The riskiest position strategies have generally underperformed.

David Hammer [10:19] And the reason is, again, you know, defaults are happening beneath the surface. Those will eventually creep into prices, and this is all during good economic times too. So I think, you know, an economic slowdown would create likely even higher defaults and more price discovery here.

Lawrence Gillum [10:34] That's very interesting. I appreciate that color. You know, that market, again, is an area that we don't do a lot with in the high-yield muni market, but, you know, it's interesting to hear why spreads are as tight as they are. As it relates to just the broader muni market and credit quality, and I would say this even, I mean, even though you're an active manager, I would say this, you know, to anyone, frankly, and we have been, but we think that this is an environment that really favors active management and being able to avoid some of those issues out there that could be problematic on a go-forward basis. Would you, I mean, softball question, of course, but would you agree with that?

David Hammer [11:14] Yeah. I mean, the muni market is exceptionally inefficient. There's, you know, as I mentioned, a million securities, all different call prices, call dates, credit rating agencies are very backward-looking, so you tend to deal with a lot of stale ratings, and you get a lot of very siloed muni investors. I think people think state local government when they think of the muni market, that's actually a minority of what ends up in our portfolios.

Most of the bonds that we invest in, they're backed by some sort of asset. It could be a residential real estate asset through a property tax. It could be a commercial real estate asset through sales taxes that are collected, hospitals, healthcare system, big public-private partnerships or infrastructure. So, you know, we've found that we believe is right here, PIMCO is really channeling the expertise from other parts of the firm that invest in these markets outside of munis, into the muni market, and you oftentimes come to different conclusions.

David Hammer [12:09] And then there's just pricing liquidity. It's a tremendous opportunity right now to take advantage of illiquid conditions, and by being a liquidity provider, stepping into the market, bidding even very well-known AA-rated munis, it's not unusual to see that bid-ask spread widen to a point or two and pick up some excess return.

This also applies to high yield space, you know, while we don't like the bottom half or so of that market, there's a lot we do like there, and an active portfolio that invests in some not rated debt that is very well covered from a collateral perspective. So real estate assets at a low LTV would be an example. You know, it's possible to earn about a 6% yield-to-worst in a portfolio that looks more like, in PIMCO's view, a low triple-B portfolio as opposed to a double-B portfolio.

David Hammer [13:03] And at 6% tax exempt, that's about a 10% taxable-equivalent. You'd have to take, you know, a heck of a lot more risk than that in other markets to achieve the same return.

Lawrence Gillum [13:15] All right. Appreciate that color as well. I did want to talk about the interest rate environment, the Treasury rate environment. It's been pretty volatile on the expectation of a new rate hiking campaign. Markets have priced in a little over three more rate hikes out to the middle of 2027, call it. A, I guess, how does PIMCO think about the Fed and its upcoming potential rate hiking campaign? And B, and this is maybe more specific, for you, David, is that, with the Fed having already hiked rates and the market pricing in more rate hikes, I guess, what's the case for buying munis now?

David Hammer [13:58] Yeah, so, I mean, you know, interesting question and a lot of volatility here over the last month. You know, I think what the inflation market is telling us when we look at real yields that are just about the highest they've been in, you know, in my career, you know, inflation is forecasted to come back down, that the Fed's preferred measure of PCE back to the mid-twos, so not all the way to their 2% target, but, you know, a substantial portion of the way there by the end of next year.

So inflation expectations have been, you know, relatively well-behaved despite this move in spot rates. You know, there are risks to that. The risks would be that oil prices continue to go higher, or that the AI CapEx cycle spills over into other prices.

David Hammer [14:48] You know, but just a reminder for those things to happen, for there to be an increase in inflation, you know, from here, the AI CapEx cycle would have to not just do what it's expected to do, it would actually have to increase, so grow faster, or oil prices would have to go up even more. And the Fed has now, you know, put about four hikes into the market in terms of already priced in.

So when we look at high quality interest rates, you know, we generally favor high quality duration. In the taxable market, that's, you know, further down the curve, five to 10 years being the sweet spot, we're still avoiding or are underweight the, you know, the very long end of the curve, because you just don't have to take as much duration risk to get the majority of that yield.

David Hammer [15:32] And I think the case for munis is, you know, base case returns here, if rates don't move, if they, you know, stop in this range, munis to us look to be about 50 basis points cheaper than they should be versus Treasuries. So on a seven-year duration portfolio, that would earn you about 3.5%. The yield, which is, you know, 99% correlated with long-term returns on portfolios of 4% to 5% tax exempt, you'd have to earn 7% to 8%+, and then some alpha on top of that.

So if you layer in those, you know, base case expectations, you're looking at a low double-digit tax-adjusted return in a very high quality muni portfolio. The question is then, you know, what if you're wrong? You know, it's not just assessing the kind of base case or bull case, but what's the risk case?

David Hammer [16:26] And I think munis look attractive through that lens as well. You know, you could argue the last three years, if you look back three years ago, rates were topping out at that point in the cycle, the 10-year between about 4.5% and 5%. And I think at that time we said, you know, what happens if you're wrong, you still probably earn, you know, 4% or so tax exempt. And just looking back, you know, that's about what's happened over the last three years.

So if rates were to continue to go up and we had a, you know, 6.5% 10-year, I think there's a pretty good shot you still earn a slightly positive tax-exempt return. And relative to riskier markets like corporate credit, high-yield corporate credit, or the equity market, which looks, you know, relatively expensive by all traditional measures, that risk-reward looks like a pretty good one.

Lawrence Gillum [17:11] As well. Yeah, we've noted the asymmetry in a lot of fixed income markets as well, just given the backup in yield since 2022. And, you know, the prospects for equity-type returns if things break right, I think is a pretty compelling case for just fixed income in general, but for munis in particular as well. So let's take a look real quick at supply-demand technicals. Obviously, supply has been a big story over the last couple of years. It looks like we're on pace for a third record year of issuance.

Demand has been pretty important to that supply-demand technical as well. Demand has been there most of the year. We've seen some of the outflows here of late. But looking into October, October tends to be another pretty weak, at least from a seasonal perspective.

Lawrence Gillum [18:07] What are you looking towards for October as it relates to supply-demand?

David Hammer [18:13] Yeah, I mean, completely agree with your assessment of traditionally weak seasonals here. September, October, and November tend to be the biggest net positive supply periods of the year. So there's more new bonds being issued, being created than there are bonds maturing and coupons flowing back into the muni market.

You know, this will be a record year, and I think that's been expected for most of the year. That's not really, at this point, a surprise, but the demand side is really what tipped things, you know, off-sides here in the last month. There were very strong inflows into the muni market through much of the first eight months of the year, and that really reversed with all the macro rate vols.

So I'd say supply is, you know, on pace as expected. This is technically a very weak time of the year, which we like, there tends to be a time of the year we like to, you know, add a bit of muni risk, whether that's through spread duration or increasing the overall duration of our portfolio.

David Hammer [19:09] And you've got, you know, a pretty fat pitch here because you've got these weak seasonals that have combined with macro volatility. And seasonals do change. So as we get into December, January, February, those technicals tend to reverse. That's a net negative supply period of the year when munis tend to outperform versus taxable fixed income.

Lawrence Gillum [19:33] All right. Appreciate that. Before we tackle how you're viewing the market from a positioning perspective, I did want to ask, you know, the muni market really has seen its fair share of volatility over the past few years as we were reminded of that volatility in September. Any structural drivers behind the increased occurrence of these selloffs, or is it just, you know, normal volatility in your view?

David Hammer [19:58] Yeah, well, it's become normal volatility in the muni market. You know, we had a client event here at PIMCO yesterday and a client raised his hand and asked, you know, "Hey, I want to sell my AA-rated muni bond this past week and the bid was two and a half points away. This seems really unusual. When will it change?" And the answer is really, you shouldn't expect it to change. The liquidity picture in the muni market is fundamentally different than it used to be.

Before the GFC, broker-dealers used to run about 50 to 60 billion in inventory to buy and sell munis every day. Today, that number's down to 10 to 15 billion. It's structural, it's not coming back. It's a combination of more capital they have to hold against that risk at banks.

David Hammer [20:44] Tax rates, corporate tax rates coming down from 35% to 21%, so tax exempt debt, it's less attractive for broker-dealers to hold on their balance sheet. And then on top of that, the profitability, I think for a lot of market makers now that commissions are on confirms that get sent to clients when individual bonds are purchased, you know, the profitability of the market making business has declined.

And probably the most striking example, Citigroup closed their muni bond business last year. They were the number one trading counterparty and underwriter of municipal debt my entire career right up until the day that they closed, but they got out of the business because it's less profitable. So the market implication is that there's less liquidity. There's a larger pool of investors that are in daily liquid vehicles that are likely to demand liquidity when there's market volatility.

David Hammer [21:37] And so it's really changed the way we've set up many of our investment vehicles here at PIMCO. In our funds, we tend to run a lot more cash when munis are rich, knowing that when valuations mean revert, that helps us avoid having to, number one, sell bonds if we see outflows like others, but number two, hopefully have some dry powder to go on offense.

We've launched some semi-liquid vehicles that aren't subject to daily liquidity that we can try to take fuller advantage of those opportunities. And then in our separate account business, you know, tax loss harvesting is one of the, I'd say, most important value adds in that business. And as liquidity's gotten more expensive, you know, it's caused us to change the way we think about it. We've built new technology that allows us to proactively harvest losses on a programmatic basis throughout the year.

David Hammer [22:28] And so we're ongoing on a day-in, day-out basis harvesting losses in our portfolio. And that means that when there are these illiquid, you know, periods, you simply have less to do. You can be patient on harvesting losses because you've been able to accomplish a lot through the balance of the year.

And then just last thing I'd say on liquidity, you know, right now at the moment, the types of strategies that need liquidity are different than the types of strategies that are committed capital. So there have been outflows from some of the longer duration, riskier strategies in the muni market, inflows into some of the higher quality, shorter duration strategies. And what that leaves is really a mismatch between the types of risk that's being sold versus bought. That creates a really great opportunity in our view that's where we're focused at the moment.

David Hammer [23:16] Where can we step in and provide that liquidity at a really big discount to where, you know, some of those bonds may trade in a more normal market?

Lawrence Gillum [23:23] So let's keep that conversation going a little bit more, if you don't mind, David. Just in terms of positioning along the curve, after the recent selloff here in September, it did seem like the curve flattened a little bit, but we think here in LPL Research that the intermediate parts of the muni curve still represent pretty attractive value. Agree, disagree, or I guess how are you thinking about the curve broadly?

David Hammer [23:47] Yeah, 100% agree. So at the beginning of the year, the muni curve had a record slope to it. So very, very steep. And what was driving that steepness is that a lot of U.S. investors, they want to stay short, they want to stay in 10 years. Muni issuers, they like to issue serialized debt. They issue a lot of long bonds.

And banks and insurance companies that used to be big buyers in the long end, because their corporate tax rate went from 35% to 21%, they're buying less. So that drove a very, very steep curve. And back in January and February, the 10-year muni-Treasury ratio was in the low 60s. Actually, you weren't being paid a lot to own munis inside of 10 years. We were generally underweight those in our portfolio. But with the big curve flattening over the last month here, 10-year munis north of 80% as a percentage of Treasuries.

David Hammer [24:38] If you add in an additional illiquidity spread, whether it's a new issue or a bond being sold in the market, we've been able to buy A-rated munis in the 10 to 15 year part of the curve at a 4.5% to 5% yield. So you're now getting about 90% of the yield that you would get in a 30-year muni bond, but with a lot less duration risk. And on a relative basis, these bonds are cheaper versus Treasuries than the long end.

So I'd agree with you, you know, we've been allocating much more to the intermediate portion of the muni market because there's been this big adjustment in valuations over the course of the year.

Lawrence Gillum [25:15] Yeah. That's great. I appreciate that. We are up against time. I do want to recap things for investors and listeners. So September, and correct me if I'm wrong here, David, September, more of a liquidity issue, and a rate volatility issue than a credit issue. So investors could, you know, potentially be looking at better starting yields because of things that aren't necessarily going to impact the credit quality of an issuer, and still provide that pretty attractive opportunity as it relates to yields. Is that fair?

David Hammer [25:53] That's spot on with our view.

Lawrence Gillum [25:55] Okay. And then I guess just for existing investors that have experienced this volatility, the message would be what? Stay the course, you know, add to positioning? I guess, how are your conversations with existing clients going?

David Hammer [26:11] Yeah, you know, I think muni investors are becoming more accustomed to these periods of illiquidity and price volatility. The best ways to take advantage of it, you know, in our view, one is to increase your exposures, whether that's a duration extension, adding a bit of spread duration to portfolios. You know, the one exception would not be adding credit risk because credit spreads have actually tightened. And then number two would be tax loss harvest.

It's a great opportunity to reposition portfolios that could be out of, you know, one ETF or fund into another. In a separate account, it's harvesting 100% of the losses in those individual bonds. So we're busy doing that here, and I'd say that would generally be our advice to clients.

Lawrence Gillum [26:54] Awesome. Great advice there. We are up against time, so I do want to thank you, David, for your time today. And of course, your great insights. And I want to thank everybody for listening to this week's LPL Market Signals. We will see you guys next week. Take care, everyone.