Episode #341: Lyle Fitterer, Baird Asset Management, “You Could Even Argue That They’re Better Credits Than The Federal Government”

Episode #341: Lyle Fitterer, Baird Asset Management, “You Could Even Argue That They’re Better Credits Than The Federal Government”

 

Guest: Lyle Fitterer, CFA is a Managing Director and Senior Portfolio Manager for Baird Asset Management. Lyle has over 31 years of investment experience managing fixed income portfolios, with a primary focus on the municipal market. Prior to joining Baird Advisors, Lyle served as the co-head of Global Fixed Income and the head of the Municipal Fixed Income team at Wells Fargo Asset Management (WFAM).

Date Recorded: 7/28/2021     |     Run-Time: 1:01:16

Summary: In today’s episode, we’re talking all things muni’s. Lyle begins with an overview of the muni bond market and the benefit of tax-exempt income for investors. Then we hear how Lyle went on the offensive when the COVID drawdown occurred last year. Finally, we walk through some of the different factors affecting the muni market right now, including state and local budgets, expectations for higher taxes and an infrastructure bill, and interest rates.

Be sure to listen until the end to hear what sectors Lyle avoids within the muni space.

Click here to follow a few slides Lyle shared for the episode.

Sponsor: Ugly Drinks – Meet ugly sparkling water: the childhood tastes you love without the sugar, sweeteners or calories you don’t. Beyond quenching your thirst, ugly celebrates the real, the raw, the imperfect – the ugly truth. As a special offer for listeners of the show, visit uglydrinks.com and use the code UGLYMEB to get 20% off your order.

Comments or suggestions? Email us Feedback@TheMebFaberShow.com or call us to leave a voicemail at 323 834 9159

Interested in sponsoring an episode? Email Justin at jb@cambriainvestments.com

Links from the Episode:

  • 0:42 – Sponsor: UglyDrinks – Use the promo code UglyMeb for 20% off
  • 1:26 – Intro
  • 2:09 – Welcome to our guest, Lyle Fitterer
  • 3:51 – Overview of municipal bonds
  • 9:34 – Common mistakes and rules of thumb for this space
  • 13:00 – Recent inflows into municipal bonds
  • 16:29 – What it was like in this space over the course of the pandemic
  • 21:20 – COVID-19 having a positive impact on state finances
  • 26:57 – Macro trends affecting the municipal bond market
  • 33:29 – What happens if Treasuries go negative?
  • 36:23 – Lyle’s thoughts on the yield curve
  • 38:54 – Portfolio composition
  • 45:18 – Areas where he’d advise investors to proceed with caution
  • 48:16 – Useful resources for examining the municipal bond space; EMMA, Bloomberg
  • 52:18 – Lyle’s most memorable investment
  • 55:49 – Learn more about Lyle

 

Transcript of Episode 341:

Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber’s the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria investment management or its affiliates. For more information, visit cambriainvestments.com.

Sponsor Message: Today’s episode is sponsored by Ugly Drinks. Meet ugly sparkling water, the childhood taste you love without the sugar, sweeteners, or calories you don’t. Beyond quenching your thirst, Ugly celebrates the real, the raw, the imperfect, the ugly truth. I invest in this company because I truly love the product. You can catch me drinking one in almost every episode. Go listen to episode 336 with founder, Hugh Thomas, and hear his story about Ugly Drinks efforts to disrupt the traditional beverage industry. As a special offer for listeners of the show, visit uglydrinks.com and use the code UGLYMEB to get 20% off your order. That may be my favorite code yet. Again, that’s uglydrinks.com and use the code UGLYMEB for 20% off your order.

Meb: What’s up, everybody? Another great show for you today. Our guest is a portfolio manager for Baird Asset Management where he runs multi-billion dollar municipal bond funds. In today’s show, We’re talking all things muni’s. Our guest begins with an overview of the muni bond market and the benefit of tax-exempt income for investors then we hear our guest went on the offence when the COVID drawdown occurred last year. Finally, we walk through some of the different factors affecting the muni market right now, including state and local budgets, expectations for higher taxes, and then potential infrastructure bill and interest rates. Be sure to listen to the end when we hear what sectors our guest avoids within the muni space. Please enjoy this episode with Baird Asset Management’s, Lyle Fitterer. Lyle, welcome to the show.

Lyle: Thanks for having me.

Meb: Where do we find you here in the summer of 2021?

Lyle: Same place I’m always at, which is down on the lakefront in Milwaukee Office Tower. We’ve been here throughout the pandemic. So we’ve been fortunate, been able to still come into the office.

Meb: When’s it time to come to Milwaukee? I’ve never been. Is it summertime, spring, fall?

Lyle: Yeah. Right about now. Anytime from, I would say, May to October. Big festival here is called Summer Fest. This year it’s going to be first three weekends in September. So get your flights. It’s supposedly one of the largest music festivals in the world.

Meb: Sweet. Man, music festivals, the world is healing. I love it. Three weekends long. There’s a conflict for me at the end of September because there’s a bucket list band I’ve never seen, Pearl Jam, and they’re playing in San Diego. I don’t have a ticket yet, of course, but hopefully, I can scalp some from somebody down in San Diego. Is it a kind of like a Lollapalooza style, a Coachella all across the board or is it particular vibe?

Lyle: It’s all across the board. I don’t even know the number of stages. I think it’s like 10 stages. It’s all down on the lakefront and then they have the main amphitheater where they have a show every night. And I think they’ve got a pretty good crowd lined up or a list of bands, but yeah, check it out. It’s worth attending at some point.

Meb: We’ll have to put that in the queue. I was just Googling the lineup to see how it is this year. And you are not joking. It is eclectic, all sorts of different things. Chance the Rapper, Green Day, Weezer, Jonas Brothers, all sorts of stuff. Sheryl Crow, Zac Brown, Dave Matthews, Chappelle, oh, man. I might have to come just for Chappelle. All right. Guns ‘N Roses. My goodness. Let’s make a hard-right shift, Lyle.

Let’s talk about munis, investing in municipal bonds. You know, this is a topic we haven’t covered that much extensively on the show. So professional investors just give us a minute or two. Give us the overview of what munis are in general. I know most people have a vague understanding, but why don’t you give us an overview of the space and then we can kind of drill down more specifically into some areas.

Lyle: Sure. So it’s a relatively small market. I think the overall size of outstanding debt is roughly 4 trillion. You know, so if you compare that, you know, to the treasury market, which I think is now over 28 trillion or something like that, corporate bond market’s probably 10 or 11 trillion. And it’s really the method that state and local governments use to finance, you know, any sort of projects, schools, roads, hospitals, not-for-profit hospitals, public universities, some private universities, a lot of infrastructure debt it’s done in the municipal bond market. So the big benefit, I guess, for investors is the income that you generate is exempt from federal taxes and depending upon what state you’re in, at times you can buy bonds that are exempt from state taxes as well. So tends to be, you know, a market where you’ve got a lot of direct retail investors who are looking for that tax-exempt income, but more and more so it’s moving towards an institutionalized market. People access it through mutual funds, ETFs, etc.

Meb: Give me an overview of sort of the different types of muni projects and bonds. To me, it’s such a varied sort of opportunity set. I mean, I don’t even know how many there are out there. You probably have a better guess than I do. Give us an overview of kind of what is the actual opportunity set and breadth of offerings.

Lyle: Literally, there are, I believe, you know, over a million outstanding CUSIPs in our marketplace. The number of issuers is, I think, 85,000 plus or minus. So again, if you compare it to the corporate market where your number of issuers is pretty limited, you know, if you think about the S&P 500, you know, there’s just 500 different companies you’re investing in. So it’s a pretty eclectic mix of offerings out there. You know, you could have something as small as a tiny little town in the middle of North Dakota. I grew up in a place called Glen Ullin, North Dakota. They could issue debt and it might be a $1 million municipal bond deal or it could be as large as multiple billion-dollar deals for some of the larger issuers like the state of California, City of LA. You could have a large not-for-profit healthcare entity like Kaiser Health out in your neck of the woods or Ascension Health, or maybe even a small single-site hospital that issues in the market.

From a quality perspective, there are AAA issuers in our market. Some states and local governments are rated AAA. Some school districts, the most popular one are well-known as probably what’s called the Texas PSF, Permanent School Funding program. And you could go all the way down to non-rated. There’s a high-yield muni market where deals get done. Today we had a deal from Guam. Guam did a deal for their airport. It was BBB-rated. So investment grade, but there’s a deal coming tomorrow for a hotel development on a golf course outside of Chattanooga, Tennessee, which is about $175 million deal that will be non-rated. So really a broad mix of things to invest in and depends upon your knowledge and sophistication.

You need a lot of details you’re going to need to know, but then again, if you’re investing in a AAA-rated municipal bond, I would argue that you could even argue that they’re better credits than the federal government in that they don’t have as much debt outstanding. They tend to balance their budgets and they tend to amortize their debt over the life of the bond. So a pretty attractive market.

Meb: It seems so varied and specific, and for me, complicated. Individual investors participate really at all anymore? Is this sort of a relic from, you know, times past or is it actually still a fair amount if you look at the probable new issuances and just investment market in general, is it totally dominated by institutions or are individuals still picking up some of these bonds?

Lyle: Definitely still have a fairly large group of individuals that will buy bonds directly. Most of them are going through some sort of broker-dealer and more and more, they’re going to what would be called a managed accounts platform. The market changed a little bit after the great recession back in, you know, 2007, 2008, 2009 time period. There used to be a lot of what were called monoline insurers that had a AAA rating and they would insure literally over 50% of new issuance, I think, at the peak, would get insured and those insurers had a AAA rating. So people bought them really without even looking at what the underlying credit was. That changed a lot. A lot of those AAA insurers got into trouble because they were insuring things outside of the muni market, things like CLOs and CDOs that we’ve heard about, structured products deals. And so their ratings got downgraded. Some of them went out of business.

So you really have to look at, you know, what are the individual credits that you’re buying. And that becomes a little bit more complicated, a little bit more time-intensive. And so now the market is migrating a little bit more towards what I would say institutional investors. They still got a lot of people that are comfortable buying these names individually. And I would argue that most of these, you know, the default rates in the muni market, BBB, municipal bond has a default rate that’s less than a AAA corporate bond. So it’s really, I think, a pretty safe place to invest your money, again, as long as you stick into the investment-grade category within municipal bond market.

Meb: And so, you know, from an institutional investors standpoint, I assume you guys have a lot more tools and software and resources from which to analyze these. If you were an individual that was going about it or professional, by the way, are there any just kind of common mistakes, pitfalls, just general overview of this kind of the dip your toe into the water sort of portfolio allocation that people make consistently over the years that you think is useful, sort of rules of thumb to think about this world?

Lyle: Yeah. I mean, I think there are a few things. One, there are some unique consequences of buying a municipal bond where the dollar price drops below a certain level. So traditionally, if you buy a bond at par 100 cents on the dollar or if you buy a bond at 90 cents on the dollar in terms of a corporate bond, you calculate a yield, then that’s really the amount of income you’re generating in your portfolio. In the muni bond market, if you buy a bond at par and it’s getting a little complicated but most muni bonds are issued at a premium and there’s a reason behind that and it has to do with the fact that if that bond drops out of what’s called diminimous, means the dollar price goes below a certain level, the difference between where you paid for it and par that you get at maturity or 100 cents on the dollar becomes taxable income.

So your after-tax return obviously changes. So that’s one thing that if you’re going to try and do it individually, you should actually try and get a little bit more familiar with. I would say the second thing is, you know, historically people have felt like, “Hey, you know what, if I just stick with general obligations like a state or a local municipality, I should be fine.” They have unlimited taxing authority. That’s really what you’re backed by, that general obligation of that issuer. And I think what we found out is that, you know, there comes a point when even having complete taxing authority, you can only tax so much. You know, if you look at a place like Detroit that filed bankruptcy not that long ago, you know, Puerto Rico is a classic example. You know, they are increasingly seeing, and again, it’s still pretty limited, but, you know, where GO bonds or general obligation bonds haven’t been able to pay their debt. Population is declining.

So, again, I think historically people said, “I should buy GOs.” Now they’re saying, “Oh, gee, maybe I want to buy what’s called an essential service revenue bond,” which would be like a water and sewer issue. Something that’s backed by a defined revenue stream that you’ve got as a bondholder, a claim on that and even in a bankruptcy filing, you should be secured from a creditor perspective.

And then the last thing I would say is just be careful on some of these non-rated yields where the yield almost seems too good to be true. In many cases, it probably is. They’ll pay for a period of time, but, you know, a lot of individuals will say, “Oh, gee, I know that continuing care retirement facility down the street, they’re issuing debt in the municipal bond market. I know a lot of people that live there, it’s got to be a good investment. And oh, by the way, I can get a 5% tax-exempt yield on it in today’s environment, but it’s non-rated.” And so they’ll buy it from their local broker-dealer, really not understanding, you know, how levered that facility might be or what the underlying fundamentals look like. So those would be just a few things that I would think about if you’re trying to do this on an individual basis.

Meb: If you look at the muni market today, we’ve seen some pretty monster flows over the past year into munis, and like you mentioned, it’s a little small relative to the traditional treasury market. What’s going on there? Who’s putting all the money in and what’s the reasoning? Is it just because everybody thinks taxes are going up with administration or what?

Lyle: You’re exactly right in terms of, I think, one of the main drivers has been the fact that, you know, people are anticipating that taxes are going up and there are very limited places where you can avoid taxes, you know, from a long-term perspective. So that’s one reason. I think the second reason is simply that there was a tremendous amount of dislocation in our market in 2020 when the pandemic started just like there was in other markets, but we were probably hit harder in terms of the price sell-off even relative to some of the other sectors. The corporate bond market recovered pretty quickly because the federal government did what they’ve done historically, where they’ve, you know, the fed came in, they started programs to support a lot of the corporate issuers, get that market moving again.

One of the things that they did that was unique this time around is they actually provided some support for the municipal bond market, but nobody knew how that was going to work exactly. So it took longer for our market to recover.

And, therefore, if you looked at valuations coming into the year, we looked pretty attractive on a tax-adjusted basis relative to almost every other market.

So you combine the two that, you know, people are seeking income, they’re seeking tax-exempt income and they’re trying to figure out where can I maximize that income in the muni market, but pretty attractive.

So we’ve seen, you know, year to date, over 60 billion of flows into municipal bond funds. You know, since May of last year, I think there’s close to 130 billion of flows into our marketplace. And if you look at the outstanding sides of municipal bond funds and ETFs, that’s over 15% of the assets in those products. So tremendous amount of demand. The problem right now is, and most of that demand again, float into longer-term bond funds and high yield funds. Why? They have higher levels of income. So people are trying to figure out, “Where can I get income?” Globally, I can’t remember what the number is off the top of my head, but the amount of negative-yielding bonds around the globe is pretty high. So you’ve even seen international investors that don’t need that tax exemption coming into the bond market, the muni bond market to buy debt.

I would say right now, if you look at the absolute yield of our market, I don’t want to be negative on muni bonds because that’s what I do for a living, but we’ve had a big run, I think, high-yield muni bond market. I just read some data here recently, it’s been the best performing fixed income market year to date across the entire globe and high-yield munis are up close to 7.5%. That’s a pretty compelling return when the 10-year note currently yields, you know, 1.2%, 1.3%. So those are just some of the reasons why we’ve seen great flows. Honestly, I think until you see a big sell-off in the treasury market or get some sort of event that people get nervous about muni credit quality, and we can go into that as well, I think, you know, technicals probably will remain pretty firm here for the near term.

Meb: I mean, obviously it attracts the treasury yields bit, but this kind of sliding of the yields down over the years, you got a big kind of quick updraft. And I feel like muni yields, last year, particularly in the high yield and then they kind of slid back down, what was the pandemic like? What was it like for the muni space? Thinking back to the depths of March of last year, a year and a half ago, and then how it played out, walk us through sort of the last two years in muni land.

Lyle: Coming into the pandemic, again, you know, historically the muni market’s been pretty safe place to put your money, but when you have a shutdown of the entire economy effectively, people start to question, you know, okay, how are they going to generate revenues to pay off this debt? You had airports that were shut down, you had the hotel industry that was shut down, you had retail sales that dropped off very quickly. And a lot of the revenue that comes to state and local governments comes from sales taxes. So people aren’t spending money, they’re not paying taxes. And so it really made you kind of have to rethink your entire investment thesis, you know, what areas of the world are going to be…or excuse me, of the U.S. economy are going to be impacted? How has that looked relative to how it looked historically? What sectors have the strongest balance sheets that can withstand a longer than expected shutdown in the economy, are local GOs.

So your local economy, most of those credits actually rely on property taxes as a main source of revenue. And, therefore, you know, they would probably hold up better in a situation like that. So you kind of had to readjust kind of how you thought about the world. You know, what we did was we very quickly went through all of the different sectors and tried to get an idea of, you know, who are the winners and losers going to be, what’s this going to look like? I mean, you almost had to go sector by sector and not to get into too much detail, but, you know, higher ed is a big issue or in our marketplace and a lot of schools shut down, they sent students home, they were giving reimbursements in terms of housing costs. So you have to think about, okay, that’s a sector that had been, I would say, under fire, even pre-pandemic in that it was becoming very, very competitive, less people going to college just because of demographics. You had huge competition between some of these smaller schools. And how was that going to play out?

What changed, I think, pretty quickly is when the federal government came in and the fed and gave support to the market. And so you saw bills passed and stimulus bills passed that sent a tremendous amount of money to not-for-profit healthcare. So the healthcare sector, because of COVID, saw a lot of funds and we on our taxable team managed a lot of money for hospitals and hospital credits. And what we were actually hearing from those investors is that, or clients of ours, was that they were getting more money from the federal government than they currently needed. And so they were actually sending us money to invest temporarily for them. Because COVID didn’t strike across the United States the same in each area beside, right? New York was impacted pretty hard. California, it took a lot longer. Midwest, there was a delay. It was a period where…I don’t want to say there were a lot of sleepless nights, but you really had to kind of rethink your thesis. But at the same time, you also had to go back on your years of experience and say, “Okay, what are sectors that have gone through this before?” Airports are a big issue in our marketplace. When 9/11 happened, a lot of the airports shut down, traffic was shut down for a big period of time. The great recession had a big impact on the airline sector, but yet airports tend to carry a lot of cash. They tend to be prepared for downturns like this.

So we started to think more from an offensive perspective rather than just purely playing defense. We were fortunate we had a lot of liquidity coming into this, you know, where can we invest our money in areas that people were selling indiscriminately and longer term, we had a pretty good idea that those sectors would recover and could weather a sustained downturn. So it was probably one of the best opportunities. I think Warren Buffet is famous for saying that those are the time periods when it’s the hardest to buy, that’s probably when you should be buying. But at the same time, you want to manage risk. So I think we selectively were trying to buy names that we knew had strong balance sheets and could withstand this.

I mean, just to give you an example, we bought things like Ascension Health, which is the largest or one of the largest healthcare systems in the country and you bought 30-year bonds at a 5% tax-exempt yield in the middle of the pandemic. Those same bonds today trade to a 10-year call, but they probably trade with a 1% type of yield on them. So a big difference in terms of valuations today relative to where they were back then.

Meb: It’s seemingly odd. I mean, there’s sort of some of the basket cases of the muni world that always get dragged out when people were talking about who’s not doing a good job, and Illinois seems to be the poster child for this. But I was reviewing one of your decks and it actually showed that some of their bonds actually got upgraded recently. Is that right? It seems like a general trend where they’ve just been getting downgraded for as long as they’ve been around. And this pandemic, oddly, is having a positive impact on some state finances. Is that right?

Lyle: Correct. I mean, I think a lot of the state and local governments that, you know, initially, I think, there was some pretty negative outlooks in terms of what the impact was going to be on their budget. But I think fairly quickly into the pandemic, what you came to realize is that they weren’t in as bad a shape as you thought they were going to be. Tax revenues actually stayed fairly strong. Why? Because the federal government sent a lot of people money in terms of the support payments. So people who were out of work were getting money from the federal government, they were going out, they were spending that money and that generates revenues for state and local governments. Plus, if you looked at the mix of who pays taxes and who doesn’t pay taxes, obviously, generally wealthier people tend to be the ones that are paying taxes.

And most of those jobs, people were still working. So they were generating, you know, income taxes. They were out spending, they were generating sales taxes for state and local governments. And there was a little bit of goofiness that went on because if you remember, people didn’t have to pay their taxes. I think they delayed tax payment date from April 15th to, I believe, July last year. State and local governments were saying, “Oh, look, our budgets, we came in well below what our budget was supposed to be for the 2019, 2020 tax year.” But a big part of that was because you had income taxes that were shifted from their ’19, ’20 tax year to the 2021 tax year. Most municipalities have a June 30th cutoff date. So by shifting from April 15th as the due date for taxes to July 15th, that pushed those revenues into the next year.

So then as you started to get into July, all of a sudden, and people were paying their income taxes that were due for the prior year, all of a sudden these state and local governments were getting a windfall and their actual revenues compared to budget were above projections. And so it changed pretty quickly in terms of what their financial situation looked like, but they did a great job of telling Congress that, “Look, we’re in dire shape.” And so you saw a couple of stimulus bills that had direct payments that went to state and local governments.

You know, the most recent one was earlier this year from the Biden administration. Just to give you an example, specific to Illinois, the city of Chicago, I think their budget for this year is roughly 11 to $12 billion. They got roughly $1.9 billion to $2 billion of stimulus funds from the latest package. So that’s 15% of their budget as a one-time payment that came in. And so what you’re seeing now is as the economy is reopening and it has reopened more quickly than people anticipated, most state and local governments are actually coming in with a budget surplus.

And so it’s having a positive impact, long way of saying that you’re seeing upgrades. So you talked about Illinois. State of Illinois, the last time they were upgraded by Moody’s was 1998. So over 20 years ago. And they were on the cusp of getting downgraded from investment-grade to non-investment grade, which for an issuer is a pretty big thing because a lot of people can’t buy non-investment grade credits. So Moody’s upgraded them from the lowest investment grade tier to the second- lowest investment-grade tier. And I think people were joking that, well, why did they do that? Well, obviously their finances look better, but the big joke was now they have room to downgrade them without taking them to a junk the next time we go into a recession.

So again, Illinois, I think, is a great example. They have a pension funding ratio that’s roughly funded at about 38%. Maybe it’s a little bit better now. They perpetually run state deficits. They have not contributed the full amount to their pension plan that they’re required to do. And even this year, I think they’re contributing like over $9 billion to their state pension fund, but it’s still below the actuarial requirement. Right now, things look pretty good and I think there’s a lot of demand and you see that the so-called additional yield you get for buying a lower quality credit declined pretty dramatically, but we’re starting to look out, you know, what’s going to happen in 12 months, or 18 months, or 24 months when the environment normalizes and the states that had problems coming into this, they didn’t do anything to address those problems? Are they going to look the same coming out of this and do you need to be concerned about what that looks like rather than just paying attention to what things look like today?

So today it looks pretty darn good. I’m not going to kid you. And I think it’s probably going to look like that for the next 12 to 18 months. There was an article in the “Wall Street Journal” today that said state and local governments. I’m just reading it here. Somebody gave it to me today, $210 billion remains unspent of the funds that they were given. And they were given about $500 billion from the federal government. So almost half of that is still unspent by state and local government. So they’re going to continue to show pretty positive results for the next year or two.

Meb: Any other trends that you think are important? Some that I’m thinking in my head are the potential migration out of cities into other places to live or what you would consider to be, I guess, tier two, three cities out of the New York’s and San Frans of the world, or potential even more spending coming down the pipe with infrastructure bills. Anything else that you guys are considering as far as the macro piece of the pie?

Lyle: I mean, I think from a big picture macro-perspective, you know, the big question everybody has is, you know, what’s going to happen with interest rates? Right now you’re seeing very elevated inflation numbers. The Fed’s talking about the fact that most of the pickup in inflation is transitory. So they’re making the bet that you’ll start to see that taper off later this year and into next year. And they’re not wrong. Just the pure math is going to show that, I think, it’s a big question of how much is it going to come off and is inflation going to stay elevated or not? You know, interest rates went up a lot. The 10-year note touched, I think, 1.75%, but more recently, it’s come back down. It’s around 1.25%. And the big question is, you know, even if inflation does pick up, how high will interest rates go?

So I think that’s one of the things we’re thinking about. You know, we’ve thematically thought that rates could probably move up towards 2% on a 10-year note, but at the same time, we’re not in a camp that they’re going to 3%, or 4%, or 5% anytime soon primarily because of some big-picture long-term macro trends that are going on. One, demographics, people are ageing, those ageing people need income. They tend to have a big desire for bonds in their portfolio. Second thing is, if you look at it from a global perspective, U.S. rates are still extremely high relative to the rest of the world. So I think there’s a lot of global demand for bonds here in the U.S. And then, you know, simplistically, if you just look at the amount of debt that’s outstanding, it would be hard for governments to service that debt if interest rates went up too much. And so, well, it shouldn’t necessarily be a reason why they wouldn’t go up, but I think they’re going to do everything they can to, I think, limit the movement higher in overall rates.

So that’s kind of big-picture fixed income-wise. I think if you bring that down to the muni market, the things that we’re thinking about, you mentioned infrastructure, there was just a headline that came across before we started this conversation that supposedly they’ve come to a bipartisan agreement on an infrastructure bill. I don’t know the exact amount. I think it’s the, you know, $600 billion-plus or minus that they agreed to plus some of the other things that the Biden administration wanted, but that is one thing that we think will pass and it’s really overdue. I mean, if you look at infrastructure around the U.S., there’s a lot of work that needs to be done. And so we do think that that is something that, A, could provide jobs and additional stimulus on a go-forward basis. It actually is making an investment in the future of the country. So hopefully that’ll pay off.

And if you look at where that debt gets financed, historically, at least has gotten financed a good portion of that in the municipal bond market. From an issuance perspective and a supply perspective, we do think that you could see some infrastructure that come to market, probably not until 2022, 2023, because that 600 billion is going to be spent that over a number of years. But the good news is if you look at the amount of debt, we talked about this earlier, there’s only about $4 trillion worth of debt outstanding in the muni market and it’s been pretty much unchanged for the last 10 years. So, you know, as a taxpayer, you and I should be excited to say, “Hey, they haven’t been issuing debt and our debt payments haven’t gone up dramatically.”

And so we do think that that opens the window for them to issue some debt. So that’s one trend, I think, that you’re seeing. The other trend you mentioned earlier is that taxes are probably going higher. They’re going to have to figure out how to pay for some of this stimulus from a long-term perspective.

And then I think the other thing you touched on was something that we’ve thought about for a long time, which is demographic trends in terms of where people are going to live. And I think the pandemic did really open up the world to work from home, the flexibility of working for a company in LA but living in Texas. And so we’ve never been really somebody who said that, “Hey, you’re going to see accelerated movements out of California or states that have high taxes to lower tax states.” But it does seem like the pandemic may actually accelerate that a little bit. So I think it’s something you need to watch, but at the same time, it’s really hard for somebody to pick up and leave California or pick up and leave Chicago. They’ve got a job there, they’ve got family there, their kids are in school. And so will that trend increase? Yes. But do we think it’s going to have a devastating impact on the market? Probably not, but something we’re watching.

And then the last thing I think that you can’t have a conversation today without talking about is just ESG, the environment, social issues, the government, the governance issues, and it does impact the muni bond market. We would be the first to tell you that we think if you’re an ESG investor, investing in muni bonds is probably a great way to have an impact. A lot of the debt that gets issued in our market is to support less fortunate people, to support programs that, you know, advocate clean water or cleaning up your sewer systems. But there are other things that are impacting the market that we need to be careful about. Global warming, what’s happening to the level of seas around the country, you know, places like Miami where the sea level seems to be rising at a gradual pace. Even New York City with some of the increased storm surges that you’ve had, those are things, the fires that you see out in California. We were just asked this last week to look at a investment in a low-income apartment project in California and one of the questions was, you know, well, what sort of insurance do they have? It was in the middle of one of the areas that are currently being impacted by forest fires. So I think there are a lot of different things that you need to think about that go into investing in not only muni bond market, but your broader fixed income marketplace.

Meb: As we drove through Tahoe last summer, we had a warning that we had to watch out for fire tornadoes. That was a potential. It was like a bad episode of “Sharknado” movie. Let’s walk through a hypothetical. You have to at least consider it. It’s probably not probable, but what happens if treasuries go negative? You know, I mean, we got pretty low last year, but wouldn’t expect it to happen here. But look, it happened with sovereigns around the world. What ends up happening with munis, you think? What would that impact have on what you guys are doing and any best guesses on what that might look like?

Lyle: We have thought about that. You know, again, globally, we’ve seen sovereign debt trade at negative rates for quite some time if you start with Japan. Now you look at most of the European continent. So it’s definitely something you got to think about. I think, first of all, what would happen initially is our market would get cheaper relative to treasuries. The reason you buy munis is because the interest that you’re getting is tax-exempt. And if you’re not getting any interest anymore, obviously that falls by the wayside. And so when you’re going to compare a municipal bond to a treasury, even if they’re the same credit quality you’re going to want to get paid something more to own a muni relative to owning a treasury. So I think that market would cheapen up a little bit at least for a period of time. So that’s one thing that would happen.

I think the second thing that would happen is that eventually, it would actually cause more people to look at our market. Why? Because if rates in our market are still positive or relative to treasuries being negative, and you saw this globally, is what happens initially sovereign credits go negative and then slowly it creeps into other sectors like corporate issuers can issue debt at negative rates. And so I think it would just confirm our thesis that there’s just going to be this tremendous demand for income from a global perspective. And I think eventually it would actually cause more demand in the muni bond market.

But I think then you get into things like, “Okay, well, how is it going to impact the state of Illinois that has an unfunded pension that’s right around 38% or 40% funded?” The math that goes into that, they’re using a expected return of 7% plus or minus. It’s going to be pretty difficult to generate a 7% return, plus or minus if bond rates are negative. So all of a sudden unfunded pension liabilities go off the charts, you start thinking about insurance companies that generate their revenues by making investments. Our view is that has very broad implications across the entire economy and it’s part of the reason why we think the Fed is going to do everything in their power to not let rates in the U.S. go negative. They’ve realized that it doesn’t do anything in terms of helping from an economic perspective. And the second derivative effects or the adverse effects outweigh any sort of positive impact that might have from a, say, a generating investment-type of thesis like they’ve done historically where they’ve lowered rates.

Meb: How much does the curve play into kind of what you guys are doing as far as looking at opportunities on what’s going on there?

Lyle: That’s a good point. In today’s low rate environment, one of the ways that you can add value as an institutional investor, even as a retail investor is looking at, you know, what is the shape of the yield curve look like? Where is two-year bond yield relative to 10-year relative to a 30-year? And right now the steepness of that curve, it’s pretty steep. So a two-year muni yields may be 10 basis points or 0.1%. A five-year muni may yield somewhere around…I don’t have it in front of me, but let’s say 30 basis points or 35 and a 10-year might yield somewhere around a 90 basis points. So not quite 1%. But in an unchanged rate environment, there are two sources of return for you as an investor. One is the income you’re generating. The second is what’s called price return. And in a bond, if your yield goes down, the price goes up.

So let’s say you buy a nine-year bond today and it yields, just for simplicity 1%, but an eight-year bond yields 0.9%. So there’s a difference of 10 basis points. If you hold that nine-year bond for one year and rates stay unchanged, now you have an eight-year bond that yields 0.8%. And when you run the math, that yield differential multiplied by what’s called your duration or your life of your bond gives you about another 1% return on your investment. So you’re generating about 1% of income, you’re generating 1% of price appreciation. So you’re actually getting a 2% return on that investment. Again, it doesn’t sound like a lot, but in a low-yielding market where your alternatives of sitting in cash are really generating zero, it is a way to add a fairly large amount of total return to one’s portfolio and then you need to make the decision, you know, a year from now, do you want to capture that by selling that bond? Are you going to take a capital gain if you do that? Can you offset it in other parts of your portfolio? But it’s just one of the ways and the tools that an institutional investor has to try and generate higher returns for our investors above and beyond what you can get from simply just collecting your coupon, which is what you might do if you just bought a bond and held it to maturity.

Meb: We’re talking about a lot of different things in the podcast so far, how does this all kind of come together in you all’s portfolio? What is the sort of composition ended up looking like as far as opportunity, or do you hang out mostly in AAA, or Puerto Rico bonds? Is it mostly revenue or general obligation? How do you put it all together?

Lyle: For us, almost all of our products are what we call duration-neutral. So we start out the process by saying, “Hey, what’s your time horizon as an investor?” You give us a benchmark, say it’s a, you know, a 1 to 15-year municipal bond index. The first thing we do is try and replicate basically your interest rate exposure. And we keep that what we would call neutral. So our interest rate exposure relative to the benchmark. We don’t make any so-called debts in our portfolio in terms of duration other than one of our muni products. And I can get into that more specifically, it’s what’s called our strategic muni fund, but it’s very unique to our lineup. Why do we do that? We would argue that it’s really hard to figure out what direction rates are going to move. I think you know this last quarter was a great example of that.

Our 10-year notes went from 50 basis points last year to 1.75% and I think most people would have argued…and we’ve probably been in the same camp, they were probably going to go to 2%, but lo and behold, where are we today? One and a quarter. So it’s hard to predict what interest rates are going to do. We think it’s much easier to predict, you know, what the shape of the yield curve is going to look like, or is this corporate bond going to do better than this corporate bond? Or is this municipal bond going to do better than this one? Is this sector going to outperform a different sector? So where we try to add value in our portfolios in the muni market is through what we would call sector rotation. So do we want to own GOs or revenue bonds, or hospitals, or higher education, Puerto Rico, Chicago, Illinois, specific security selection, you know, within the state of Illinois, do we want to own the city of Chicago or do we want to own Liberty Heights, or do we want to own, you know, a different small municipal credit?

So get into security selection. And then what sort of credit quality, you said earlier, do we have all AAA-rated bonds? Do we want to own more BBB-rated bonds? So that’s how we think about building a portfolio and based on our bottom-up view of what’s going on in the world and with individual sectors and credits, we’ll build a portfolio based upon what our views look like. So today, what are we doing? Today we’re starting to what we would characterize as take up the overall credit quality, meaning buying more AA’s or AAA-rated bonds and letting our exposure to A or BBB or non-investment grade rated bonds decline in our portfolio. Why? Because as we talked about earlier, there’s been a huge amount of demand and the additional income you get for buying those lower-quality bonds, we don’t think is necessarily compensating you for the long-term risk.

So that’s one of the things we’re doing. Second one is what we talked about earlier where looking at the shape of that yield curve, we can do a strategy where we think we can benefit by over-weighting in the taxable market, more of the seven-year part of the curve and the muni market, kind of the nine-year part of the curve. And then underweighting kind of the two to five-year portion of our portfolio structuring what’s called a barbell and you capture that yield curve roll-down. So those are two of the things that we’re doing in our portfolio.

And then the last one in all honesty is we’re getting closer to what we call index type of weightings. And the reason I say that is, generally speaking, when times are really good, those credit spreads decline, you’re not getting paid for taking additional amount risk, you want to get what we would characterize as closer to home because usually what happens, we get some sort of event and we want to have dried powder or liquidity available to take advantage of the dislocations that we know at some point’s going to happen.

I don’t know what it’s going to be, but at some point, it will happen in our portfolio. So that’s what we’re doing. You know, I mentioned that strategic fund. In that particular portfolio, we will make interest rate bets or duration bets, but it’s more based on valuations within the muni market relative to other markets. So, as I said earlier, muni rates didn’t go up nearly as much as treasury rates did this year. And so if you look at valuations of munis relative to treasuries, we look a little rich. So we’ve decreased our duration exposure in our muni portfolios with the view that even if the treasury market rallies rather than migrates back towards 2%, like we think is probably a higher probability, maybe we could protect our investors in terms of a rising interest rate. So that’s really the only differentiation in our strategic fund is that, again, we will make interest-rate bets, but again, more based on our view of valuations and munis which tends to be a pretty inefficient market relative to treasuries and corporates.

Meb: Do munis sector funds exist? I know there’s not really any ETFs in that space, but as far as the mutual funds, has anyone ever tried to kind of split out all the different areas of the muni bond space and chop it up for people that would say, “Look, I only want to exposure to airports or water-based, or…” Is that a thing?

Lyle: You have state-specific funds, but away from that, you have had some funds that have come out with, I think, focused areas like where it’ll be on infrastructure or, you know, ESG compliance. I will be honest, I don’t think they really taken off. More of what the ETFs look like in the muni market when you, you know, rather than broad market ETFs, you might have a short duration or an intermediate duration or longer duration ETF. And then the other thing that would exist is there is a portion of our market that is taxable. The municipal issue is where we’ll issue taxable debt and there are some outstanding ETFs, I believe, that only buy taxable municipal bonds, which again, for you and I or retail investors, probably not what you want to buy unless you want to put them in your 401K. But for larger international investors or for people who traditionally will buy corporates or mortgages, it’s a way to buy a pooled vehicle of taxable muni bonds.

Meb: Any specific areas of the muni world where you would definitely not weight in where you’re like, “Oh, man. Investors, stay away from that. That looks dangerous?”

Lyle: We always say we never say never, but there are certain sectors, I think, that we historically have not been big investors in. We have not been a big player in Puerto Rico. We did buy some of the restructured sales tax bonds when they did that deal a couple of years ago. You know, you need to have a lot of resources in terms of analyzing what was going to happen in that bankruptcy. And actually, the guys who have put money in there when it was very, very distressed have done pretty well. And Puerto Rico is coming out of bankruptcy. And so, you know, we’ll take a look at it in terms of once it’s restructured, but, again, it’s just a fairly limited economy, a lot of debt. And so we’ve avoided it.

The second area that we’re very careful when we invest in is long-term care deals in our marketplace. Again, demographics would argue that it’s a place that should continue to see great demand, you know, retirement facilities and that sort of thing. But most of them come non-rated. Most of them are very heavily leveraged and they have construction risks. So you want to be careful there.

I would say another area is the multifamily housing market. We’re very comfortable, obviously, with debt that’s backed by the federal government, Fannie Mae or Freddie Mac-insured bonds. But I think you need to be careful in terms of buying lower quality or non-rated multifamily housing projects in the muni market that are backed by, you know, low-income housing credits or what tends to happen is they buy a project from a for-profit, not-for-profit buys it, they do a little bit of CAPEX investment, occupancy goes up for a period of time, and then it tends to tail off as those CAPEX expenditures aren’t reinvested, they don’t keep up with the upkeep.

Trying to think of any other sectors that we generally would avoid. Right now, nothing specifically comes to mind, but I think that you just need to know what you’re doing. Land development deals are another area where developers will issue muni debt for the infrastructure for a housing project. You really need to know what you’re doing. Some of those can be great long-term investors, especially in California where there’s some protections in place, but if you don’t get the development you were looking at, going to have some not so great results.

Oh, and then the last one I would say is what are called project financed bonds in our marketplace. So I guess I would throw out American Dream. Have you heard of the big mall up New Jersey, New York, a lot of moving parts to that? There have been ethanol deals done in our marketplace. So specific deals that are backed by a unique or new type of a process, resource recovery bonds, they’re going to take wood chips and they’re going to develop a process to make them into particle board or ship them overseas. Those projects historically have more risk to them, and so it’s just not an area that we tend to get involved in with.

Meb: Any particular resources you find useful in your job? And some of these, obviously, can either be public-facing or not. You probably have a lot more tools that cost a lot more money than the public may, but is there anything in general you think is particularly helpful when examining the muni space and the gazillion offerings out there?

Lyle: Start with what everybody has access to. There’s a service called EMMA. You can just Google it, E-M-M-A. And basically, it provides all disclosures that are done by municipal issuers. So you could pull up the state of Illinois, you could pull up city of Chicago, you could pull up a healthcare issuer. You can either pull it up by name or by CUSIP and it’ll give you the most recent disclosure that they have, whether it’s financials, whether it has to do with any sort of violation of their covenants, a ratings change, anything like that. So I think that’s a great place for individual investors and even institutional investors to get kind of the latest credit research information for a bond that you may own or maybe thinking about buying in your portfolio. And then they also have a lot of great other websites that you can access from EMMA that just give you a lot of great details about the municipal bond market. That’s probably the best one for retail investors.

If you get into the institutional marketplace, and a lot of people use Bloomberg, obviously. Most likely you’ve heard that. Bloomberg’s not cheap. You know, most retail investors cannot access it or the information on Bloomberg, but that’s a great way to analyze the bonds in your portfolio. But there’s a service called BitGo that gives you access. You have to subscribe to it. But it basically pulls news articles from all news publications around the country. Gives you information on different credits that would pop up on that. So say, for instance, your local school district has a voter initiative to raise taxes which is going to impact obviously the credit quality of that municipal issuer, that’s something that as a municipal bond analyst, it would be hard to follow all of those, but you can set up your portfolio and effectively screen for any news that’s coming out of the local issuers and you may get a headline, XYZ school district votes not to raise taxes, people concerned that it may impact their ability to pay their debt. I’m making that up, but those are the types of headlines or XYZ local small hospital in talks to be acquired by Ascension Health.

And so it’s a great way as a muni bond portfolio manager or a research analyst to get a lot of information on the local level about what’s going on with some of your credits that you may not get because small local municipal issuers don’t disclose financial information on a quarterly basis. In some cases, it’s only yearly. So I think that’s a great tool that we have that gives us access. Obviously, we have access to the rating agencies, the broker-dealer community. There are certain people that are specialized in certain areas that we’ll talk to get a better understanding.

And then this is going to be a little bit of a plug because they’re related to Baird and where I work, but there’s a company called Stratigus that we work with, but there are other people around the country that have a real good toehold on what’s going on in DC. They’ve got people on the ground that are doing work on a day-to-day basis to try and analyze what’s coming through Congress, how that may impact taxes, how they may impact the amount of support you’re going to get for state and local governments. Are there bills coming through from the legislative process that are going to change regulatory requirements?

Again, that’s not only good for muni bond investors, but that’s also obviously good for general investors. So having some sort of toehold into what’s going on within Washington for us has been a great tool as well. And again, we’re fortunate, we have a sister company that does that and that we have access to, but those are some of the things that I would say that general investors, if you can try and find the source of that, will help you be a better investor.

Meb: As you look back over your career, gazillion different bonds, everything else you’ve looked at, is there a particular one investment that is your most memorable, anything stick out in your brain? Good, bad, in between?

Lyle: The bads tend to stick out more for me than the good, unfortunately, but I think we all have those situations where you learn. When I got into the business, the portfolio that I took over had a lot of investments in multi-family housing projects. So that’s probably one of the reasons why I’m a little adverse to our projects that aren’t supported by your Fannie’s and Freddie’s of the world. Many, many years ago, we had an investment in what was called Vision Land. If you haven’t heard of it, it was an amusement park outside of Birmingham that was financed in the municipal bond market. And it was in the portfolio that I took over when I started managing muni bonds. But I think it was a great exercise in learning about when people show you projections or do a feasibility study, feasibility studies, you learn pretty quickly that you can get anybody to give you a feasibility study that you want. The problem is, in most cases, they don’t live up to expectations. And so that was an investment that did very, very poorly.

You know, on the flip side, I think there are a lot of things that if you do your homework and you do your credit research and you’ve got a long-term understanding of how the market works, you can make a lot of money. I mean, I will tell you that one of the biggest things I’ve learned from an investment perspective is just having liquidity when others don’t have liquidity will provide a tremendous amount of opportunities. And again, Warren Buffet probably says it the same way you see it in his portfolio, he’s got billions and billions of dollars of cash, and when does he tend to deploy that cash? In the midst of the pandemics or in the midst of the great recession back in ’08 and ’09.

So I think as an investor, we’ve always tried to run very liquid portfolios, carry more liquidity than we probably need and be the ones that are going to provide liquidity when the market needs it and then when everybody wants bonds, like in today’s world, my view is that you should be increasing liquidity in your portfolio. Being prepared for the next downturn, not getting too greedy, I think is one of the things that I’ve learned as well.

And then the last thing I would just say is that again, I think having a long-term history in the marketplace gives you a sense of what managers, or what credits, or what municipalities historically have treated municipal investors very well and have done a very good job of managing through distressed time period. So I think last March and April was part of the reason why we were able to play offense in our portfolios.

A, we had built up liquidity coming into that pandemic. Why? Because valuations look pretty stretched coming into the pandemic. And two, we knew a lot of these issuers and we knew how they performed in prior times of crises and it gave you confidence to give them money in the midst of what looked like a pretty long term unstable marketplace. So those are just some of the things that I’ve learned and you need to be humble in this business. You could have a great track record for a one-year, three-year, five-year and, and if you make too big of bets, you could lose that right away. So running a very diversified portfolio, I think, is something that we do as well. You give up some of the upside but you protect yourself a lot on the downside.

Meb: Makes sense. You know, it’s funny, it’s one of the reasons I’m a Quant, is like every investing pitch in the world, every startup sounds so good to me. Everyone is getting to 100 million in revenue. Every feasibility study looks gorgeous. So one of the first things you learn as a young analyst is how to be skeptical, which is a useful in most parts of life without being a cynic, maintain an optimistic skeptic attitude. Lyle, this has been a tour de force of all things munis. If people want to follow you all’s writings, your funds, everything that you guys are up to, where do they go? Where do they find out more?

Lyle: The Baird Funds website is a great place that’ll will give you access to any of the materials. We recently wrote a piece talking about the baby boomers and how they’re being impacted by the low rate environment. And we did a white paper, you know, in the midst of the pandemic, talking about reasons why municipalities are going to be fine. So I think it’s a way to get access to some of the research that we do. That would probably be the best way.

And then if they’re interested, obviously in investing with us, you know, we have several municipal bond funds, depending upon what you’re looking for. And, again, I would say that what we’re concerned about and how we want to build a business is, you know, we tend to build very diversified portfolios, we think about risk management first in our portfolios we manage. Our mutual funds are some of the lowest-cost mutual funds away from the passive products that are out there. And then our view is that if we consistently outperform the benchmark by 25 to 50 basis points, over the long-term, you’re going to win.

And then finally, taking care of your clients. I think we provide a lot of direct access to portfolio managers, to analysts, no matter what your investment size is. That would be the plug that I put in for Baird advisors. I’ve only been here a couple of years, but it’s a great place to work. It’s a privately-held company, you know, two-thirds of the employees are shareholders and they can think about the long-term and methodically growing portfolios and not about, “Hey, we got to be at X assets under management today and we want to be at, you know, 3X or 4X in the next five years.” That’s not the way they think about the world. If we do a good job for investors, guess what? The rest takes care of itself.

Meb: And the analysts will buy you a coffee or beer at Summerfest while watching Guns ‘N Roses, right?

Lyle: You come out here, we’ll definitely do that. But you should. It’s a great festival. And again, usually, it’s held in late June, early July, but because of the pandemic, they pushed it out. It’s usually, I think, 10 or 11, or 12 days in a row, but now it’s going to be, I think, over three weekends in September. So come on out.

Meb: Awesome. Lyle, thanks so much for joining us today.

Lyle: Thanks for having me.

Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.

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