The Benefits of Active Municipal Bond Management

Transcription

1 The Benefits of Active Municipal Bond Management May 21, 2017 by Robert Huebscher of Advisor Perspectives Robert DiMella is an executive managing director and co-head of MacKay Municipal Managers team, which he manages jointly with John Loffredo at their Princeton, New Jersey office. Together, Robert and John oversee a team of ten municipal bond specialists with a focus on all aspects of the group s business, including oversight of portfolio management and research, as well as client relationships and product development. The team works by looking at the economic landscape, policy and market technicals and determines the impact these factors have on the muni market. In total, as of 3/31/17, MacKay Municipal Managers (MMM) team's municipal bond assets total $20 billion, this includes the MainStay Tax Free Bond fund (MTBAX). Robert has been a municipal portfolio manager and municipal analyst since 1993, with a broad range of experience in portfolio management and research in the municipal markets. Robert joined MacKay Shields in July 2009 when the firm acquired the assets of Mariner Municipal Managers LLC, where he served as president and co-founder from 2007 to From 2006 to 2007, he was a managing director and co-head of BlackRock s Municipal Portfolio Management Group. Prior to BlackRock s merger with Merrill Lynch Investment Managers, he served as a senior portfolio manager and managing director of Merrill Lynch s Municipal Products Group, where he worked from 1993 to Robert earned his MBA at Rutgers University Business School and BS at the University of Connecticut. He is a CFA. He has been working in the investment industry since I spoke with Bob on April 27 at the Morningstar Investment Conference. What is your role in your organization and what areas of the muni market do you focus on for financial advisors? I am the co-head of the MacKay Municipal Managers (MMM) team. We manage all of the municipal bond products for the umbrella company under New York Life. Therefore, we have mutual funds, private funds, closed-end funds, and separately managed accounts for clients. My specialty within that group is investment-grade strategies. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 Which segments of the market do you focus on to serve financial advisors? MacKay Municipal Managers sub-advises the MainStay lineup of municipal bond funds offered to financial advisors and we set ourselves apart as an active manager. We focus on investment-grade and high-yield municipals as well as specialty states such as California and New York. As a longstanding institutional investor, we tend to focus on segments of the market where access for many investors may be limited. The landscape has changed for financial advisors where direct access to the municipal marketplace with individual bonds has become problematic. Many advisors use us as a complementary strategy to some of the more traditional approaches that many clients have taken over the years. As an example, for clients with traditional separately managed accounts (SMA) or a laddered portfolios, we explain it to the advisors and say, That s fine. It has some limitations and here is a product like our MainStay Tax-Free Bond fund (MTBAX) that may help overcome some of those limitations. Your client has the potential to pick up income, pick up total-return capability; in addition to that, he or she may pick up diversification and liquidity. Some clients may not want to sell an individual municipal bond out of an SMA, so they can look to a mutual fund to augment what they are doing and add that type of liquidity feature into the mix. It is an asset allocation process. With all of our products, we complement the advisor s approach, shed light on where we think the value is in the municipal marketplace, and deliver that to their clients. Clients may reach a better riskadjusted return profile by taking this complementary approach. In your most recent commentaries, you identified five key legislative initiatives that could impact the muni market: tax reform, repatriation of corporate taxes, student loan financing, deregulation of corporate actions and healthcare reform. How has the uncertainty surrounding those initiatives and the federal budget affected the muni market? The municipal marketplace often comes under significant technical pressure. Behavioral finance plays significant role in the municipal market because the average retail investor is risk-averse and they don t want to lose money in munis. They take a very conservative approach when gaining market exposure while reacting quickly and broadly to market events. Therefore, any headline news gets priced into our marketplace, most likely to an extreme, either over- or underpriced. We have published our insights every year since Our theme for 2017 is titled, Rebuilding America. Policies are going to come, they will evolve over time and they are going to impact all asset classes including the municipal marketplace. However, it doesn t mean it s all going to at the same time in one, uniform direction. As an example, take tax reform. We believe tax reform is going to happen probably not a big tax reform policy, but a more modest version than what the administration wants to implement. We believe Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 tax cuts will materialize and we may see more than that. But the marketplace started pricing in this approach last fall that if you have an extreme tax reform coming, it will severely weigh on demand for munis. We see it differently and believe the market is pricing in tax reform to an extreme. There are things you can do to actively navigate and capitalize on these mispricing in a fund strategy to take advantage of that. That s what we do as a team. Tax reform is one example. Healthcare reform is another. We believe our marketplace priced in a repeal and replace of the Affordable Care Act. I don t think they are going to repeal it. They will change it and modify it without question, but the marketplace has priced in to extreme, early on. Hospitals and healthcare systems in municipal bonds came under significant pressure last fall. We increased our exposure to health care when it came under pressure, because we didn t think it s going to be a full repeal and replace. The day after the House failed to do anything about it several weeks ago, hospital credits within the municipal marketplace rallied substantially. We capitalized on the opportunity and sold into it. We suggested advisors talk to their clients and say, Listen, things are going to change; things are going to evolve. These policies that are implemented are going to die probably 10 deaths before their ultimate solution is going to be put into law. Therefore, take an active approach. Take advantage of these swings in the marketplace. I haven t studied the Trump administration s proposal that came out yesterday, but it s likely that federal tax rates will come down, but not necessarily state rates. Will the decrease in federal rates make munis less attractive, and will state income tax rates have a bigger role in the muni market? Taxes are going to come down, but the extent of the reduction surprised us a bit. You are absolutely right, there wasn t a lot of detail yesterday and the primary focus was on high level themes related to tax reform. What surprised us was the upper marginal tax rate was only coming down to 35% since many were saying it will likely go to 33%. But Trump was simplifying the code, and he was also changing some of the deductions. He s keeping in mortgage deduction and he s keeping in charitable contributions, which is interesting. That was something the people thought was going to be on the table. What he eliminated was state and local taxes. On the margin that helps the municipal bond marketplace because now you are taking away the deduction that high-residence and high-tax states use to help their tax liability which we believe increases the demand for in-state taxable municipal bonds. On the margin, that s positive. We emphatically believe we will have tax reform. The ultimate solution is not likely to be as severe and extreme as what the market wants to price into it. Therefore, we expect to have a relief rally, and it s not going to be this huge problem that the municipal marketplace is going to have to address. You wrote about public-private partnerships (P3s) and that they ll play a role in the new Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 administration s infrastructure plans. What effect will that have on the muni market? This is a key insight for 2017 and we believe innovative financing in 2017 accelerates. Everybody knows about the aging infrastructure in the United States. Everybody knows we need a massive amount of dollars to upgrade it. Historically, the municipal marketplace financed the infrastructure in the United States, which is very different than in rest of the world. State and local governments can t possibly afford it on their own. You need some innovative financing ideas and strategies. P3s are not brand-new to municipal marketplace. We ve had some throughout the country. If you look in the greater New York City area, we have the Tappan Zee Bridge replacement that used the P3 structure. The LaGuardia Terminal refurbishment is also a P3 structure, as well as bridges and tunnels in Ohio. It is gaining prominence, but it is really small on a relative basis. Expanding that only makes sense. The President, as a developer himself, fully understands that how you finance something is critically important and the P3 structure provides for that. It s a positive for the municipal marketplace, because without it the debt would hit the municipal marketplace, increase supply, and drive down prices. But if you can expand it and tap into capital from other sources, then you re spreading out the cost of this infrastructure. That is a huge positive development with a strong possibility of happening under this administration. With the proposed deregulation in the banking industry, more capital is likely to be available for trading and investment. Will that increased liquidity drive down muni prices? There is going to be some scaling back of banking regulation. They are not going to completely eliminate Dodd-Frank, but they are likely to scale it back. The capital dedicated to the municipal marketplace, since the financial crisis over the last nine-plus years, has dropped considerably and have caused a significant reduction in liquidity and increased volatility. If we see deregulation in the future, this would free capital from the banks and liquidity would improve on the margin. We believe liquidity is going to improve, but only for rated securities. We think non-rated securities will still be problematic for banks to increase their exposure, and, as a result, there will be a bifurcation in the municipal market. The business model of the banks has shifted from a proprietary principal trading model to an agency model. They are still going to be in a largely agency model, but they ll expand their ability to do a little more slowly over time. It really doesn t have a direct impact on prices on an intraday basis and instead surfaces when you see these periodic technical dislocations in the market. For example, when you are a forced seller in a dislocated marketplace and there is nobody there to show you a bid, the velocity of prices has been a lot higher over the last several years than it ever has been. That should abate somewhat. But increased liquidity does not mean municipal bond prices are going to go up. Where are spreads in the muni market relative to Treasury bonds and relative to where they Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 have been historically? What direction you expect them to take? Look at the historical norm of relative value metrics in the municipal marketplace, the ratio of AAArated munis over Treasury bonds. That takes out credit risk, which is a good way of looking at it from a relative market pricing perspective. That is the ratio trade. I will use a 10-year maturity as an example. The municipal marketplace is trading between 90% and 95% of the Treasury marketplace. Historically, it s closer to 75%. So today we are trading cheap. We normally are trading cheap in a low-rate environment to begin with, for a whole slew of different reasons. Slowly over time that ratio should glide down from 95% to 75% which, by definition, municipals would outperform Treasuries. It is important and helpful for clients in a diversified fixed income portfolio, regardless of what tax bracket they are in, which is a key distinction, to increase their allocation to munis. Muni yields and Treasury yields should not be so close to one another at 95%. With the upper marginal tax bracket today at 39.6%, muni yields are not factoring in a tax discount. I don t think any discussion about the municipal market would be complete unless I asked you about the pension fund situation and how that might unfold. Where do you expect distress to show up and to have its greatest impact, and when do you think that will happen? This is another topic we ve talked about in our insights considerably over the last several years where the themes are built into our suite of MainStay Municipal Mutual Funds. We have an overweight in revenue-backed bonds. We are telling clients, Go after dedicated cash-revenue streams. It s easy to analyze them. As an example, we love transportation-backed bonds. That is a long-term play for us. Underweight general-obligation bonds and tax-backed bonds, because those are directly the bonds that have the pension and healthcare liability issue. But keep in mind, general-obligation bonds only represent about 20% of our marketplace, so the pension and healthcare problems of the municipal marketplace are the tail wagging the dog. But having said that, they are real. We still have the state of Illinois to deal with; New Jersey is right behind it; and Connecticut is right behind that. The Market is still vetting out Puerto Rico and their issues. When working with professional managers, it is important to have a good handle on the underlying credits and whether or not the bond is wrapped with insurance. It s not as big of a concern as it was a couple years ago, but it is still a lingering concern that has to be addressed, and so it s a real problem. The bigger problem is if we go into recession sooner rather than later. If we do, then this problem becomes more severe and the municipal marketplace, from a long-term health and pension liability perspective, is a long-term liability. As long as the economy is growing somewhat, we believe the muni market should be well-positioned. You don t need robust growth, but you need some growth which provides municipalities with some flexibility to work on the solution. But if the economy suffers and revenues drop-off, it gets much more difficult for municipalities. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 The way we look at our MainStay Tax Free Bond Fund (MTBAX), it is about fundamental credit analysis. It is about relative value and in that analysis, we factor in politics. In a recession, it s very difficult for elected officials to cut expenditures when revenues are dropping. That s not a forecast for a recession; it s an issue that you should think about when you are thinking about this overhang of pension and healthcare liabilities. The reason unfunded liabilities haven t been as acute in the last couple of years as it had been before is that rates have gone up a little bit, so it s made the funding ratio a little more favorable. Somewhat, but there are two reasons why this has abated. First, the economy has stemmed its decline and has been growing somewhat. Just as important, we have had 43 or 44 states enact pension reform. While many have worked on pension reform they will need to continue doing so to make additional improvements. You ve actually had a lot of structural changes in the municipal marketplace. You don t have this impending illiquidity problem and therefore a default problem. So you are hearing about it less and less. When it does happen it is not this draconian-type of workout situation that everybody was worried about. Look at Detroit and how they vetted out those problems. Where are the opportunities going to be for active management in 2017? Many of our insights, not only from this year but over the last couple of years, are still built into our portfolios. We are an active shop. We are very transparent in how we manage our mutual funds. If you have read our insights, know that we have implemented the ideas in our portfolios. That is unique. A lot of people in the municipal marketplace like publishing information, but it doesn t show up in their portfolios. We are active managers; it s in there. We are overweighting high-tax states in our portfolios. If you look at liquidity improving on rated securities, but not non-rated securities, we are underweight in non-rated securities. Last year we overweighted tobacco, as well as the year before that and we still maintain an overweight in the portfolio. We come up with five insights each and every year, but we don t have just five strategies in the portfolios. We over-weighted health care when it came under pressure after the election, and reduced again after the appeal failed. That doesn t show up in an insight, but it shows up in the portfolios. It shows up and you can track our relative exposures in our portfolios over time. My job is to educate advisors and have enough information for them, so they can talk succinctly to their client, and have some conviction in what they say. Transparency is tantamount in that. If I don t have transparency then I won t have confidence from that individual. They are not going to talk about going after the municipal marketplace. How do you help advisors with asset allocation? We do a lot of asset allocation modeling for advisors and ultimately their clients, to give them an idea Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 where the relative value is and how they re municipal portfolio should be allocated across the entire spectrum. This is something that is lacking in the municipal marketplace. We publish it on a quarterly basis. I think it s incredibly helpful, not only for national investors, but also for specialty-state investors. It pushes forward the idea to goals-based investing in the municipal marketplace, whether your client is looking for capital preservation, purchasing power preservation or simply long-term strategies. It breaks it down into conservative, moderate and aggressive clients. I haven t seen another municipal investment advisor do it consistently. Obviously, it has an active management wrapper on it, which is what we are. The opinions expressed are those of MacKay Shields LLC as of the date of this report and are subject to change. There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Before considering an investment in the Fund, you should understand that you could lose money. A portion of the Fund's income may be subject to state and local taxes or the alternative minimum tax. The Fund may invest in derivatives, which may increase the volatility of the Fund's net asset value and may result in a loss to the Fund. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. For more information about MainStay Funds, call 800-MAINSTAY ( ) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. New York Life Investment Management LLC engages the services of federally registered advisors. MacKay Shields LLC is an affiliate of New York Life. MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.