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Peter Hayes: Surveying the Municipal-Bond Landscape

BlackRock's head of muni-bond investing on how states and municipalities are faring, where stimulus is most needed, and the risks and opportunities that investors face.

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Our guest this week is Peter Hayes. Peter is a managing director at BlackRock where he heads the firm's municipal income group and sits on its global fixed-income Executive Committee. In his role, Peter oversees all aspects of municipal fund management, including portfolio management, research, strategy, and trading. Among his responsibilities, Peter is one of the managers of the BlackRock Strategic Opportunities Fund. In addition to these duties, Peter is also a member of BlackRock's Global Operating Committee. Before joining BlackRock in 2006, Peter was a portfolio manager at Merrill Lynch Investment Management, where he led the short-term tax-exempt trading desk and managed short-term municipal bond strategies. Peter earned a bachelor's in economics from the College of the Holy Cross.

Background

Peter Hayes Bio

The Big Picture

Local Finances Are Troubled, but Fund Investors May Still Profit,” by Carla Fried, nytimes.com, July 10, 2020.

Muni Investors Scale Back,” by Peter Hayes, blackrock.com, Oct. 7, 2020.

How Much Is COVID-19 Hurting State and Local Revenues?” by Louise Sheiner and Sophia Campbell, brookings.edu, Sept. 24, 2020.

Record Increases of new Covid-19 Cases in 3 U.S. States With the Most Population,” by Jay Croft, Christina Maxouris, and Douglas Wood, cnn.com, June 24, 2020.

Stimulus

Second Stimulus Checks (10/1/20): What Will the Next Stimulus Package Look Like?” by Claudia Dimuro, pennlive.com, Oct. 2, 2020.

CARES Act Includes Essential Measures to Respond to Public Health, Economic Crises, But More Will Be Needed,” by Sharon Parrott and others, cbpp.org, March 27, 2020.

Municipal Liquidity Facility definition

The Fed Says It Is Expanding its Municipal Bond Buying Program,” by Jeff Cox, cnbc.com, April 27, 2020.

U.S. Municipal Market Activity Witnessing Positive Momentum Post Fed’s Intervention,” by Nikhil Francis and Saswata Mohanty, acuitykp.com, Sept. 18, 2020.

Lawmakers Tangle Over Fed’s Muni-Market Rescue,” by Heather Gillers, morningstar.com, Sept. 17, 2020.

Riskier Fixed-Income Sectors Bounce Back in the Second Quarter,” by Gabriel Denis, Morningstar.com, July 6, 2020.

Credit

Municipal Bond Perspective: Where We Go From Here,” beyondbullsandbears.com, April 24, 2020.

How Is the Coronavirus Crisis Affecting the Municipal Bond Market?” by Daniel Bergstresser, econofact.org, April 8, 2020.

Bond Insurance Returns to the Muni Market in a Big Way,” by Heather Gillers, wsj.com, Oct. 22, 2020.

Muni Bond Insurers See Demand Grow Amid Pandemic Worries,” by Liz Kiesche, seekingalpha.com, Oct. 22, 2020.

Supply and Demand

Municipal Bond Market Update—September Edition,” by Corey Boller, dividend.com, Sept. 10, 2020.

Supply and demand shocks in the COVID-19 pandemic: an industry and occupation perspective,” by R Maria del Rio-Chanona and others, academic.oup.com, Aug. 29, 2020.

Will Supply-Chain Disruptions and Delayed Capital Spending Be Material,” by Brian Bernard, Morningstar.com, March 25, 2020.

Munis in Focus: 2020 Municipal Market Update,” by David Hammer, pimco.com, Sept. 11, 2020.

Global Supply Chains in a Post-Pandemic World,” by Willy C. Shih, hbr.org, Sept.-Oct. 2020.

Reviving States, Cities and the Munibond Market Amid COVID-19,” by Brian Wynne, morganstanley.com, April 27, 2020.

Revenue Streams Drying Up? Municipal Bonds in the Pandemic,” by Dennis DiCicco, jhinvestments.com, Aug. 20, 2020.

Taxes

Calculating Tax Equivalent Yield: Are Municipal Bonds Right for You?” by Thomas Kenny, thebalance.com, May 11, 2020.

7 Best Tax-Free Municipal Bond Funds,” by Barbara Friedberg, money.usnews.com, Oct. 7, 2020.

Taxable Munis? They’re Worth a Look,” by Jeffrey R. Kosnett, Kiplinger.com, Jan. 2, 2020.

Coronavirus Fears Affect the Municipal Bond Market,” by Cooper Howard, schwab.com, March 18, 2020.

What Is the Muni-Treasury Ratio or M/T Ratio?” by Thomas Kenny, thebalance.com, July 29, 2020.

Portfolio/Positioning

Strategic Municipals Opportunities Fund

Muni Market Tailwinds Turn to Headwinds,” by Peter Hayes and Sean Carney, blackrock.com, April 2, 2020.

Short Term Treasuries Are ‘Overvalued’: BlackRock Muni Bonds Head,” Peter Hayes on “On the Move” video panel, finance.yahoo.com, Sept. 18, 2020.

Stay the Course Amid Market Volatility,” blackrock.com.

Volatility, the Vote and Taking the Long View,” by Tony DeSpirito, blackrock.com, Oct. 12, 2020.

Issue Selection

How Munis Can Boost Your Investment Health,” gsam.com, Oct. 5, 2020.

How to Invest in Municipal Bonds,” by Miranda Marquit, forbes.com, July 9, 2020.

Small Investors Ruled the Municipal-Bond World for a few Days in March,” by Heather Gillers, wsj.com, May 7, 2020.

How and Why to Build a Bond Ladder,” fidelity.com, Sept. 17, 2020.

Rising Rates Series: The Ups and Downs of Bond Ladders,” by Karen Schenone, fundsociety.com, June 4, 2018.

2011: The Year 60 Minutes Misled Americans About Municipal Bonds,” by Janet Tavakoli, businessinsider.com, Dec. 30, 2011.

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar.

Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Our guest this week is Peter Hayes. Peter is a managing director at BlackRock where he heads the firm's municipal income group and sits on its global fixed-income Executive Committee. In his role, Peter oversees all aspects of municipal fund management, including portfolio management, research, strategy, and trading. Among his responsibilities, Peter is one of the managers of the BlackRock Strategic Opportunities Fund. In addition to these duties, Peter is also a member of BlackRock's Global Operating Committee. Before joining BlackRock in 2006, Peter was a portfolio manager at Merrill Lynch Investment Management, where he led the short-term tax-exempt trading desk and managed short-term municipal bond strategies. Peter earned a bachelor's in economics from the College of the Holy Cross.

Peter, welcome to The Long View.

Peter Hayes: Thank you very much for having me. Nice to be here.

Benz: So, let's start big picture. How are state and municipal finances looking and where are we in that process? It seems like states and municipalities might have gotten a reprieve amid all of that fiscal and Fed stimulus. But has that just postponed a reckoning? Where are we in the process with municipal finances?

Hayes: It's actually a good question, because when you think about what's taken place, it gives you a sense that we're still pretty early in the entire process. Think about where we were, from the U.S. economic standpoint, pre-COVID and where we are today--we're still operating only a fraction, whether you look at mass transit, or airline travel, or toll roads or restaurant capacity--every state has different rules, but certainly a fraction of where we used to be. That means that revenues are below where we were--well below where we were pre-COVID, and it's going to take a while to get there.

And I don't know if anybody really knows the answer to that. Clearly, we all know uncertainty is a big part of this pandemic. When we'll have a vaccine, when we'll return to normal work environment? I mean, all these questions have to be answered. And until we get some of those answered, we don't necessarily know the state of muni finance. But I think many people think about municipals as being a school bond or a general obligation bond of their state, etc., pretty generic stuff. But municipal finance is really very, very broad based. It's water and sewer bonds, it's airports, big and small, it's mass transit, it's large public institutions, universities, it's charter schools, it's healthcare--I could on and on. But the point is, it covers basically every sector and every element of the U.S. economy.

So, in March, that economic activity basically ceased to exist, and slowly reopened over the coming months, which means that every sector of the municipal market has been really impacted and some a bit less than others. Obviously, water and sewer bonds, people continued to use water and sewer for pretty much the same way--you transmuted from the work environment to the home environment. But that continues on to some degree. So, municipal finances are across the board, the state yields, school district bond, hospital, etc., are well below where they were.

Have they gotten a reprieve? It's hard to say they've gotten a reprieve. Clearly, the first stimulus helped. I think it helped a bit more with market psychology maybe than anything else. But our guess is, we have a long way to go. We've estimated where deficits are. And when you look at deficits, if you include states and local governments over the next couple of fiscal years, the number is approaching $1 trillion, far bigger than what it was in the financial crisis coming out of 2008-2009. So, it's a pretty big hole. I think we have a long way to go.

Ptak: We're going to talk stimulus in a little bit. But before we get there, maybe we can talk about where some of the impacts have been most keenly felt thus far. I think you gave the example of water and sewer as a category that's impervious to some of these impacts. But there have to be some in the opposite category where already they are showing signs of strain. Can you give a sense of where those signs of strain have begun to form?

Hayes: I'd say a couple of areas. One is mass transit. You take a look at the MTA, Metropolitan Transportation Authority, in New York, which came into the pandemic not financially very strong. So, given that ridership is off a dramatic amount, their financial situation has actually decreased. Small colleges is another area. What's the outlook going to be for small colleges going forward? Clearly, big, well-known institutions will continue to thrive and there will continue to be great demand for that. Will there be for small colleges? And we're already seeing some signs of that where there's just less applications, less matriculation in a lot of these colleges. I'd say dedicate a tax where a certain tax, sometimes it's a sales tax, etc., goes to repay those bonds. So, naturally, they're seeing signs of stress as well. Airlines, museum bonds, I think to a large degree. We've seen charter schools. I mentioned earlier, toll roads revenues are off. So, some of those areas are clearly more impacted than others.

And then, finally, states that I think came into this in a financially weak position, either because they had a big unfunded pension liability or other types of high expenses, poor management largely, that are seeing great strains because of a big falloff in revenues. And many of those big states actually depend heavily in terms of their economic activity and revenues on large metropolitan areas, like New York, like Chicago, etc. So, those are having a bigger impact than other states that don't have the same reliance on some of those big metropolitan areas.

Benz: Speaking of geography, if we had to tally up a short list of the biggest losers from the pandemic, is it safe to assume that it's the populous states with their reliance on those big metro areas that you referenced?

Hayes: That would be I think the initial indication. There's a lot of talk about migration patterns and what it means and high-tax states. And now, will we be a permanent work-from-home environment, and by permanent, I don't mean 100%, but some percentage of the workforce now can work remotely and can work anywhere. So, they are going to basically pack up their household and move from the New York, New Jersey area to some more remote state where they typically couldn't have been able to operate.

So, there is certainly an element of that where some of those big populous states that have concentrated workforces are certainly really seeing a much bigger impact. The economic activity in a place like New York and Chicago isn't anything close to what it was pre-COVID. And the big question remains is how many years will it take to get back to that type of activity, if at all, in the future? So, there's clearly been, I think, a bigger reliance there than perhaps on some states, perhaps. Let's take Georgia and Atlanta, not a big reliance on the part of state of Georgia on what happens in Atlanta. In some respects, Atlanta has been a beneficiary of this. And there's probably other examples like that as well.

Ptak: So, let's turn to stimulus. Is a second federal stimulus for states and municipalities needed?

Hayes: I could answer that in one word: yes. It definitely is needed. Again, let's go back to that number I quoted earlier that if you look at just states, or if you combine states and local governments, the number over the next couple fiscal years is approaching $1 trillion. How are they going to possibly make that up in the lost economic activity? And the purpose of all these entities is to be able to provide basic services--that is really the necessity. So, in order for them to do that, they need to have revenues. And with revenues off, you are seeing budget cuts, and it takes different forms in different states. I think a lot of it depends on the political environment, etc. But clearly, budget cuts are part of this process. And in order to avoid that, in order to give relief to states and local governments to help them provide these basic services, there is a second stimulus needed.

Sometimes I think there's a perception that in May and June when the economy began to slowly reopen. And you look at the unemployment number as evidence of this. There's this false sense of that things are normalizing, but it's not. As I mentioned earlier, economic activity is only a fraction of what it was pre-COVID. So, the states and cities absolutely need a second stimulus. What will it look like? Who knows? What's the amount? Who knows? I mean, it's all in the middle of this election rhetoric right now, a bit of a political football where big numbers are being thrown out and one party wants to include state and local governments and other does not or how much will that be? Will it be targeted towards mass transit? Who knows? But that's a long way of answering your question. Basically, a second stimulus is absolutely needed.

Ptak: So, if you could craft a Federal bill, I know it's a big IF, but if you could do that, what provisions do you think would be most important to write in, what's most vital?

Hayes: Well, you've given me a blank piece of paper to be a legislator and write a stimulus package. That would be interesting. I mean, I really haven't thought about it. But it gets back to my answer about being able to provide basic services. So, what are those? Education, public safety, healthcare. So, all those elements I think have to be written into a stimulus package. They have to ensure, no matter what your politics are, that basic services can continue to be provided. There's likely also some degree of infrastructure that's needed. If you go back to the financial crisis in 2008 and coming into 2009, the municipal market, which is a funding source for state and local governments to do a lot--highways, airports, hospitals, everything I mentioned earlier--that market was broken in 2008 and 2009. And what essentially fixed it was a portion of the American Recovery and Reinvestment Act of 2009 that created the Build America Bond program.

That was a taxable municipal program that basically gave a subsidy to issuers for what was called at the time shovel-ready projects. Well, that program was much more successful than I think everybody thought, largely probably because the subsidy was a bit too high. But the point is, it did reopen the market. And I think it helped economic activity as well. So, I think here again, given the low level of economic activity and the difficulty in recovering and getting back to pre-COVID levels, it does seem that infrastructure should be part of that. Again, both parties agree that infrastructure is badly needed in this country. And I've seen some big numbers thrown around in terms of what that is. There's probably different solutions and how to get there--a combination of the municipal market, public/private partnerships, infrastructure, banks. So, there'll be some combination of that. But a stimulus bill clearly, in order to just help the general infrastructure of the U.S. and also be able to help economic activity with the U.S., should probably include some type of infrastructure funding in that bill. So, that's how I would write it.

Benz: The Fed rolled out its $500 billion municipal-lending facility in April. It's aimed at helping states and municipalities manage their short-term liquidity needs. It doesn't appear to have gotten a lot of uptake so far from eligible borrowers. As of September, only $1.7 billion or so have been borrowed against it. So, is this a disappointment to you?

Hayes: I can't say it's a disappointment to me. And I'm not sure it's really a disappointment to the Fed, either. It's interesting. When you go back in time, and you think about the discussions, and we were involved in those discussions with regulators in Washington including the Fed and the Treasury and the SEC on the municipal market, which was completely closed in March and April--just wasn't functioning, lack of liquidity, no new issuance, etc.

So, I think a lot of people believe that the Fed, like they did with Treasuries and buying mortgages directly into the balance sheet, would do the same for municipals to help the market. But that wasn't the case. And part of the reason for that is, it's really complicated. First of all, it's a political football. When you look at the issuance patterns in the U.S., the perception that the Fed is bailing out one state over another. The market is probably one of the most, if not the most complicated fixed-income markets there are. When you look at just the number of issuers involved in the market, which depending on how you look at it is 70,000, there's over a million different CUSIPs. So, how could they possibly go in and do that for their balance sheet?

So, they didn't. Instead, they came up with this municipal-lending facility--municipal liquidity facility--and it really was designed to be a backstop. That's what it was really about. It was being able to provide being the lender, this is the Fed, of last resort to municipal entities. Now, when they first opened it up, I think they wanted to keep it a little less complicated. So, they opened it up to 70-some-odd issuers, which were the largest states and then cities with populations over X--I forget what the number was at the time. And that was a fairly limited subset of the entire municipal market. They since expanded that a couple of different times. So, now there is a larger potential set of borrowers in that market.

But again, the Fed only wanted to be the lender of last resort there. They didn't want everybody rushing in and borrowing from the Fed. If an issuer wasn't able to solve its cash crunch in the short term by going to the market, the Fed was there. And that's why I think we've only seen--I think we've only seen two issuers use it so far. Both those issuers are a bit on the lower-quality spectrum of the market. So, Illinois, and the MTA who I mentioned earlier. I think those are the only two that have done that so far. And so, I don't think it's necessarily a disappointment. I think that that's what it was designed to do as opposed to the Fed buying securities directly on its balance sheet and helping out the market.

The market has responded favorably for a lot of different reasons. But I think one of the last reasons is this municipal-lending facility. We've seen a tremendous snapback since the lows on March 23rd, I think is when the index reached its low point, we've seen a big, big snapback. And I don't necessarily think it's because of this municipal-lending facility. Sure, I think investors, particularly institutional investors, realized that being a lender of last resort, issuers do have at least some backstop there, which gave them some comfort. And it just begs the question about what is this? Is this a solvency issue? Or is this a liquidity issue? It gets back to your opening question about finances. It's very much a liquidity issue, simply because revenues are off so much. Normally, they collect these revenues constantly in the form of personal income tax, corporate income tax, sales tax, property taxes, etc., etc. So, that revenue stream isn't there. They have this big cash crunch, and in a cash crunch now, they have the Fed backstopping that as the lender of last resort. So, hard to say it's a disappointment. Our feeling coming into this was that it wouldn't be very widely used and so far, that's actually borne out.

Ptak: And maybe just turning to the concept of systemic risk in the muni market, do you feel like the Fed's municipal-lending facility has in effect mitigated that risk taking it off the table? Or do you think investors need to be thinking of other sorts of interconnections that maybe exist within the municipal bond market that still pose a threat?

Hayes: It's actually an interesting question. And to some degree, it begs the question a little bit about, where are we going to go from here, and what's the fallout going to be? I think, initially in March and April, we heard a lot of people say this is going to be--and I got plenty of calls from clients saying, “We're going to see widespread bankruptcies and defaults.” And it's important to sift through all the smoke and all the dust that got kicked up as a result of the onset of the pandemic and the shutdown of the U.S. economy and just think about that. So, the large part of the market is investment-grade, meaning it's rated BBB or higher. About 10% of the market is what we call project finance, that's high yield, that is rated below investment-grade.

So, I think, that part of the market continues to be problematic, but the investment-grade part of the market, there's not really a mechanism by which--states have no ability to default or declare bankruptcy. They just don't. Even cities within--I think it's only 26 or so states--there's some type of provision or statute for them to file, Chapter 9, which is the Municipal Bankruptcy Code. So, I think there was a lot of rhetoric about the impact to the economy. But in reality, there's not a lot of mechanisms for municipalities and states to be able to just walk away from their debt.

So, getting to your question, I think it's a little less systemic than people think. I don't think the municipal-lending facility necessarily takes away all elements of systemic risk. Yes, it buys some of these municipalities time. And I think that's what it's done. Maybe less so with Illinois, which is a large state, has a lot of options at its disposal in order to raise revenues. It can raise taxes, it can cut spending, etc., etc. The MTA--it may have bought some time for the MTA until ridership ultimately, and the hope that ultimately picks up. So, we'll see. But I don't think it's necessarily a systemic risk.

Now, if this were to drag on for multiple years, which is A) somewhat unlikely, and B) there were to be no help from Congress in the form of additional stimulus, which I think is very, very unlikely. If that were to happen, you'd have to think about what does that mean for increases in defaults and the pain that we would see. I mean, the way we've described it is less around systemic risk and solvency and more around downgrade risk, and we've seen a lot of that already, but I think that'll likely continue. And the municipal-lending facility clearly buys them some time and helps with that cash crunch that I described earlier.

So, then we'll start with the point I made earlier about investment-grade versus non-investment-grade or the high-yield part of the market, which is only 10%, small part of the market. In that high-yield part of the market, there are sectors like continuing care facilities, nursing homes, stadiums, some regional trains that we've seen that have started over the last few years, even casinos and hotels, student housing bonds, all those are going to be pretty vulnerable on a sector-by-sector basis, and that's where we think the bigger default risk is. And that's typical of the high-yield part of the market. It's still not as bad as the high-yield corporate market. But nonetheless, it's an area that is likely going to see increases in defaults and missed payments—in fact we've already seen it. There's just an easier way to walk away on those specific project finance that have dedicated revenues to repay the debt than it is in the investment-grade part of the market, which makes up 90% of the market and it takes into consideration all those sectors that I mentioned earlier, all of which provide basic services to some degree. And again, many have at their disposal a lot of means by which they can help dig their way out of a bad financial hole, like raising taxes or raising fares or fees on revenue bonds, just a lot of different things that they can do. So, it's a very relevant question in terms of sector by sector. I do think you have to parse them out and sift through the good ones versus the bad ones. But I think you start with that investment-grade versus high-yield divide and then you kind of go from there sector by sector.

Ptak: Given the fact that you invest in your flagship strategy, let's call it--which we'll talk about a little bit later in high yield and investment-grade alike--you have a good perspective on where the market is being a bit blasé about the credit risks that a particular issue is courting, and perhaps where they're being overly pessimistic about the prospects for a given credit. Can you give an example of each drawing on the work that you've done that's expressed itself in the portfolios you manage?

Hayes: Interestingly, a big part of the high-yield market is the tobacco sector. So, if you remember, a number of years ago there was a master settlement agreement in lawsuits, basically that resulted in settlements to states and in some cases, counties and cities. And they've basically securitized those payments from the tobacco companies by issuing municipal bonds. The tobacco sector for a long time was an area that was probably somewhat misunderstood. And then coming out of the financial crisis, a lot of different types of buyers began to understand the bonds, so it remains kind of a liquid part of the market. Now, interestingly, in this particular pandemic, tobacco bonds have done very well, because the thinking was that people, now they're not spending as much on things like restaurant and travel, so they're going to spend it on tobacco products. Tobacco bonds have actually run up in price here and been a little bit pandemic-isolated, I guess to some degree, if you will, oddly enough, which you might not really think of. But that is a big part of the high-yield market typically.

Another area that's been interesting is Puerto Rico. Now, that's been, as you know, it's been in the market for quite some time where they've been attempting to restructure their debt in different names, whether it's the electric bonds, the water or sewer bonds are all playing out a bit differently here. But that's an area that exists in the high-yield part of the market just given the construct of Puerto Rico's overall debt service, that has actually done OK in here, believe it or not. And then, there's other areas when you have to think about, like nursing homes, for instance, where they were so hard-hit by the pandemic early on, what's the business model for nursing homes going forward? So, a lot of these nursing homes that were being built, or were at particularly low levels of occupancy, that's an area that our analysts identified even before the pandemic is an area we didn't like because of just the business model and the structure and the risk that people were taking in this particular deal. So, we came in very, very underweight those type of securities. And, unfortunately, because of the pandemic, that sector has done very, very poorly as well. And that's where you're likely see more nonpayments and defaults I think on a going-forward basis. So those are some examples of things that have done well in here that we've identified and others that haven't done as well due to the nature of the pandemic.

Benz: How do you think about potential demographic population shifts, if at all? It seems that some of the places that were already financially strapped were also hard-hit during the pandemic, and they're losing population in some cases, too. So, does that figure into your thinking at all?

Hayes: It's definitely something where we're thinking about. There's all these different elements that are beginning to manifest themselves. And I think the question is, how long are they going to last, and we're all going to read a great book in five or 10 years that's going to basically rehash every element of this and some of the long-term changes and behaviors that have taken place as a result of this. But the book hasn't been written yet. So, we don't know how it plays out.

The demographic shift and the population migration is an interesting one. I read a book a while back about the migration that took place to cities for a very long period of time. And now, you're sort of seeing the reversal of that to some degree. Is that going to be long term? Hard to believe that. I mean, there's such an attraction that people have towards large metropolitan areas, it's hard to believe that's going to be a permanent pattern going forward. And then, there is the case from northeast to the south and south to southeast, etc. I think this kind of accelerates that to some degree. But we've also seen examples where, for instance, take California--California when they raised the personal and state income tax there to 13% several years ago now, everybody said people are going to move out of California; not going to have any tax base left; they're going to move to different places. Well, look what's happened? It hasn't happened. It's a difficult thing to just pick up and move. It might be a little easier now if we do have this – depending on what the work from home situation looks like on a going-forward basis. But in general, I think that's a pattern that plays out over a very, very long period of time. It takes a long time to manifest itself. It's just not that easy.

I just coincidentally happen to see a stat today. Somebody asked about, I think it was the trivia-type question. They said, for 72% of Americans, what's within one hour of travel time? And I think there were all kinds of answers that came through. And it was actually the answer was “parents”--is that 70% of Americans live within one hour of their parents. So, the point there is that I think people like to live where they generally have grown up and where they have family members, etc. It's not that easy just to take everything lock, stock, and barrel from the northeast, and move it to Florida or move it to Texas or Arizona, etc., particularly states that don't have an income tax like Texas or Florida--it's widely thought you'll see more of that.

So, it's likely, I think it's happening, but I think it's happening slowly. It's probably more around aging demographics than anything. We have people leaving a colder, higher-tax north, moving to the warmer, lower-tax south. But again, all that takes a long time to manifest itself. So, we do think about it in the credit process. But we're always trying to assess the ability of an issuer to repay its debt when we're looking at them as an issuer. And if you think about migration patterns over a very, very long period of time, it's a little bit more difficult to say they can't repay their debt, because those patterns take so long to manifest themselves and then have an impact on their financials and on their rating and obviously, ultimately, their ability to repay their debt. You asked earlier about impacts in areas, particularly around states that have large metropolitan areas--I think some of that is around tourism. So, places like Las Vegas and Miami perhaps you've seen some impact. We’re kind of thinking about those. The point is that that's a nearer-term phenomena rather than a longer-term phenomena, which is what demographic and population shifts usually tend to be.

Ptak: Let's shift to supply and demand, and I wanted to talk for a minute about taxable munis, which have been kind of a sleepy corner of the municipal bond market, but that appears to be changing according to your estimates. Taxable munis represented about one third of muni-bond issuance in September of this year. So, can you explain to the listeners what's spurring demand for taxable munis, where it's coming from, what are the motivations and also the implications for traditional tax-exempt municipals?

Hayes: So, I'll start by saying sleepy no more. It's actually a pretty fascinating area of the market that continues to grow dramatically. The history of this market has always been a very small part of the overall market. So, you take a municipal issuer that normally can issue for a public purpose and issue tax-exempt debt. When you issue tax-exempt debt, you're limited into how you can use the proceeds. With taxable debt, an issuer can use taxable debt and use it for any proceeds; they're not restricted, which is sort of one element of why more issuers are utilizing it. And I think the realization came again back in 2009 with the advent of Build America Bonds. They only lasted a couple of years, but it really drew a broader investor audience to taxable municipals. When those went away in, and I think it was either the end of 2010 or 2011, for a number of years the taxable market just sort of languished as a very small part of the market.

Last year, it got a little bit bigger. And this might be a little complicated, but it was a result of a change in the 2017 tax law change that eliminated advanced refunding for tax-exempt bonds. It means that an issuer couldn't issue a tax-exempt bond and then use those proceeds to defease or pre-refund an existing outstanding issue. But what happened in 2019, with the relationship and the fall in rates and the relationship between muni rates and Treasury rates, issuers now were able to bring taxable debt, be unrestricted in their use of proceeds, and still refund the existing outstanding tax-exempt debt and have a large substantial interest-rate savings on their existing debt.

So, hopefully, that wasn't too much there. But it really began to increase the issuance in the market. And that has increased again this year, along with the fact that the demand has gotten so strong from a number of investors and this is a low-yield world--everybody's looking for yield in fixed income, which is why some of our biggest demand are actually coming from overseas investors, both in Europe as a result of Solvency II and also in Asia. That's a little bit more of a yield play where they are just looking for yield wherever they can get it. And by the way, they love the infrastructure play and the high-quality nature of the municipal asset class. So, you're getting that combined with a yield on a taxable type of debt. So, this type of debt isn't appealing to the high-net-worth individual who buys the traditional tax-exempt debt in the U.S. It's a different buyer base. But that Build America Bond program really opened investors' eyes to the municipal market. And now that we have this phenomenon of advanced refunding, less restrictions on the use of proceeds, more and more traditional issuers are beginning to use it.

In the last two weeks alone, we've seen about 40% of new issuance has been taxable. That would have been unheard of three or four years ago. So, it's a growing part of the market. Every deal that comes to market has incredible demand. What it means for tax-exempt a bit(subhead) is that there is still very good demand for tax-exempt securities. It means there's less of those now, because this debt that these issuers are bringing to market is taxable to appeal to a different set of investors. So, it definitely has implications for the market, implications for valuations. And it'd be really interesting to see. The conventional wisdom is, if--I'm not predicting the election here--but the conventional wisdom is if we do get a democratic sweep of Congress--so if they control the Senate, the house, and they win the presidency--that tax rates, particularly on corporations likely are going up, you're going to see more demand for traditional taxes and municipal bonds. And it will be interesting to see what will happen to that composition. But if we continue like we have been, it means that taxes and bonds should do significantly better from a price standpoint going forward. So, hopefully, I've answered your question there. But it's a really, really interesting phenomena that has occurred over the last 12 months and just seems to continue to grow.

Benz: We have more questions about taxes, which you just touched on. But more generally, can you talk about how the complexion of supply and demand has changed during the pandemic?

Hayes: It's changed dramatically. When you go back to day one, which, I don’t know if there was really a day one, but somewhere right around that first week of March, the markets shut down. There was no market. We basically had come into that period of time where from a demand standpoint, I think we had seen something like 58 or 60 straight weeks of inflows into municipal mutual funds. We have seen tremendous demand. Then we get to the first week of March, we see this big drop in prices. The market basically becomes illiquid. There's very little market--I don't want to say it was completely illiquid--it was more liquidity at a very distressed price. So, the market falls dramatically in price. We see outflows and I think we saw something like $42 billion in outflows in a few weeks' time, almost a complete reversal of what we had seen. And a lot of these sellers in the market now had to fund the redemption. A market that was already stressed and having a hard time handling some of the selling now had to sell more to fund some of these redemptions in a very difficult period of time. Then, on top of that, the market basically closes for new issues. So, there's no new issue market at all. The market is completely shut.

Now, you would think that would last a long time. And we've seen these other instances, particularly the financial crisis, where it took a long time for the market to normalize and reopen, by some measures almost nine months. And I think in a matter of probably five or six weeks, the market really began to first stabilize, then normalize. And now, the new issue market is back to probably actually more than it was from a week-over-week perspective than it was pre-COVID demand. Now, we've seen those big outflows have reversed. In fact, they reversed in a few weeks' time, which to me is still a little bit baffling given what has changed and some of the things we talked about earlier. But nonetheless, those outflows turned to inflows, not as dramatic as they had been, but now for the year, I think we're up $21 billion. So, the supply/demand picture is much, much better. And again, the composition of supply tax-exempt to taxable, given the fact that demand is strong has been a good tailwind to municipal performance over the last several months. So, we've had in, call it, a seven-month period of time, we have just had a roller coaster of a ride in terms of supply, in terms of demand. And the market certainly feels like it's normalized despite some of those weaker credit fundamentals that we talked about earlier.

Ptak: Let's shift and talk taxes, which we alluded to a moment ago. Tax equivalent muni yields were recently exceeding comparable Treasury yield. So, let's talk about why. Do you think the market is already pricing in a likelihood of higher federal and in some cases, higher state tax rates as well?

Hayes: Interestingly, they're not. We would think they would, particularly as we get closer to the election and the polls are telling us that the democratic lead seems to get bigger, which usually means higher taxes. So, you would think the market would factor in higher tax rates, but it's not. And I think part of the reason it's not is because that rally that I talked about, that big snapback in performance. I'll just give you some quick numbers. So, the index went from up over 3% to down over 8%. That was an 11% swing in a market that's not known for volatility. And that was in a period of a few weeks in March. At one point in time that index return was up over 4%. Now, we're down closer to 3%. But think about that picture that in your mind graphically. It's a roller-coaster ride. And the market really did that based on the supply/demand aspect rather than the fundamentals. Christine asked about supply/demand and what it's meant. It's been a technical rally. That's how we really bounced back.

The fundamentals remain weak. And I think the market has ignored that. And for that reason, I think that's why these valuations, they're not factoring in higher tax rates, and that's why some crossover non-traditional buyers continue to like the market. And you go out 20 or 25 years, we're trading at ratios over 100%, which means that a muni yield is actually above that of a Treasury yield, which hasn't typically been the relationship. It's usually been the other way around.

Benz: So, have BlackRock's taxable bond managers been looking at munis?

Hayes: Oh, yes. Yes, very much. We have a process in place, and we've become very popular with them. Every new issue that comes to market is oversubscribed. We have great demand internally, and we're competing obviously against others in the market that are seeing the very same demand. And that's why I think a lot of this taxable issuance has increased so much. So, definitely, it's a yield play. You think about where Treasury yields are today. I think that we're in the 70 to 80 basis-point range over the last bunch of trading sessions for the 10-year Treasury--pretty low yields. You can get something spread above that, depending on how far you want to dip down credit quality for a taxable municipal. And that's the reason we're seeing such demand not only from taxable bond managers but also from other types of buyers I mentioned earlier, even overseas.

Benz: Many people who live in high-tax geographies automatically reach for muni bonds or funds focused on their own state in order to pick up those state and local tax breaks. How should they balance those tax benefits alongside the loss of diversification?

Hayes: I like that question. That's because I don't think enough investors think about that. And they do have this familiarity aspect where they've said, “I can see it, I can touch it, so I'm going to buy it.” And that does two things. One, it sort of ignores sometimes the underlying credit fundamentals that are so important. And it becomes so important with the absence of monoline insurance, which basically went away after the financial crisis, you really needed to know what you're buying. And then, the second is the diversification aspect.

So, the way that we answer that question is that if you're in a very high-tax state--and you can think about them, there's a handful--the opportunity cost of investing out of state is pretty high. You give up a lot of the tax benefit. But you also have to ask yourself about the credit strength in that state and the type of issuance in that state. A state like California, they issue a wide variety of bonds, where you can fully diversify a portfolio into not only different names, but different types of sectors, revenue versus geo, etc. And the opportunity cost is very, very high to go out of state. If you take a state like New Jersey, which also is a high-tax state for individuals, they don't have enough of that good diversified issuance to be able to fully diversify a portfolio in addition to the fact that some of their bonds are a bit weaker from a credit standpoint, largely because of their pension issues more than anything else. So, the advice there is probably some diversification out of state. If you had to pinpoint me on a percentage, I would say something like 20% to 25%. Out of state, we would probably say more except for the fact that the top income tax rate is so high, and by the way it's going higher with the new budget that's just been enacted. So, it varies a little bit by state, but you have to ask yourself those questions: What's your tax rate, what's the opportunity cost, can I diversify a portfolio in names and in sectors within that state?

Ptak: Let’s turn to portfolios you manage and positioning. But before we did that, I think you and your team recently wrote that you expect increased volatility in the months ahead. As we know, there are headline-risk galore. So, that could be one possible cause. But can you elaborate a little bit on why it is you foresee increased volatility in the muni market in the months ahead?

Hayes: So, we thought the market had gotten a bit ahead of itself. I mentioned earlier that the rally, this big snapback that we saw from, call it late April really through the peak--it really peaked probably in August sometime--was more technically driven. There just weren't enough bonds to be able to fulfil the demand that was out there. And there was a certain ignoring, if you will, of the credit fundamentals. And I think the market now is more focused on the credit fundamentals. So, I think there's going to be a bigger discourse between some of those sectors that we talked about earlier. You asked early on, you asked about winners and losers, and that's, I think, going to be the case going forward. As you're going to see, that's going to become more apparent in the pricing of the market, which is one of the reasons we think there will be more volatility. We think there's also going to be likely more issuance. We're actually seeing that right now. Some of that's probably trying to get ahead of the election outcome. And then I think the election itself is going to bring a fair amount of volatility. I think there's still some rate volatility to come. The Fed obviously has been very engaged in keeping zero interest rates on the front end. But what does that mean for the intermediate and longer part of the curve where so many municipalities issue debt? So, for all those reasons we believe the market had simply gotten ahead of itself and it had to get to a little bit better valuation standpoint, which it's beginning to do--may have a little bit more to go. But those are the primary reasons behind that.

Ptak: Given that, how have you constructed the portfolio to ward against some of those risks that you just mentioned? Maybe you can give an example or two of some measures that you've taken in the portfolio maybe at some of the typical dimensions like yield curve, duration, credit that some cladding that you built into the portfolio, so to speak, to try and ward against some of those risks?

Hayes: Credits are really important. When very early on we created something called the triage, or municipal sectors, and we've looked across the entire spectrum thinking about those that were going to be less vulnerable, somewhat vulnerable, more vulnerable, and most vulnerable. And we definitely have migrated, whether it's been liquidity, out of those more vulnerable, most vulnerable categories to up in quality. So, that's one.

Another is structure. I think structure is sometimes very underappreciated in the municipal market. It's a high degree of optionality in the market. Typically, the coupons can be a bit higher. Sometimes when the market gets ahead of steam, coupons tend to be a bit lower. But what happens is, with bonds priced to par and lower coupons, when the market sells off, those bonds vastly underperform, and the liquidity becomes a bit impaired on them as well. So, we focused on structure, owning higher coupon bonds which have a little bit of a defensive nature built into them in periods of volatility.

And the other, we just simply tried to take some off the table. We like to often pose a barbell structure and sometimes our barbell is kind of front end of the curve, longer end of the curve, where we can maximize income and keep duration dampened to some degree to try to minimize volatility. But in this case the front end of the curve is just so expensive. So many people are hiding out in one-, two-, three-, 4-year securities, it just doesn't offer really any value. And from that ratio relative-value standpoint you talked about versus Treasuries or corporates, front end is very expensive. So, we prefer cash. It may not be the most glamorous answer I can give you, but right now we think that cash will serve you well and will give you an opportunity to enter the market with better valuations in the weeks ahead.

Benz: Individual investors often gravitate to individual municipal bonds with an eye toward holding them to maturity. So, do small investors get a fair shake in the muni market, and what should they bear in mind before they buy individual munis? Are there any steps that they can take to ensure a better outcome?

Hayes: I think what I've found over the years--I've been doing this a while--and municipal investing seems to just be almost a personal choice for people. People like to own individual bonds. Remember, 30, 40 years ago, there actually used to be bonds and there would be coupons attached to them. You would clip that coupon off and you go to the bank and you get a check. I mean that literally is how bonds were treated. I think people like that aspect and that cash flow. And then, we obviously went to DTC. But I think the individual ownership aspect remained.

And then, there's others that say, “Look, I want a manager to manage my credit risk, and my diversification and do everything I can,” and they go into some type of vehicle like a mutual fund or a closed-end fund, etc. So, I think, it's how they're investing. Do they get a fair shake? I think they do. I mean, new issues have definitely gravitated towards a preference for retail individuals. In many cases, you actually have to give zip codes, so people that reside in that state, in that geography, have preference in getting new issue allocations. I think that a lot of times when they sell individual bonds, that's the difficulty. It is an over-the-counter market, and because of those 1 million CUSIPs and 70,000-plus issuers in the market, there can be a bigger bid to offer spread, particularly on smaller blocks of bonds that a lot of individual investors own. So, I think they need to think about that when they're buying the municipal bond. Might they need it for liquidity, might they have to sell it. If they don't, I think they're absolutely fine. If they may have to sell it, they may want to think about it, because that actually may erode some of the income advantage that they've earned by buying munis in the first place.

Ptak: For the closing question, maybe to widen out for a minute, do you find that there are still misconceptions about the fragility of the muni market among some investors? And, if so, what are those misconceptions?

Hayes: It ebbs and flows--that's the best answer I can give you. And I think it ebbs and flows with headlines. The individual investors are very reactive to headlines and we saw that a number of years ago with the 60-minute scare about widespread municipal bankruptcies, which we never saw. But they pulled a lot of money out of funds at the time. So, I think that there are still occasionally some misconceptions. But whenever you see something like in Puerto Rico, like in Detroit, etc., begin to get more attention in the press, then yes, they think the muni market is very fragile. The other side of the coin is that oftentimes there's a great degree of complacency. If we haven't had a Puerto Rico or Detroit in some period of time, often individual investors take more credit risks and they're really comfortable owning, and they get very complacent. So, I think there's kind of two extremes, but I think that a lot of it's driven by headlines as well.

Benz: Well, Peter, this has been a really illuminating conversation. We so appreciate you taking the time to be with us today.

Hayes: You're very welcome. Thank you so much for having me. I enjoyed it.

Ptak: Thanks again.

Benz: Thank you.

Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

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Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

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