Talk Your Book: Why Rising Rates Won't Hurt You Anymore

0:00Ben Carlson:Today's Animal Spirits Talk, your book, is brought to you by Franklin Templeton. Go to franklintempleton.com to learn more about their whole suite of active municipal bond ETFs. It's franklintempleton.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick 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 Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:34Clients of Britholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:42Ben Carlson: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. I still remember when Meredith Whitty came out with her call. after she kind of, quote unquote, her thing was, her claim to fame was Citigroup, right? She's like, Citigroup's going down. She shorted it. Yeah, yeah. And then after the great financial crisis, she said, oh, shoot. For my next trick. Yes. 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?

1:13I can't quite remember.

1:14Ben Carlson:Yeah, I'm sure. Chicago's the one people always talk about. Maybe California. And obviously didn't happen. There have been no huge problems. There's probably been some small ones. but this is an area of the market in municipals that I don't think there's a ton of people that 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.

1:49Ben Carlson:But this is a space that you and I aren't experts on, obviously. But we have clients in muni bond funds because sometimes, especially for higher income people, the tax breaks can be phenomenal. But as we get into with Ben Barber, who is the director of the municipal bond department at Franklin Templeton, muni 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. We want to step on in here. Here's our talk with Ben Barber from Franco-Dappleton.

2:25Ben, welcome to the show. All right. Thanks very much for having me. Appreciate it. All right. Let's start here. Over the last couple of weeks, the market has increasingly become focused on the direction of interest rates up and to the right at almost every area of the yield curve. I'm curious, how do interest rates impact the municipal bond market? Yeah, absolutely. Great question and a great place to start. 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.

3:05And over time, you could actually set your clock to how correlated the muni market was versus treasuries. That correlation has 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 smarter than the muni bond market. How impacted are municipalities by interest rates today? I would say that they're very impacted. So when we think about the two main angles of risk or the two main factors that drive price volatility in the muni market, it would be number one, interest rates.

3:46By 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, issue municipal bonds to finance some sort of infrastructure project, they're very mindful of what's going on in the overall interest rate environment before they get out there and borrow significant money.

4:33Ben Carlson: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 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 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.

5:07Ben Carlson:Do you look at this as 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 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, 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 straight volatility in their fixed income portfolios.

5:51Now, here we are with a 10-year that's floating somewhere around a 460, 470 in 10-year treasury space. Right now, it is exactly at 458, but it's been sort of 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 seen a lot of investor movement from cash and cash equivalents, pushing out the yield curve as far as they're possibly comfortable. We've got a pretty good, steep shape to the yield curve.

6:32So for every year that you're willing to push out in terms of investing, you're getting compensated that much more in terms of additional yield. So yeah, we definitely look at it as an opportunistic time.

6:43Ben Carlson: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 uninverted 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 essentially 100 basis points of steepness in the treasury curve from twos to thirties, give or take. And so, yeah, that's a fairly normal shape to the yield curve. You want the yield curve to be upward sloping. You want those expectations set up that way.

7:16And that's exactly where we 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 of 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-at-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 AI, but certainly some areas of it. Anthropic might be coming later in the year. But outside of just the equity space, I can't remember the number.

8:02It 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 where data centers are being built. Has that infiltrated your headspace? It's definitely infiltrated our thoughts. We've got a very large and experienced research team that works here. Right next to our team is basically half portfolio managers and traders, and then half research analysts or large team, roughly 27 people. And so, yes, the notion of AI and data centers and financing and capital structure, capital formation around financing all this stuff has definitely taken up a lot of our headspace.

8:50We 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.

9:20Ben Carlson:You guys have a whole suite of municipal bond ETFs that can range in how aggressive they are, the type of credit risk they take, or the type of duration. 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. Many of 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.

10:04It's called the Franklin Dynamic Muni Bond Fund and muni bond ETF. 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 our sort of our best, you know, quote unquote, best ideas, muni bond ETF.

10:31Ben Carlson: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 spread's pretty similar in munis as well. Like, where are you guys finding value these days? We see a lot more opportunities in the muni market than certainly that I'm hearing from my colleagues and the rest of fixed income. We spend 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.

11:04That's not true in munis. So I think from an opportunistic perspective, from a yield, we think about it a couple of different ways, overall duration and yield curve. And so to your point, yes, We're a little bit further 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.

11:43So 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 rapidly. I would imagine it's like a very slow moving 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.

12:25However, there are dozens of other sectors within the municipal market that have different elements of risk, 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, etc. There are several different sectors within higher education, whether 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.

13:01And so there you're taking on an airline credit risk. There are lots of different healthcare sectors, for example, nonprofit acute care hospitals, their retirement centers, et cetera. So there, 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. 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.

13:36Even 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 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.

14:10Ben Carlson:It seems like once every few years, someone comes out with a proclamation that the states and municipalities are all screwed and 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 cities or whatever states. What do you think are some of the misnomers about this, about these types of bonds that people don't seem to understand? Because it is kind of like the US government debt where people are constantly predicting there's going to be a crisis and then one never comes. What is it about munis that people want to predict a crisis, but it seems like there just hasn't been, you know, many waves in this space?

14:46Well, I think there are two things that really stick out. And we, you know, we had to answer this 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 of the municipal market.

15:23Two 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 a balanced budget. It doesn't mean that gaps and 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.

15:58That's number one. Number two, in general, remember that with municipals, 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 major reconstruction needs to be done. Municipals amortize their debt generally in line with the average useful life of whatever asset was being financed. And so that's another critical difference. When you think about the post-GFC time in 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.

16:41In municipals, 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. And that amortization of your principle of municipal bonds is critical to think about the overall credit strength of the municipal market.

17:17So I'd say there's two things. Number one, the balanced budget discipline. And number two, the amortization in general of municipal debt in line with the average use of the life of the assets. So those are two critical features. As you're thinking along these lines and 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. Because 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.

17:55Where's the value in the yield curve? Where is it 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, you know, 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 an open-end municipal bond mutual fund, both of which we manage here at Franklin Templeton.

18:32It'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, but I'm curious.

19:05You 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, you know, here's the yield on a muni, tax-free. 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.

19:49And to take a look at the after-tax analysis. And what you'll see is as you push out the curve from one to 30 years, when you get longer and 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 on an after-tax basis, given the overall very, very high credit fundamental potential of munis, you can even find munis 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.

20:39So 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.

20:55Ben Carlson:I'm curious how you explain that because Michael and I have noticed in wealth management that, especially in the last few years, the tax alpha thing is a real thing that clients are coming to us 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 in your pocket? And municipal bonds have this interesting feature that it's almost like phantom savings, right? Or phantom yield. And so you have to show this tax equivalent yield to show people, put them on the same wavelength, right?

21:25Ben Carlson:Because it's the taxes that you're not paying on this income versus the 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 the attractiveness. 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 a corporate bond or or government bond, you know, whatever the range of taxation is, you know, 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.

22:06Either way you want to do it, you can get to apples to apples on an after-tax basis, which is critical for that analysis. So we do that quite a bit. The other angle of tax efficiency that is really attractive in municipals is tax loss harvesting. 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. 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.

22:44Conversely, 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 bond holder, 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 munis is that to get around the 30-day wash sale rule, 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.