Animal Spirits Podcast - Talk Your Book: Why Rising Rates Won't Hurt You Anymore

Starting point is 00:00:00 Today's Animal Spirits Talk Your Book is brought to you by Franklin Templeton. Go to Franklin Templeton.com to learn more about their whole suite of active municipal bond ETFs. It's franklinthempleton.com. But learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Redhol's wealth management. This podcast is for information. informational purposes only and should not be relied upon for any investment decisions. Clients of Ritthold's wealth management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Michael tax alpha is all the rage these days. You know, I've been talking about it a number of different ways.

Starting point is 00:00:51 I still remember when Meredith Whitney came out with her call after she kind of, quote unquote, what did she, her thing was her claim to fame was Citigroup, right? She's like city groups going down. She shorted it. Yeah, yeah. And then after the Great Financial Crisis, she said, oh, she said, oh, she said. And for my next trick. Yes.

Starting point is 00:01:07 And she predicted that there's going to be massive defaults in the muni bond market. Was it Detroit? I can't remember. Did she single out cities? I can't quite remember. Yeah, I'm sure. Chicago's the one of people always talk about, maybe California. And obviously didn't happen.

Starting point is 00:01:21 There have been no huge problems. There's probably been some small ones. But this is an area of the market in municipal that I don't think there's a ton of people that cover it essentially. Would you call it the almost like the small caps of the bond market, just in terms of like coverage? Overlooked. Yeah, right, overlooked. But it's interesting because states actually are different than the federal government and how they have to spend and their budgets. And a lot of these are like revenue-backed bonds and such. But this is a space that you and I aren't experts on, obviously. But we have clients in unibunded funds because sometimes,

Starting point is 00:01:56 especially for higher income people, the tax breaks can be phenomenal. But, As we get into with Ben Barber, who is the director of municipal bond department at Franco Templeton, unity bonds are not just people with really high income, right? So he says. So he says. We talked a lot about the whole space, how to think about rising interest rates in the market. What else we talk about? A bunch of stuff.

Starting point is 00:02:19 We want to step on in here. Here's our talk with Ben and Barber from Francoe Templeton. Ben, welcome to the show. All right. Thanks very much for having me. Appreciate it. All right. Let's start here.

Starting point is 00:02:30 Over the last couple of weeks, the market has. increasingly become focused on the direction of interest rates up to the right at almost every area of the yield curve. I'm curious, how does, how do interest rates impact the municipal bond market? Yeah, absolutely. Great question and a great place to start. You know, the Muni market very much follows the treasury market. We like to say it doesn't follow it tick for tick, So it's not exact. There's always a lag between the muni market and the treasury market. And over time, you could actually kind of set your clock to how correlated the

Starting point is 00:03:09 muny market was versus treasuries. That correlation is broken down over the years for a bunch of different reasons. But overall, the muni market will follow the same general trends as the treasury market up and down the yield curve. I guess more specifically, like how reliant. I know this is a very dumb question, but hey, I never claimed I was smart than munibon market, how impacted are municipalities by interest rates today? I would say that they're very impacted.

Starting point is 00:03:36 So when we think about the two main angles of risk are the two main factors that drive price volatility in the muni market, it would be number one, interest rates by far and away, that's your most important factor in terms of what causes prices of bonds to move up or down. So it's number one, interest rates, number two, credit risk. So is the credit story of the particular borrower on a positive trajectory or a negative trajectory? And that's a factor as well. But interest rates by far is the most important factor in terms of what drives price volatility of muni bonds. And so if you're thinking about it from an issuer perspective, say the city of San Francisco or New York City needs to issue debt, issued municipal bonds to finance some sort of infrastructure project, they're very mindful of what's going to.

Starting point is 00:04:27 on in the overall interest rate environment before they get out there and borrow, you know, significant money. I'm curious how you think from a macro perspective about interest rates, because Michael and I have been talking that people are framing the rate rise as, oh, this is bad, right, because it's going to be harder for people to borrow, and it's going to be, it's going to make it more onerous for governments because interest expenses are higher. But I look at it from the perspective of a bond investor, and to me, it's short-term pain for more long-term gain. And we've for years fixed income investors were saying this is terrible there's no yield anywhere what are we supposed to do now yield is finally here but you just had to go through the pain to get there like

Starting point is 00:05:07 do you do you look at this as is more of an opportunity like man these are yields we haven't seen in a very long time potentially yeah without a doubt we look at it much more from the opportunistic side of things if you think about what has happened you know over the last several years when you were at a near zero, zero or near zero interest rate environment for quite a long time, there were many, many investors who just went to cash and say, you know, forget it. Rates started rising on the short end of the curve, and it was a very popular trade, was just to stay in cash as the fear of rising rates really precluded a lot of investors from pushing out the yield curve and taking on more interest rate volatility in their fixed income

Starting point is 00:05:51 portfolios. Now, here we are with a 10-year that's floating somewhere around a 460, 4-70 in 10-year treasury space. Right now, it is exactly at 458, but it's been sort of, you know, moving around in that general area. You've got 30-year treasuries north of 5%. And so investors are really, really waking up to that exact point that there's finally yield in the market. And it's a heck of a lot better than sitting in money markets, for example. And so we've seeing a lot of investor movement from cash and cash equivalence pushing out the yield curve as far as they're possibly comfortable. We've got a pretty good, steep shape to the yield curve. So for every year that you're willing to push out in terms of investing, you're getting compensated that much

Starting point is 00:06:38 more in terms of additional yield. So yeah, we definitely look at it as an opportunistic time. And from a risk perspective, it's funny because people were really worried about a recession when the yield curve inverted, right? Now the yield curve is under. inverted, and it's back to what I think is more normal-ish. If there is such a thing as normal in the yield curve, right, this is more normal, correct? Yeah, absolutely. I mean, we're talking about, you know, essentially 100 basis points of steepness in the treasury curve from twos to 30s, give or take. And so, yeah, that's a fairly normal shape of the yield curve. You want the yield curve to be upward sloping. You want those expectations set up that way, and that's exactly where we

Starting point is 00:07:17 are now. I think the fixed income market gets very uncomfortable in an inverted yield curve situation, which is where we found ourselves a couple years ago. So yeah, this definitely feels much, much better for investors to be able to push out a little bit beyond money markets and cash a cold type of investments. This week on the podcast, Ben and I were talking about how impactful the AI trade has been for capital formation. We're getting the SpaceX IPO, not exactly, you know, AI, but certainly some areas of it. Anthropic might be coming later in the year. But outside of just the equity space, I think, I can't remember the number.

Starting point is 00:08:02 It was like 87% of high yield issuance, some crazy number, and a lot of the investment grade issuance also has been related to AI. I'm wondering if you're starting to see municipalities be impacted at the local level, between like where AI, where data centers are being built. Does that infiltrated your headspace? It's definitely infiltrated our thoughts. You know, we've got a very large and experienced research team that works here. You know, right next to our team is basically half portfolio managers and traders and then half research analysts. We're a large team, roughly 27 people. And so, yes, the notion of AI and data centers and financing and capital structure, capital formation,

Starting point is 00:08:44 around financing all this stuff has definitely taken up a lot of our headspace. We think about it from a bunch of different perspectives, but one, when you think about municipalities specifically, you're really concerned about electricity usage and water usage and space. So there are certainly positives and negatives with regard to capital formation around building all of this infrastructure. But there's also on the risk side of things, a lot of water usage, a lot of electricity usage. And so municipalities are definitely having to plan ahead for that. You guys have a whole suite of municipal bond ETFs that can range in, you know, how aggressive they are the type of credit risk they take or the type of duration.

Starting point is 00:09:31 Are any of these like go anywhere funds that kind of can go different durations or do you have pretty strict guidelines for the types of bonds you can buy in these funds? The answer is yes to both. You know, many of our Our Muni ETFs that we have here at Franklin Templeton are very specific. They're state specific, and they are generally market duration type of funds, mostly investment grade. So that's the largest number of ETFs that we manage here. But yes, we do have a sort of quote unquote go anywhere, muni ETF. It's called the Franklin Dynamic Muni Bond Fund and Muni Bond ETF.

Starting point is 00:10:09 And the whole notion there is that we have a little bit more flexibility on the portfolio management side to move around duration, which is your interest rate volatility side of things, as well as credit risk. So we can move both of those levers as we see opportunities in the market. That's sort of our best, quote unquote, best ideas, munibon DTF. I'm curious where you're seeing that now, like, are you moving out on the duration a little bit because those yields are higher? it seems like credit spreads for corporate bonds are pretty tight. Is it pretty similar? The spreads pretty similar in Munis as well. Like, where are you guys finding value these days?

Starting point is 00:10:46 We see a lot more opportunities in the Muni market than certainly that I'm hearing from my colleagues than the rest of fixed income. We spent a lot of time with the other asset classes around fixed income, and we continue to hear spreads are either at or very close to all-time tights across many of the different fixed-income asset classes. That's not true in Muni. So I think from an opportunistic perspective, from a yield, you know, we think about it a couple different ways, overall duration and yield curve. And so to your point, yes, we're a little bit further

Starting point is 00:11:17 out duration-wise than we are normally. We're trying to get access to that 20 to 30-year portion of the curve, which is the steepest portion of our curve right now and quite attractive from our perspective, as well as on the credit side. So we're pushed down a little bit more on the credit risk side of things. So taking on a little bit more credit risk than we ordinarily would because credit spreads from our perspective are very attractive in munis. So we have not had nearly the tightening that other asset classes have had across fixed income. You've mentioned credit risk a number of times. I'm curious, what does that mean through the lens of municipal bonds, what does lousy credit look like? I would imagine that these are not things that change

Starting point is 00:12:05 rapidly. I would imagine it's like a very slow moving, you know, upgrade, downgrade cycle. So what does that all look like? Great question. I think one of the things that people think about with regard to the municipal market is they think about states and cities and counties as being the issuers. And that's absolutely true. However, there are. dozens of other sectors within the municipal market that have different elements of risk, that some of which have nothing to do with the state or the city or the county where that bond is being issued. So there are lots of sectors around the utility sector, water and sewer, electric authorities, et cetera. There are several different sectors within higher education, whether

Starting point is 00:12:46 it's private schools, public schools, you name it. There are lots of different transportation sectors around toll roads and bridges and ports, airports. Even airlines can issue debt in the municipal market if they're doing infrastructure at airports. And so you're taking on an airline credit risk. There are lots of different health care sectors, for example, non-profit acute care hospitals, their retirement centers, et cetera. And these all have different types, different elements of risk, different drivers that affect the economy, that will affect these sectors in different ways. And so what does credit risk look like in the municipal market? Well, you have to take it sector by sector.

Starting point is 00:13:26 Default rates are very low in the municipal market overall, but they do exist, most specifically down in the below investment grade high yield portion of munis. Even in that space, defaults tend to be much, much lower than defaults in the corporate high yield space, for example, and recoveries tend to be higher than they are in corporate defaults. It's a fascinating market. I've loved it for my, you know, for my decades in the municipal market because it's so nuanced, specifically, it's pretty illiquid in terms of, as you go down the credit spectrum, it's very inefficient as an asset class overall. And so that creates lots of opportunity for us as institutional managers. It seems like once every few years, someone comes out

Starting point is 00:14:12 with a proclamation that the states and municipalities are all screwed and these good luck with these muni bonds, right? Meredith Whitney was the most infamous one back in the day, but a lot of people say this, and they picked certain, you know, cities or whatever states. What do you think are some of the misnomer's about this, about these types of bonds that people don't seem to understand? Because it is kind of like, you know, the U.S. government debt where people are constantly predicting there's going to be a crisis, and then one never comes. What is it about mutinies that people want to predict a crisis, but it seems like there just hasn't been, you know, many waves in this space. Well, I think there are two things that really stick out. And we, you know, we had to answer this

Starting point is 00:14:53 question quite a bit in the aftermath of the GFC thinking through, you know, I was getting the question. I remember, you know, what's going to be first to default? Is it going to be Portugal, Ireland, Greece, Spain, or the state of California? And I was being asked this question by a lot of folks that were not, you know, experts in the municipal market. And it was really interesting when we kind of thought, through different ways to explain the overall strength of the credit fundamentals in the municipal market. Two things really stood out to us. Number one is that states have to operate with a balanced budget. That's a mandate for every state in the country, with the exception of Vermont. But every other state has to operate with the balance budget. It doesn't mean that gaps and

Starting point is 00:15:37 deficits don't get created. Of course they do, but they have to have that discipline of coming back into balance at the state level. Not true at cities and counties or other sectors that I mentioned earlier, but at the state level, which is a major, obviously major borrower in the municipal market, that discipline of having to have a balanced budget is very, very important. That's number one. Number two, in general, remember that with municipalities, we're providing financing for public infrastructure, and that infrastructure will have an average useful life. Say it's a bridge or a school or a hospital, call it 30 years average life before, you know, major reconstruction needs to be done. Municipals amortize their debt generally in line with the average useful life of whatever asset

Starting point is 00:16:22 was being financed. And so that's another critical difference. When you think about the post-GFC time and Greece and other countries in Europe having to face the capital markets at a time where the capital markets weren't terribly happy to lend more money, they had these walls of maturities that were impending. In minisibles, you don't really have that because you are constantly amortizing your debt, meaning you're paying down your debt. So if you borrow a billion dollars to build a bridge, you won't have a billion dollars that's due in 30 years. You'll be paying that off through serial maturities or sinking funds, but you're paying down that debt over time over that 30 years. So in year 30, you might only owe 50 million left or 100 million left, not a billion dollars.

Starting point is 00:17:05 And that amortization of your principle of minors, of minors, municipal bonds is critical to think about the overall credit strength of the municipal markets. I'd say those two things. Number one, the balanced budget discipline and number two, the amortization in general of municipal debt, you know, in line with the average useful life of the assets. So those are two critical features. As you're thinking along these lines in building a portfolio, how do you think about different areas of the curve and different durations and attractive opportunities? How does that all filter into your process at Franklin? That's a very iterative process that we have between our portfolio management staff and our research team.

Starting point is 00:17:46 Because, you know, it's sort of the beauty of the municipal market is you've got the highly quantitative side, which is just your straight up bond math, which is kind of what you're referring to. Where's the value in the yield curve? Whereas it's the steepest, where's the best roll down and that sort of thing. Those are critical features of just straight up quantitative bond math. On the other side, you've got the creative side of what's required to research properly. these different sectors from a top-down perspective and then from a bottom-up perspective, thinking about individual security selection. Those are the critical features of how we analyze the municipal market, how we go about building portfolios is very specific. So if we're talking

Starting point is 00:18:25 about an ETF or an open-end municipal bond mutual fund, both of which we manage here at Franklin Templeton, it's all going to be about the target, the goals of that specific fund that we're managing. Same sort of thing on the SMA side, the separately managed account. side where we have very customized goals for our clients. So it's all about the target. What do we have to work with? What's our risk budget stipulate for us with regard to interest rate risk? And then we go about building the portfolio based on the best value in the yield curve to get us to that duration number at the end of the day. Same sort of thing with credit risk. So within the same vein, how do you think about it? Maybe this is not your job per se,

Starting point is 00:19:04 but I'm curious, you obviously talk to a lot of clients, advisors and their clients, Are municipal bonds only for high-income people in high-tax states? I'm really glad you asked that question. I think that's the biggest misnomer that we've got in our market is, I think the answer is that munis are attractive really for any investor in the U.S. that's paying any sort of taxes, any sort of income taxes. It depends where you are on the curve, but it's very easy to look at the after-tax analysis and say, here's the yield on a muni, tax-free.

Starting point is 00:19:39 here's the yield on a corporate or a government bond. And here's how we line up from a credit perspective as well as from a duration or interest rate risk perspective. And to take a look at the aftertax analysis. And what you'll see is as you push out the curve from one to 30 years when you get longer, longer on the maturity spectrum, the term structure, munis get more and more attractive on a relative basis. So looking out in that 20, 25, 30 years of maturity, it's very difficult to compete with, municipal bonds across any other fixed income asset class that you might see on an after tax yield perspective. And even down in the shorter portion of the curve where munis are less attractive

Starting point is 00:20:20 on an after tax basis, given the overall, you know, very, very high credit fundamental, you know, potential of munies, it's, you know, you can even find munies down on the short portion of the curve that are attractive on an after tax basis when you really compare credit to credit and try to get to an apples to apples comparison. So I think munis are for sure attractive to high income people, but even those in a lower income bracket, lower income tax bracket at the federal and or at the state level, there's quite a bit of opportunity in the municipal market. I'm curious how you explain that because Michael and I have noticed in wealth management that, especially in last few years, the tax alpha thing is a real thing that clients are coming to us

Starting point is 00:21:04 with and asking for. They understand better than ever that it's not your gross returns that matter. It's your net after taxes, after fees. That's the only thing that matters. What's, what's in your pocket? And municipal bonds have this interesting feature that it's, it's almost like phantom savings, right? Or phantom yield. And so you have to show this tax equivalent yield to show people, like put them on the same wavelength, right? Because it's, the taxes that you're not paying on this income versus taxes you are paying on other types of bonds. I'm just curious how you go about presenting that idea to show these on a one-to-one basis, to show, like, the attractiveness.

Starting point is 00:21:36 Yeah, we definitely had a lot of conversations with clients around tax equivalent yields. Very easy math to do. Just looking at any sort of taxable bond, whether it's corporate bond or government bond, whatever the range of taxation is, take that off of the yield to get to a taxable, you know, to get your tax equivalent basis. Or you can gross up the muni yields to get to a taxable equivalent basis. Either way you want to do it, you can get to apples to apples on an after-tax basis, which is critical for that analysis.

Starting point is 00:22:12 So we do that quite a bit. The other angle of tax efficiency that is really attractive in municipal's is tax loss harvesting. And here what we're talking about is if we invested today and rates go down, we all know that the price and yields are inversely correlated. So if yields go down, prices rise, you're sitting on an unrealized capital gain. we'd be very reticent to have turnover in that situation because the last thing we want to do is book a capital gain, investor has to go out and pay taxes on that capital gain. Conversely, if we invest today, rates go higher and we're sitting on an unrealized loss in a separately managed account, we would be very incentivized to book that loss, that loss flows directly through to the bondholder, to the client that they can use against gains they might have in real estate or equities or whatever. But that loss can be very, very valuable. The key to this whole transaction in Munez is that to get around the 30-day wash sale rule,

Starting point is 00:23:13 which is if you sell Cisco at a loss, you can't go back into the market and buy Cisco back within those 30 days. Otherwise, it's a wash sale. In Moneys, because you have so many different attributes to what a Muni bond is, you've got the issuer, the coupon, the call, the maturity, all of which can be slightly different to escape that 30-day wash sale rule. And so it's a very efficient asset class to take tax losses as well as obviously providing the very attractive yield on an after-tax basis. Do you think there's any particular wrapper for the investor that is better than the others, whether it's an SMA, mutual fund, an ETF? It's really interesting. We do all three here at Franklin Templeton, very large and growing, circular managed account business, ETF.

Starting point is 00:24:00 We have lots of different stripes and varieties of Muni ETFs. And the history of the Franklin Muni Group, of course, is in open-end municipal bond mutual funds. So we have loads of those state-specific, as well as national, all sorts of different risk, et cetera. It comes down to client preference, which is, I think, you know, what I'm most proud about with this group is that we were able to offer all of our capabilities in municipal's in all three of the major wrappers. I don't think there's a one-size-fits-all here type of situation. I think every client is going to be a little bit different in terms of their tax sensitivity, in terms of their desires around duration and credit risk. Liquidity in open-end funds, obviously, is daily with muni ETFs.

Starting point is 00:24:47 It's intra-daily, which is an advantage for some people. In SMAs, you own the individual bonds as a client. And so that's very attractive for people as well. It really depends on client goals, but I'm really. really happy that we were able to provide all three of those major rappers to clients. You know, we don't hear that argument too much these days, which is, I like individual bonds and I hate bond funds. I'm sure that drives you nuts because we know that a portfolio of bonds, it doesn't matter if you own the individual bonds are not their own somewhere. And it's the

Starting point is 00:25:19 exact same thing. But whatever, you can't change human nature. I don't have a question. That's more of just a comment. Do you have any thoughts on that? Well, I do. I think it's an excellent comment because it's spot on. And I think the really interesting part of that comment is in periods of interest rate volatility, specifically in an interest rate increase in environment, like 2022 was, you know, worst year on record for total return in the municipal bond market. It was just, you know, rates were going higher and higher and higher, 200, 250 basis points in different portions of the curve. So it was a very difficult year from a total return perspective in 2022. very typical response from shareholders of open-end funds historically was to sell the losing asset class and buy the winning asset class.

Starting point is 00:26:08 And so in a year like 2022, rates rising, NAVs falling, and shareholders redeem like crazy out of open-end funds. That was a record-breaking year from a redemption perspective from open-end funds. So our open-end funds were getting liquidated, getting redeemed, just like everyone else's. our SMA business, very interestingly, every month in 2022 was positive net flows in 2022. And I think what you just hit on was exactly it. And that is the difference in the psyche of the retail investor. Wow. With open-end funds, they can tend to be, you know, kind of flighty with SMAs.

Starting point is 00:26:43 Kind of the theory is if I liked this investment at a 2% yield, I should love it at a 4% yield. And I'll give more money. And so we found that the investors over. Lots of different cycles that we've been managing money in all these formats have been very good and responsive and really opportunistic in the SMA space. So you've been doing this for a long time. I've had this talk with Michael before that I think that investors are actually becoming better behaved at this kind of thing.

Starting point is 00:27:12 They're not running from the burning building anymore. They're running into it, right? Have you seen that over your career where people are more apt to put money in when you get something like that, a downturn and yields go higher? and they're better understanding what this means? Well, I think education is critical to that exact question. And so that's why I'm very appreciative to be on this podcast today. Because the more information, more education we can provide to clients, the better investors they will be.

Starting point is 00:27:40 And to your exact point, you know, rates rise, we don't want people to be scared. We want them to be, you know, think on the front foot. And maybe this is a better environment for them to put money into fixed income. and in particular munies. And the whole key here is we know that rates are going to move up and down. We know that that's going to cause price volatility. That's a given. And we also know, and we fully acknowledge as fixed income portfolio managers,

Starting point is 00:28:03 we can't guess interest rates correctly every single time. No one can. No one ever has. And so the key is, you know that's coming and let's take advantage of it. So rates rise a little bit. It might be a great time to tax less harvest. It could be a great time to put more money into, you know, extend more capital, more of your asset allocation into fixed income at that moment with a higher

Starting point is 00:28:25 rate environment. So yeah, I do believe that investors are smarter, more well-informed, but the more the merrier in terms of education and, you know, client interaction. Ben, where can we send people learn more about your funds? Well, Franklin Templeton has a very good website. There's a lot to do there. You can look specifically into the municipal bond group. We're very happy to connect, and there's lots of information online for sure. All right. Thanks so much for time, Ben. Thank you.

Starting point is 00:28:57 Okay, thank you to Ben. Remember, check out Frankent Templeton.com to learn more. About all our active mutiny ETFs and more, email us, animal spirits at the compound news.com. Investors should carefully consider a funds, investment goals, risks, sales charges, and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money. Investments involve risk, including possible loss of principle. Please see each product's webpage for specific details regarding investment objective, risks, performance, and other important information.

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Animal Spirits Podcast - Talk Your Book: Why Rising Rates Won't Hurt You Anymore

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