Video: Technical factors driving active investment potential in municipal bonds

0:05

Keith Black

Hello, I'm Keith Black with RIA Channel, joined today by Whitney Sweeney, Senior Client Portfolio Manager for Macquarie Asset Management.

Welcome, Whitney.

0:13

Whitney Sweeney

Hi Keith, thanks for having me.

0:16

Keith Black

Macquarie Asset Management has a long history in managing municipal bond portfolios and has won Barron's Best Fund Families in the tax-exempt bonds category for two of the last five years.

Can you tell us how the team approaches the municipal bond market and how it may have influenced the launch of your second fixed income ETF, HTAX?

0:36

Whitney Sweeney

Yeah, I'd love to be able to talk about what the team is doing and how that's influenced launching HTAX, our high yield municipal bond ETF.

The team prioritizes generating a high level of tax-free income. There are two drivers of return, income and price, and income is the most significant component of total return over time. This plays out both in rising rate environments as well as falling rate environments. An investment process that emphasizes the yield component of total return mitigates price volatility. We're not saying that price isn't important, that it’s not an important piece of return. And we have a top-down macro view. But consistently delivering high levels of income is supportive of strong long-term returns.

Now you may not know this, but Lipper not only ranks managers on returns, but they also rank managers on income distribution within their peer groups. And that's what the team considers their scorecard. We've consistently been top decile or just outside, depending on the fund within our peer group, in terms of income producers across our municipal platform. And this is important to note, particularly as we talk about the high yield municipal bond space: we're doing that without leverage.

When we think about the ETF and why we launched it, our goal has been to make our municipal bond capabilities accessible to advisors in any wrapper that they'd like to use with us. So launching the ETF – as we said, the high yield municipal bond ETF or HTAX – expands access to our suite of municipal bond capabilities. We first launched our initial active ETF – this was a short-term tax-free ETF, STAX – and it was just really natural that we'd follow up with our flagship product, which is the high yield municipal bond fund.

2:20

Keith Black

How should advisors be thinking about active ETFs and why might now be the right time to invest in munis using an active strategy to capture opportunities for tax-advantage income?

2:31

Whitney Sweeney

Well, ETFs are an increasingly important part of the municipal market, capturing a larger share of municipal assets.

If we look at municipal bond inflows year to date, we are close to 90% of municipal bond inflows have gone to ETFs. That number’s moved around over the course of the year, but that's a big number. Close to 90% of municipal bond inflows have gone to ETFs.

Now what's really interesting is the dynamic between active and passive municipal ETFs. A couple more statistics for you. Active ETFs accounted for less than roughly 20% of ETF assets last year, yet they accounted for a little over 40% of the ETF inflows. So, a much smaller percentage of the overall ETF assets, but a larger percentage of the actual inflows. We're seeing that same thing again this year. If we look at active ETFs year to date, they're capturing roughly 60% of ETF inflows. So there's demand for active municipal ETFs, and it makes sense if we think about active management in the municipal market. The municipal market is inefficient. It's fragmented across thousands of issuers and over a million individual bonds. They're traded primarily over the counter, with no central trading exchange, and many of those bonds aren't even traded regularly. There's limited institutional credit research.

I've just listed a number of different inefficiencies, but those inefficiencies are what are creating opportunities for active managers to add value through the credit research that they're doing and taking advantage of market dislocations that just can't be replicated by a passive strategy that's indiscriminately replicating an index. And it shows in performance. If we look at actively managed municipal bond funds, they have outperformed passive funds historically.

4:21

Keith Black

And what are some of those opportunities that you're seeing as an active manager to exploit in the market?

4:28

Whitney Sweeney

Well, it's interesting. There's been a lot going on in the municipal market so far this year. The one thing I would say that really has driven a lot of the opportunities in the marketplace, and really some of the technical drivers of the market, is the status of the municipal tax exemption. This is something that was introduced in the beginning of the year with the list of “pay-fors” for extending the Tax Cuts and Jobs Act. It's really weighed on the market over the course of the year, as to whether or not the municipal tax exemption would be maintained. We're getting closer to certainty on that. It's not a done deal till the legislation is finalized or has been signed, but we're getting closer. That threat of that municipal tax exemption going away really hung over the market and a lot of issuers pulled their supply forward. So we had a lot of supply that was issued in the beginning of the year. We're actually on pace to be record issuance versus last year, which was also very strong supply.

We also had “Liberation Day.” So if we think about the combination of Liberation Day, the uncertainty around the municipal tax exemption, we had a seasonally weak period in the municipal market, and we created an environment earlier in the year where we saw elevated yields that we really haven't seen in quite some time. If we look at the long end of the curve specifically – this is where high yield paper tends to be issued – yields were reaching levels that we haven’t seen since COVID or the global financial crisis, and this is the really important part, is that you're getting these very high, very elevated yields, and it's due to a technical event, it’s not a credit event.

So, those dislocations that we talked about – supply being pulled forward, uncertainty around Liberation Day – it really created a technically driven event, where you saw some really exceptionally high yields that are not credit associated, which is a really interesting opportunity for us. So, it was a good time for us to be putting cash to work in the new ETF that we launched. I'll say, across our platform we took the opportunity to rotate the portfolio into higher yielding bonds. We were locking in higher book yields at the same time that we generated tax losses to carry forward.

The other thing that I’d point out is muni-Treasury ratios; they also remain high. This is the ratio of municipal yields relative to Treasury yields, and it's an indicator of when municipals are cheap or expensive relative to Treasurys. And they're cheap right now, particularly at the long end. So, absolute yields are high, muni-Treasury ratios are attractive, credit quality is sound. It's a really nice entry point into our marketplace.

And I’ll also just point out that 2s30s curve – looking at the steepness of the municipal bond curve – it's the steepest that it's been since 2017. So you're getting paid to be at the long end.

7:16

Keith Black

Tell us a bit about the high yield market in municipal bonds. What might be the opportunities there?

7:21

Whitney

Well, high yield is a small part of the municipal market. It's roughly 10-12%. And we talked a little bit about supply and the municipal tax exemption weighing on the market, and we're on pace for a record year in issuance as issuers pulled forward deals to get in front of potential changes to that tax exemption. But we haven't seen that in the high yield municipal paper. It’s actually down this year. And that sets us up for a strong technical, as supply is limited but there's still strong demand for high yield municipal paper. Flows to high yield municipal bond funds account for roughly 40% of flows year to date. So, a really strong technical, when we think of that limited supply but still strong demand for paper.

The other thing that I would want to touch on is the name “high yield municipals.” I think that's a bit of a misnomer. Municipals are a higher-credit-quality asset class. Across credit rating, municipals default at a fraction of the rate of the comparably rated corporate credit. And it's no different for high yield municipals. High yield municipals default at about a quarter of the rate of a high yield corporate bond.

Now the last thing that I’d touch on is performance. Investors have been rewarded for allocating to the high yield segment of the market with higher returns. If we look at annualized 5-year returns, high yield municipals have been the best-performing sector among fixed income sectors on a tax-adjusted basis, followed by high yield corporates and emerging markets (EM), both of which have very different risk profiles. So, for investors that are seeking to keep more income with a balanced approach to risk, high yield municipals may offer a good solution.

8:57

Keith Black

Thanks for sharing with us today, Whitney.

9:00

Whitney Sweeney

Thanks, Keith. I appreciate the opportunity to talk with you.