Podcast: Markets, myths and milestones—30 years in muni bonds

Podcast transcript

Welcome to Talking Markets with Franklin Templeton. I'm your host, John Przygocki from the global marketing organization here at Franklin Templeton. Today, I am joined in the studio by Ben Barber, Head of Municipal Bonds at Franklin Templeton Fixed Income. Franklin Templeton Fixed Income, otherwise known as FTFI, is one of the largest municipal bond managers in the United States and has been managing tax-free income strategies for over 40 years.

The team is comprised of fixed income specialists with a measured, no-surprises approach. FTFI is committed to pursuing consistent, resilient fixed income results for clients with the outcomes they expect. Ben, welcome to the show.

Ben Barber: Thanks very much, John. Appreciate being here.

John Przygocki: Ben, I've been looking forward to our conversation focused on the municipal bond landscape and your unique insights on several topics that most investors may not be aware of when it comes to investing in muni bonds.

As a professional in the muni bonds market for over 30 years, what are the biggest changes that you've seen in over three decades.

Ben Barber: Okay, well, first of all, that makes me sound really old. I don't really feel that old, but we'll go with it. I think there have been significant changes, of course, over the last 30 years. And I sort of look back on my career and think about it in a couple different pieces. One is certainly the pre-2008 world and the other being the post-2008 world. And so I would say the first answer to the question would be certainly the market has changed dramatically. You know, in 2008, the real shift that took place in our market was due to the insurers, the monoline insurance companies that had typically wrapped about two thirds of the municipal market, all lost their triple A status in different portions of 2008.

At the beginning of 2008, the downgrades of the monoline insurance companies began, and they continued through 2008, and some went out of business, some formed the good bank, bad bank. But the change to the insurance company ratings in 2008 dramatically changed the municipal market. As I said, you know, about two thirds of the municipal market was triple A by virtue of these insurance wraps prior to 2008 and when the downgrades started, that amount of the market that was triple A, went from about two-thirds down to about 15% of the municipal market.

So roughly from 60% down to about 10% to 15% was triple A. And the big implication of that is the municipal market became less efficient, it became less correlated to the Treasury market, as the market really needed to recalibrate and have pricing based on, you know, the underlying value of the bonds as opposed to the value of the insurance wrap as a triple A provider.

And so that shift in 2008 was just a tectonic shift in the municipal market. And it really changed things quite a bit. And one of the main things that was a result of that massive movement from largely triple A to a minority triple A in the municipal market was the lower correlation to Treasuries, because what that really didn't allow anymore was a very easy and efficient way to hedge municipal duration.

And the impact of all that, of course, was that the broker-dealers became much less enthused to own large chunks of municipal bond inventory, even at the very high-grade level, because that hedge just didn't work that well anymore. The correlation between high-grade munis and Treasuries, as it broke down, that hedge became less and less valuable.

And so therefore, you had the dealer community much less willing to stock bonds and the liquidity of the market, by virtue of that, really came down quite a bit. I think that one shift to the municipal market back in 2008 really made professional investing, as we do here at Franklin Templeton—it made professional investing in the municipal market much more interesting because the asset class became much more opportunistic, much less efficient.

And so for professional investors such as ourselves, the market became a lot more interesting, and a lot more fun to operate in. For long-term investors, this a really good result for the municipal market, because you're ostensibly buying an asset class that is too cheap relative to its credit fundamentals, very high credit fundamentals that we have in the municipal market. So, I look at that change in 2008 as being just a massive difference.

I would say, you know, a second change in our market over my career has certainly been the improvements in technology. And the municipal market is very large. It's roughly $4 trillion of overall market cap. You know, people talk about a million different CUSIPs. And that's true.

There are over a million different individual CUSIP line items out there, over 50,000 different issuers. So it's a very large market, but it's very fragmented. And so to keep it all in check and to keep it organized, to keep your views on the credit fundamentals of all the different credits and credit sectors out there is a huge challenge and technological advancements have made that much easier over time.

And I would say the other big deal with technology changes over time is the ability to trade much more efficiently, right? Just setting up algorithms that can help you slice and dice the market quite a bit better. Figuring out price discovery in the market quite a bit better. You know, these have all been really big improvements in the municipal market and enables us, as large institutional managers, to be able to manage munis in all of the different formats in a really efficient way. So I'd say, you know, the technological changes have been another big difference over my career.

And the last thing I would point to would be the changes in ownership and sort of the changes in where money is flowing into or out of the municipal market over time. And this is really accelerated in 2022, if you'll remember. You know, that was the year where rates really increased quite a bit. There were record redemptions out of open-end municipal bond mutual funds, but very interestingly, there were very positive flows into muni separately managed accounts, SMAs, and so that shift that had been taking place for quite some time really did accelerate in 2022 with the big outflows out of open end funds into SMAs. And that continues today. You know, flows have definitely stabilized and have returned to positive in the open-end fund world, but not nearly to the degree that was, you know, lost in 2022.

And meanwhile the SMA flows have been increasingly positive year-over-year. So that's been a pretty interesting dynamic. And the reason I bring that up is because those changes in flows really from open ends over into SMAs, it's actually had an impact on the market. It's had an impact on the shape of our yield curve, and it's had an impact on credit spreads.

And thinking that through a little bit, you know, SMA investors tend to be very high-quality investors. You know, looking at the highest portions of the quality spectrum in the municipal market. They also tend to be a little bit shorter on the yield curve. They tend to be sort of intermediate and shorter type of durations that SMA investors will typically go after, as opposed to open-end funds. The bulk of the assets there tend to be longer out on the curve, and they can tend to also hold a little bit more credit risk in those funds. Because yield is such an important portion of what sells open-end mutual funds. So as that money has flowed from sort of longer duration down the credit spectrum types of investments into shorter on the curve and higher quality investments, that's impacted both the yield curve and the credit spread environment in our market.

Again, when we think about the result of this, I think this is a good result for long-term investors. It's creating more yield out the curve. It's creating more yield as you go down the credit spectrum and sort of fits perfectly into the managed products that I think can be really appealing for many investors. So those would be some of the major changes, John, I think over the last 20, 30 years of my career that have made the muni market what it is today.

John Przygocki: It really sounds like three massive changes, but there's still tremendous opportunity to be found in the municipal bond market. With that being stated, what are the misconceptions or maybe misunderstandings that people have in general about the space that you've come across?

Ben Barber: Yeah, I think it's a great question. There are several misconceptions about the municipal market. And again, I think these are all good to have these misconceptions because it keeps the asset class maybe a little bit cheaper than it ordinarily would be.

I think one misconception is that munis move exactly in lockstep with Treasuries. And of course they don't. They'll generally follow the same sort of trend. If rates in Treasuries are going higher, you know, for a long period of time, or if they're going lower for a long period of time, of course munis will follow along with that directionally, but they certainly don't move tick for tick and even, you know, day over day or week over week. And that creates opportunity, when the valuations between munis and Treasuries change quite a bit. It provides opportunities for different investor bases to come into the municipal market. Sometimes if munis get particularly cheap relative to Treasuries, sometimes we can have crossover buyers, you know, buyers that would typically buy taxable fixed income investments that could cross over into the tax-exempt space because they find it particularly attractive. And that can happen from time to time. So I think that's one of the misconceptions with regard to the muni market is that it moves in lockstep with the Treasury market. It really does not. And I think when it does not, that is certainly, you know, one of the times where you can pick up really good opportunities in the municipal market.

I think a second misconception about the municipal market is what is risk in the municipal market. And I think a lot of people think about risk in overall fixed income markets or, you know, most securities as some sort of a risk to principal, in other words, a default risk. And I think that the misconception is that that's really the only risk with regard to munis is the bond going to default. And as we know, for those of us who've been in the municipal market a long time, you know, default percentages are quite, quite low in the municipal market overall, especially in the investment-grade world. But they do happen, and you've got to be prepared for that and make sure you're in the right investments, of course. But one of the misconceptions is that risk really only comes in the form of default. And I would say that risk comes in the form of default for sure. But it also very importantly comes in the form of liquidity.

Liquidity is always difficult in the municipal market. I like to say it's always difficult and sometimes it's extremely difficult in the municipal market. Again, this is one of those things that it sounds scary, but it's really one of the really nice attributes to the municipal market that provides the opportunity for quite a bit of yield, especially on a taxable equivalent basis for investors that are long-term in nature.

So thinking about risk in the municipal market, I think it's very, very wise to think about the liquidity risk that we have in the municipal market. We spend much of our time here on the Franklin Templeton Municipal Bond team, thinking about the liquidity in the market and what is a good portion of liquidity from the yield curve perspective and the credit spectrum perspective, thinking about across the country, is liquidity better in certain states or certain sectors rather than others? And we spend a lot of time thinking about liquidity. It is, I'd say, one of the most important, if not the most important risk that we have in the municipal market. And, of course, when you think about risk, you're also thinking about opportunity. And so I would say that's a really, really big one is liquidity is probably your biggest risk. It's also your single biggest portion of opportunity that we have in the municipal market.

You know, the third misconception that I would highlight in the municipal market is thinking about the construct of the rating spectrum in municipals. There are the rating agencies like S&P or Moody's or Fitch that will put ratings on many, many of the municipal bonds out there. And they start at triple A and they go to double A and single A and then triple B, and then once you get below that, that's the below investment grade world. And the reality is, in the municipal market, many of those bonds are rated. Many of the bonds come as non-rated. So S&P, Moody's, Fitch is not asked to put a rating on many municipal bonds.

And there's several different reasons why. I think the genesis of that is that a lot of municipal bond offerings tend to be quite small. And the cost to get a rating could be prohibitive for a small or maybe a one-time issuer in the municipal market. And so as a result, a big municipal bond portfolio management team like ours would always have a lot of research analysts who are very well versed in looking at deals in which there's no rating. Again, this is another really unique attribute to the municipal market, quite different than the taxable fixed income markets in that there are quite a few sectors and many, many bonds that come to the market as non-rated bonds. And as a result, because you cannot rely on an outside rating agency to rate the bonds and have an opinion, as a result they tend to come cheaper. So you pick up more credit spread, more yield for those non-rated bonds. I think the misconception that I'd like to highlight would be non-rated doesn't necessarily mean junk bonds or below investment-grade or high yield in nature. A lot of the non-rated bonds in our market are actually, you know, very solid credit.

And when we buy a non-rated bond here on behalf of any of our portfolios, we're required to have our own internal rating on there that would be pari passu to, you know, how a rating agency would view the credit. And you know many times a non-rated bond will be in the investment grade space in that triple B or single A or even AA type of category for non-rated bonds. So that's another misconception in the municipal market is that non-rated bonds doesn't necessarily mean junk or below investment-grade bonds. They can be perfectly fine investment-grade quality type bonds. They just don't have a rating by an outside rating agency, which again can be one of those attributes that can provide very good opportunities in the municipal market.

John Przygocki: Very, very interesting. So in that answer, you mentioned your team two or three times. I'm thinking about the transition and all the change in evolution that has occurred in the market in your time in the municipal bond market. And I'm wondering how your team has evolved over that period of time to address the opportunity. Is there anything that you could share there?

Ben Barber: Yeah, it's interesting. When I think about what has changed on our team, the first thing I go to is what has not changed. And what has not changed is very, very strong, focus on research. You know, the research analysts in our group are required to analyze the financials, of course, but you're also analyzing demographics and demographic trends. And you're analyzing political structure. And who do we think is going to be the next party in power? For example, at the state legislature, the state gubernatorial race, and that sort of thing. So there's all sorts of research that needs to take place and that has not changed over the decades that I've been in this market.

But I think a couple of things that really have changed, you know, the risk management evolution has been just fantastic from my perspective. You know, very typical for a large asset management shop like Franklin to have a risk management group that looks over each asset class and reports to the C-suite of the firm, whether that's to the CIO or COO. Maybe it's the CFO or CEO. And that's a very typical structure for a large asset management group. And we have that, of course.

But in addition, we have an internal risk management function that we have embedded here in the municipal team. This person sits on our desk, is very much part of the entire portfolio construction process. And the tools that we can utilize now are so far superior to what we had 10, 15, you know, certainly 20, 30 years ago, it's really been a welcome addition to a portfolio management team like ours.

And so the risk management evolution is something I'm really, really happy about, really proud about here at Franklin. And it enables us to slice and dice the portfolios exactly as we want and really see where risk and opportunities are coming from in all portions of the portfolio, whether it's, you know, yield curve or coupon structuring or optionality, the call optionality of bonds or sectors or individual, you know, idiosyncratic type risk, etc.

And so, the tools that we have now at our disposal have evolved quite a bit. And so, I love that about the change, you know, certainly of our team over the years. You know, I'd say the other significant change to how our team operates is really the, you know, the trading frame. The challenge here is to the how to make an incredibly disjointed, fragmented market much more organized and efficient. Right? And that's especially important with the massive growth in the separately managed accounts, where you, as a large manager, are not going to have a couple dozen accounts, you're going to have hundreds, if not thousands, tens of thousands of accounts. And how can you keep that all organized in the context of a market that, as we said earlier, has 50,000 plus issuers and a million different CUSIPs?

It's very difficult. And so the trading framework is critical. Obviously, the technological advancements that we've had have been really, really helpful over the years. You know, the algorithms and the electronic trading that can help us slice and dice the market, help on price discovery. These tools can be very, very helpful, you know, for a large shop like ours, managing across, you know, different platforms of open ends and SMAs, ETFs, closed end funds, all the different formats that we manage munis in.

John Przygocki: So you just mentioned the new vehicles that are available for investors to use investing in municipal bonds. Are there additional impacts to those changes, opportunities, risks associated with exchange-traded funds [ETFs] or separately managed accounts?

Ben Barber: Yeah. You know, I'd say first it's all about investor choice, right? We're committed to offering our capabilities across all the vehicles to be able to provide for all investors. You know, from our perspective, we've managed up and down the yield curve very, very short, very long. We've managed up and down the entire credit spectrum as well as national diversification. But being able to offer all of those capabilities across the different formats is really critical for our investor base. With regard to ETFs, I'd say the growth up until now has really been in the passive world, and a slight problem with that, in that they tend to be fairly restrictive in terms of their investment profile.

They tend to have, you know, customized benchmarks that exclude large portions of the muni market. And our view is that the beauty of the muni market is really how large, but also how fragmented and inefficient it is. So many of the best values, in our market could very well be in the portions that are excluded by the more passive muni ETFs. So, you know, we definitely favor having less restrictive, more active muni ETFs that can take advantage of all the unique inefficiencies in the muni market. So that's the idea on the ETF side.

On the SMA, you know, with regard to SMA investing, you know, demand is very, very strong and has been for several years. And as I said before, you know, it accelerated in 2022 with a lot of muni money moving from open ends over to SMAs. So strong, in fact, that, as I said, it's been impacting the market from two perspectives, from both the yield curve and credit spreads. You know, with regard to SMAs, I think that the demand will continue to be quite strong. You know, investor preference is showing up that way. And I think the level of customization that I know we can get to for clients has been very, very attractive for a lot of the investors out there.

And so I would anticipate that demand in SMAs to continue. The interesting thing with regard to SMAs will be: Will they continue to evolve in terms of their level of sophistication? As I said before, you know, most of the SMA demand has been the form of intermediate and shorter and very high credit quality. And so the question is, will SMA investing continue to evolve down the credit spectrum out the credit curve, out the yield curve, to provide more opportunities for investors?

I think the answer there is absolutely yes. We're definitely on the forefront of that. And, you know, I feel really good about the different offerings that we have, for example, in the SMA space.

John Przygocki: So, Ben, as we look to close today's Talking Markets conversation, you've talked a lot about change and evolution in the municipal bond space. You've talked about great opportunity and why that opportunity exists. Is there a final takeaway that you would like to leave our listeners with as it pertains to the municipal bond market?

Ben Barber: Well, I think that the municipal market has matured in certain ways, certainly with regard to technology and product availability, but it also continues to be very inefficient, and it tends to be very opportunistic for long-term investors.

So that's the overall takeaway. What I love about how we're set up at Franklin Templeton, I really appreciate that we have the capabilities that we have, but also the investor choice that we have through open end mutual funds, through ETFs, SMAs, a couple closed end funds, you know, to be able to tap into our resources and our capability and our entire team here at Franklin Templeton. And it allows us to be at the forefront of all that change and innovation.

John Przygocki: Ben, thank you for your time and your very valuable insight today. To all of our listeners, thank you for spending your valuable time with us for today's exciting and informative update. If you'd like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify or just about any major podcast provider.