Podcast: Maximizing yield in a volatile market

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Podcast intro

Welcome to Think Again, a podcast by Macquarie Asset Management, providing financial advisors with a fresh perspective and innovative insights designed to keep you and your clients a step ahead.

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Denise St. Ivany

Thanks for tuning in to Think Again. I’m Denise St. Ivany.

Today I'm joined by one of our favorite guests, Greg Gizzi, Head of US Fixed Income and Head of Municipal Bonds at Macquarie Asset Management.

Greg, thanks so much for being here.

00:00:31 - 00:00:32

Greg Gizzi

Thank you for having me, Denise.

00:00:33 - 00:00:55

Denise St. Ivany

A recently published “Outlook 2025: Plan for growth, prepare for volatility” highlights actionable ideas for investors to focus on this year, and so today we'd love to have you talk about maximizing yield in fixed income and specifically the opportunity in municipal bonds.

Why don't we start, if you would, with a brief overview of the Fed policy changes at the end of 2024 and how these changes have impacted the market.

00:00:56 - 00:03:06

Greg Gizzi

So, the year did not end quietly, Denise. We had a fair amount of volatility and quite frankly that volatility was a confluence of factors that led to what I believe is maximum pessimism in the marketplace. Let's walk through what happened. If we go to the eve of the first rate cut in September, the 10-year Treasury was yielding 3.65%. On the eve of the election, we had seen rates already rise approximately 62 basis points to 4.27%. And then go to the end of the calendar year, we had risen another 30 basis points, 92 basis points higher than where we were on the eve of the first Fed rate cut. All because of exactly what I mentioned. It was a confluence of factors that combined to create uncertainty, and the one thing investors do not like is uncertainty.

So, what are those factors? Well, we've continued to see after the commencement of rate cuts, resilient economic data. Resilient economic data in conjunction with a Trump administration win. Many of the policies potentially adding or contributing to inflation cause the Fed to rethink the aggressive posture that they were embarking on in the markets. Recall we had a 50-basis-point cut followed by two 25-basis-point cuts. However, our contention is, depending on your view, this has really provided an opportunity for fixed income investors. Looking back over the past 15 years, all-in yields remain attractive, and that's not just in municipals, that is across fixed income in general.

The fear obviously investors have, you know, does the Fed have it wrong? Will rates head higher? And certainly, if we don't get the pro-growth bump from the Trump administration, are we going to see credit deteriorate or credit spreads widen out? And these are really the two main concerns that fixed income investors have today.

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Denise St. Ivany

With the Fed's policy shift and the normalization of the yield curve, why should investors consider reallocating out of cash?

00:03:13 - 00:06:00

Greg Gizzi

If we are correct, at some point the Fed will resume its rate cut moves and move toward what we refer to as the neutral rate, the rate that neither stimulates nor deters the economy. The neutral rate currently sits about 130 basis points below the current rate from what the median committee member thinks is the neutral rate for the economy. And quite frankly, if we just take the most conservative committee voter, it's still 70 basis points above that neutral rate. So, if in fact the Fed has done its job and inflation is contained and/or we start to see unemployment tick up, at some point we do believe that the Fed will resume rate cuts.

There are scenarios and I just mentioned it, if we did see a significant pickup in employment, or excuse me, unemployment, the Fed could become a lot more aggressive and not adopt this wait-and-see policy that we ended the year with. And the question I ask everyone, as an investor, is, do you want to lock in an attractive yield of say 4.25%, where the 2-year Treasury is, for two years, or do you want to lock in close to a 4.60% yield for 10 years, which is where the 10-year is trading, right? Because at some point that's really what we're referring to, is reinvestment risk. You’re going to lose the opportunity to lock in some of these attractive yields that we're seeing across fixed income.

One thing I should point out, it's a word on the technical, and it's pretty analogous across the fixed income complex. In 2022, we had record outflows in munis, $120-odd billion in outflows. If we look at the two ensuing years, in 2023, we saw about $15 billion worth of inflows come back into the market, and last year was a little bit more robust, about $40 billion. So, if we look at it, there's still more than half of the outflows that are still parked, I would argue, indecisively in the front end of the curve or in cash instruments. And again, what you're doing is embarking on potential reinvestment risk. I think the Fed and its wait-and-see policy is allowing investors time to certainly take advantage of those high yields, but at some point there could be an inflection point, and it'll typically be by some surprise data point or something exogenous to the markets that cause the Fed to get more aggressive. And I highlight the technical because there's going to be a lot of money chasing yields lower.

00:06:01 - 00:06:10

Denise St. Ivany

So, what is priced into the muni bond market and what are the biggest drivers for municipal performance? And then how does that set up for the rest of the year?

00:06:11 - 00:10:23

Greg Gizzi

The same factors priced into the muni market are priced into fixed income markets in general. So, what is that? It's a slower paced Fed, right? The Fed has adopted a wait-and-see attitude, scrutinizing all the data as it comes out, and we mentioned earlier in our discussion, Denise, that the economic data has been relatively resilient. Certainly, there's a pro-growth initiative. We've seen stocks post-election react positively. So, from a credit fundamental standpoint, it should not be a year where there's significant credit degradation for fixed income products, right? And then thirdly, tariffs. We know we're going to get some type of tariff, but I think for muni investors, in particular, we did get the release of a report from the House Ways and Means Committee, which was identifying for the Trump administration revenue-raising opportunities to extend the Tax Cuts and Jobs Act (TCJA) cuts that we saw back in the 2017 timeframe. And so, some of these are quite alarming if you're not a seasoned professional in the business.

Number one, first and foremost, the elimination of tax exemption. The elimination of certain tax preferences for private activity bonds, Build America Bond subsidies, or non-municipal bonds. Repealing the SALT (state and local tax) deduction entirely. Elimination of non-profit status for hospitals, and then a higher ed endowment tax for those schools that have access to the tax-exempt markets but have these tremendously large endowments – a tax has been floated for a while.

Our contention is with a thin margin in Congress, many of these are unlikely to really even pass through Congress, and really there are some devastating impacts that would result. For instance, from the outright elimination of tax exemption passing or eliminating the cheapest way for state and local governments to finance their budgets and certainly build infrastructure.

And just to put this in perspective, this is the fifth time we've already seen the threat to tax exemption in the last 15 years, on four different occasions during different negotiations, whether they were budget-deficit negotiations or debt-ceiling negotiations, and our contention is the same. We don't think this is going to eliminate. And just to put it in perspective, the savings associated with the elimination of tax exemption is roughly $25 billion a year over 10 years. If they were just to eliminate or not renew the TCJA tax cuts, that's a $4.6 trillion proposition. There's a tremendous mismatch in scale, but you know from an opportunity standpoint, credit is outperforming. It did in 2024, and as I think I've highlighted here, we're not expecting the economy to crash land or even have a soft landing, right? We continue to see growth. We have a pro-growth administration in and so from a credit standpoint, fundamentals should remain sound. And while credit spreads remain on the tighter side, I want to emphasize this again, if you look at across fixed income where all-in yields are, they are at or near the highs of where they've been over that 15-year time period. We're talking about a very, very attractive proposition for investors.

As we look at this year, in 2025, rates are going to peak sometime in this first or second quarter and then gradually grind lower to levels that will finish the year below where we started. While we're looking for some price appreciation, for us, the real opportunity in 2025 is going to be with managers that focus on income. Income will be the component in total return that will drive overall total return this year. So, we really recommend people focus on the lower-investment-grade or below-investment-grade tiers in the muni space.

00:10:24 - 00:10:25

Denise St. Ivany

So, is now a good entry point?

00:10:26 - 00:11:18

Greg Gizzi

I would use volatility as an opportunity to add to allocations. You know, like I said, yields are attractive, and they're not going to stay here forever. Think reinvestment risk. Credit, while trading on the tighter end of historical averages, I would argue given the state of municipal credit, state and local governments – and we've talked on your podcast before about the unprecedented amount of fiscal aid that was received by state and local governments – they're still riding the tailwind of that. We're not looking for any significant credit degradation, so spreads will remain tight, but you need to shift from thinking about spreads and look at where all-in yields are. That's something that I think investors have had a hard time doing. Just keep this in mind, the closer we get to the neutral rate, the greater the reinvestment risk for investors.

00:11:19 - 00:11:33

Denise St. Ivany

Very helpful. All right, so what about practical steps? What are the practical steps that investors should take to capitalize on the current yield opportunities, while at the same time managing risk, and how can investors stay informed and make these strategic decisions in a rapidly changing market?

00:11:34 - 00:14:49

Greg Gizzi

I do believe that, first, investors have to think about that reinvestment risk scenario. You know, a 4.25%, or if you did it when 2-years had a 5 handle, that’s really attractive for a couple years, but rates can be significantly lower at the end of your 2-year Treasury bill or your 2-year CD that you invested in. And we would advise that investors again use any volatility at all to start to scale into investments. We do expect fundamentals, and I want to re-emphasize this, fundamentals will be solid this year. So don't expect to pick a point where you're looking for credit spreads to widen by ‘x’ because that's probably not going to happen. I think what we see not only from domestic flows but also international flows that have been really robust as we turn the calendar year here into what quite frankly is the healthiest economy out there. You know, we continue to argue that you're going to almost have to put a blinders on and buy all-in yield where it is now because yields are not going to stay here forever. The wait-and-see approach, it's really afforded people the opportunity to take your time and do this. And like I said, I think you have a quarter or two before rates peak, so again, any volatility we would use to add to allocations.

Since return will be dominated, or total return will be dominated, by income, you have to find an income manager, right? And I would argue with anybody that the active manager has the skill set to really isolate those issues within a particular asset class to provide investors with that extra income or excess income to really drive total return in a year where it's going to come from the income component. So go out and hire an active manager and let them make strategic decisions for you, would be my advice.

The other thing I would say, not just having a muni hat on, just thinking about fixed income in general – and we've seen this certainly validated by flows thus far, similar in the belief that we have where the economy continues to do OK, no significant credit degradation, and the Fed has this patient view – bank loans or Floating Rate Fund…Floating Rate Fund should be, and is, seeing flows because that's a place that really sound credit and high yields will resonate with investors, and we are seeing flows into that space. So, I think, just in some, Denise, this is a unique opportunity. Yes, it takes a little bit of intestinal fortitude to realize you're buying when spreads are tight, but we haven't been in a spread-focused market now for two years, or over two years. I would argue we've been in a yield market, and that's why we're seeing the international flows. All-in yields are very, very attractive in the US, but remember that the opportunity's not going to be here forever.

00:14:50 - 00:14:55

Denise St. Ivany

Well, Greg, thanks so much for taking the time to share your insights and expertise, really helpful. Appreciate you joining us.

00:14:56 - 00:14:56  

Greg Gizzi

Thank you, Denise as always.

00:14:58 - 00:15:17

Denise St. Ivany

Don't forget you can read all the insights and analysis from our investment teams in the “Outlook 2025: Plan for growth, prepare for volatility.”

You'll find a link in the episode show notes, and don't forget to join us next time on Think Again, where we will discuss another topic for investors to consider.

00:15:18 - 00:15:28

Podcast outro

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