Travel’s Back but So Is A New Variant: What’s Next for Muni Investors?

By Brandon Brouillard and Nick Venditti

This podcast features a discussion around themes impacting municipal fixed income markets, including travel and the COVID-19 delta variant. To discuss the implications is Nick Venditti, Senior Portfolio Manager on our Municipal Fixed Income Team.

Listen to the podcast here

Brandon Brouillard: I’m Brandon Brouillard, and you’re listening to On the Trading Desk®.

We’ve got an exciting conversation teed up today around travel and the impacts of the newly emerged delta variant on municipal markets. With this in mind, we’ll be talking about three things that are deserving of investor’s attention right now. The first, impacts of the summer travel season on municipals; the second, opportunities and challenges created by the pandemic; and the third, what our Municipal Fixed Income Team is doing to position itself around these elements.

And with me to discuss these implications is Nick Venditti, Senior Portfolio Manager with our Municipal Fixed Income Team. Welcome to On the Trading Desk, Nick.

Nick Venditti: Thank you so much for having me, Brandon.

Brandon: Well, let’s get started with our discussion around something fun. Let’s talk about travel. After having been quarantined through much of 2020 and into 2021, I’ve got to think that one of the greatest hopes on U.S. citizens’ minds was the prospect of traveling once vaccinations started rolling out. So now, as vaccination rates continue to rise, how have you seen this impact municipal markets, particularly those closely linked to travel like airports, toll roads, infrastructure, and the like?

Nick: Definitely. Look, I think it’s been a pretty consistent theme across all markets, but certainly the municipal bond market, the idea of this pent-up demand. The idea that people have been largely locked in their house or locked in their communities for a long period of time and they are eager and willing to get out and go anywhere else. And we’ve seen that play out in the municipal space, particularly in sectors that are closely related to travel. Certainly, it’s true in the airports and toll road spaces travel picked up in the second quarter and throughout the summer of this year, but we’ve see ancillary effects in things like sales tax collections as consumers have gone out and spent money on new items or on things associated with travel.

Brandon: That’s interesting, and I would think that a lot of investors were anticipating this travel rebound. So how are you and the team able to source opportunity here, and what were some of the risks that you had to account for as you’ve been researching around and through this theme for the portfolios?

Nick: Since the beginning of the COVID-19 outbreak, I think investors were particularly concerned about sectors that were likely to get hit disproportionately hard by the economic slowdown, by the economic shutdown.

And in the muni asset class, we really saw that happen in some of these travel-related sectors, again, airports, toll roads, etc.

And as the idea of a reflation trade, a reopening trade started to percolate, we recognized that there was some significant opportunity to play in some of those sectors that sold off fairly heavily during the shutdown.

And so we positioned the portfolios pretty aggressively in some of those sectors, as they’ve really rallied on the reopening trade and, of course, the great benefit that economic stimulus, federal stimulus has provided to some of those issuers.

Brandon: It’s interesting and thanks for that color. So we’re about two-thirds or so through the summer, so this part of the travel season, I guess is going to be slowing down. Is that going to create any types of challenges or opportunities for municipal investors going forward or is that just too short-term of a window to look at this opportunity or this theme through?

Nick: I think it’s really going to depend on COVID delta and how that plays out over the next couple of months, because as you know, travel, particularly as it relates to airline travel, airport travel, is largely driven by business travel. And that is a sector that hasn’t yet rebounded as many of the finance and tech sectors are still in a work-from-home kind of environment. There haven’t been major conferences. There hasn’t been major business travel yet.

If the economy continues to open up, if we see work-from-home come to an end, and we see business travel start to ramp up more aggressively, it’s not going to matter that we’re coming out of the kind of summer leisure travel period.

But if COVID delta continues to hamper that type of travel on a go-forward basis, then I think you could see some disruption, some volatility around those types of names.

Brandon: You bring up the point of the delta variant, and it seems like every night on the news I’m hearing a discussion around this delta variant and the rise of this across the U.S. And so it seems as though breakthrough infections are happening, but that vaccinations are really helping with that. So how is the municipal team modeling the impact of this on its portfolios?

Nick: Look, municipal bonds have been on fire this year. They have performed very well. In fact, they’ve outperformed all of their fixed income brethren by a pretty significant amount.

It’s been a great year to be a municipal bond investor, but one of the risks associated with that that investors need to be cognizant of is that prices now are very high and in many cases, credit is priced to perfection. And it’s priced to perfection because of some of the things we’ve already discussed, right?

Federal stimulus has been incredibly generous to municipal issuers on the back of this, again, reopening trade. But federal stimulus isn’t perpetual. We cannot keep that going forever and ever and ever. And if COVID delta slows down the reopening trade, then some of these credits that are priced to perfection are likely to stumble a little bit.

And so when we’re looking at credit in the portfolio, when we’re looking at bonds on an issuer by issuer basis, we’re really trying to model in the ability of these issuers to withstand another economic slowdown should that occur under a more aggressive delta variant scenario.

Brandon: Gotcha. And piggybacking on that, education and healthcare are certainly sectors that could be impacted by any kind of prolonged stay of the COVID variants.

So you mentioned pricing and kind of things being priced to perfection. And so I wondered what is the team’s research revealing in terms of relative value across these types of sectors that maybe aren’t tied to a travel rebound but certainly could be impacted by COVID? I think like in the case of education, are reimbursements or subsidies at risk if attendance continues to be impacted because of virtual or students not being able to come in to the classroom because of COVID?

Nick: Yeah, I think that’s a very interesting point. Look, at the kind of secondary education level, that’s not necessarily a factor, right? We have to provide students K through 12th grade education in some degree or another, and so likely, they will continue to get support from local and state tax revenues and disbursements.

But I do think it’s a question at the higher education level, colleges and universities, and ongoing attendance in a more aggressive COVID scenario.

I think everyone is ready for schools to open up, both primary and higher education schools, but if colleges and universities can’t open up or if students aren’t as eager to attend, given some of those realities, then it puts continued strain on their balance sheets and income statements.

So again, in a world where credits are priced to perfection, in a world where we’re trying to extract relative value, one of the things we’re doing is we’re looking at credits that are all essentially trading at very similar prices. We’ve created almost a homogeneity risk in this market. Prices have driven up so much that all higher education credits are trading at the same level. All hospitals are trading at the same level. And that’s a little bit of hyperbole, but not as much as you would imagine. And the danger there is that we know that all higher education credits aren’t created equally, that all hospitals aren’t created equally.

And so the challenge for us on a day-to-day basis is to buy and continue to hold the diamonds in the rough and get rid of the rough, right? Buy and hold the best of the best and start to pare back those that are subject to volatility in kind of a worst case scenario.

Brandon: Excellent and thanks again for that insight there. And so shifting gears for a moment, I want to touch upon some market dynamics that I know have been on investors’ minds, like the low yield environment and tight spread environment. So what are yield curves suggesting today and what types of strategy are you all employing across the portfolios, given these scenarios that we’re facing today?

Nick: Every day I come to work and I ask myself a very simple question with a pretty complicated answer. And that question is are we getting paid to take risk? And if the answer is yes, then hey, let’s go take some risk. But if the answer is no, then we have to be comfortable doing the boring thing because the boring thing is the prudent thing.

And so if you look at my job and dumb it down to kind of two levers that I can pull to juice the risk, juice the yields, juice the returns in these portfolios, those levers are duration and credit.

I can buy longer-dated bonds and try to increase the yield of the portfolios that way. But as you mentioned, we’re living in a world where absolute yields are low. We’re living in a world where muni-to-Treasury ratios are almost as low as they’ve ever been. We’re living in a world where the yield curve is pretty flat. We’re living in a world where duration as a risk is expensive. And so when duration is expensive, maybe it’s prudent to take a little bit less duration.

So across the portfolios, across the complex, we aren’t actively bleeding out of duration, but we are letting the portfolios naturally drift down. That was a winning trade, we’re taking some of those winnings off the table.

And the same thing is happening on the credit lever. Credit spreads right now are as tight as they’ve ever been. Credit is as expensive as it’s ever been. And when something is as expensive as it’s ever been, it might be prudent to buy less of it. So again, we’re not actively bleeding out of credit, but we are being much more selective about adding it to the portfolios on an ongoing basis.

Brandon: Perfect. Well, so I want to take a step back for a second just to the municipal market overall. There are a host of considerations for municipal investors to think about, which you’ve outlined some of those and covered some of them today.

So I wondered, though, if you might share what the team’s learning from the technical environment. We know that munis have continued to have an excellent run. What’s happening on the issuance front? How is this impacting the market? I wondered if maybe you could just share some of your perspective around what you all are learning and informing yourselves from, given this technical environment that we’re experiencing right now in the municipal landscape.

Nick: First and foremost, I think we have learned that technicals can drive markets.

One of the interesting things that that we produce here, and that I’m sure others produce as kind of collateral to support investment decisions, is a periodic table of elements that shows fixed income asset classes and the yields available to them, right? Asset-backed, corporates, structured finance, tax-exempt munis, all of the fixed-income asset classes available to investors.

And if you look back at that periodic table over the last 6, 7, 8, 9 months, tax-exempt munis fell to the bottom consistently over and over again. That periodic table indicated that tax-exempt munis were the wrong place to be, and it turns out that periodic table was wrong over and over again.

It was wrong because tax-exempt munis in spite of the fact that they had a lower absolute yield outperformed all fixed-income asset classes except for corporate high yield by quite a bit year-to-date. And they’ve done so because demand for tax-exempt munis has been historic.

If we were to end the year right now at August 11, it would already be the third-highest inflow year in municipal bond history. Pair that with the fact that we have got this stimulus that has helped credit and all of a sudden, technicals have driven this market aggressively. And look, I think those technical factors persist throughout the rest of the summer and maybe into the first few weeks, a couple months of the fall.

But ultimately, fundamentals will win the day. And that’s true in any asset class over time. And so while technicals have been a very, very strong tailwind for municipal investors, I think it’s time for muni investors to reassess their holdings and make sure they know what they own, make sure they’re being paid for the risks they’re taking, because that is going to tell the tale for the next six months.

Brandon: As we wind down our conversation, I wondered if you could share a parting thought for our listeners on tailwinds, headwinds, or otherwise.

Nick: Know what you own. Look, again, not to beat a dead horse, but we’re in a market where risk is getting more and more expensive every day. Rates are low. Credit spreads are tight, but that’s true across all markets.

The reality today is that you don’t own muni bonds because they’re a home run. You own muni bonds for the reason you should always own municipal bonds. You own them because of the low correlation to equities. You own them, frankly, because of the low correlation to Treasuries, which we saw play out earlier this year when Treasury rates backed up. You own them for that tax-exempt income. You own them for consistent, durable income yield. You own them because they are historically a lower volatility asset class.

And as we approach the back half of this year, as we approach Federal Reserve responses to the economy and the uncertainty of COVID delta, municipal assets makes sense for almost every portfolio.

Brandon: Well, that’s an excellent way to close out and I appreciate you sharing a lot of these insights with us today, Nick. This has really been a just enjoyable and really informative discussion. So thank you again for making the time.

Nick: Thank you so much, Brandon. I appreciate it.

Brandon: Well, that wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from our investment teams, you can find them at our website or our Advantage Voice® blog.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you may subscribe to the podcast on iTunes, Stitcher, Overcast, Google Podcasts, and Spotify. Thanks for listening. I’m Brandon Brouillard and we’ll catch you next time.

Originally Posted on August 16, 2021 – Travel’s Back but So Is A New Variant: What’s Next for Muni Investors?

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