Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, I lead mutual fund and active Research at Bloomberg Intelligence. Today we're going to be discussing munis and the advantages
that active management can provide. Little context. First, active municipal mutual funds actually took in over twenty four billion in inflows last year, and as we all know, mutual funds are the less preferable wrapper right now, so you definitely know this interest and active munifunds. And I will also say that active muni ETFs also took in nearly twenty two billion last year. And so for this discussion to discuss munis, we're happy to have Alex Patron on with us.
Is managing director and head of fixed Income and head of distribution for the Americas for Rockefeller Asset Management. Alex, thank you for joining me today.
David, thank you, it's great to be here.
So you spent your career in fixed income across multiple market cycles. What do you think feels fundamentally different about today's environment compared with past periods.
Well, I think you.
Know a couple of features that make this cycle distincts. First of all, we've transitioned from this really long period of zero and negative policy rights to a world where the yield curve is steep, The municipal yield curve is tremendously steep, and there's really compelling opportunities for investors today within fixed income, and it resets in our view, both returns across the curve.
And it improves fixed income's role.
Both as income and a ballast within portfolios. And I would say secondly, the macroeconomic environment mint is unique today and dispersion is elevated. You've seen inflation moderating a bit from its peak, but it remains stickier in spots. You've seen growth that's remain and proven quite resilient. But there are going to be clear winners and losers, whether you look at the equity markets, the bond market, and very
specifically within municipals. So for our view for investors, this really argues in the environment that we're in today, sell activity over beta and investors really will continue to benefit from active management where you are getting paid in many respects to do the bottom up credit research and identify opportunities where there might be idiosyncratic spread drivers or other factors that can really drive returns from here.
So glad you mentioned that with active, because you know, Active obviously made a comeback, especially on the equity side the last couple of years. And you know, I think active was underwhelming to a lot of retail folks for a while. Well you know, they just they looked at index funds and the you know, very very cheap. You know, there seemed to be this kind of sentiment that passive
was the way to go, even in fixed income. And you know, passive can look efficient on the surface, but where do you think the gaps really are with you know, where active management can add value, especially in fixed income.
You know, David a great question, and you see it tremendously within the municipal market. More specifically, if you look at twenty twenty and eighty five, it was a really interesting year in which you saw investment grade municipal indicices outperform high yield municipal indices. Now, what makes that interesting and unique is in most environments, your fixed income or your income is a key part of your total return.
If you look at the higher yield municipal indices, the yields were in the five and a half percent range tax exempt really compelling. If you look at high grades, the yields are closer at about four percent over the course of the year tax exempts. So inherent your setup should have been that the high yield media indicies outperform.
But what we saw in twenty twenty five is there is a handful of issuers and sectors really tobaccos and then from an issue perspective, transportation and bright line that really drove down returns within the high yield market. For those investors that focus on passive indices. There's a structural
inefficiency there. You might be over allocated to these areas just because they tend to be larger components of the benchmark that are issuance weighted, not necessarily quality or relative value weighted.
You can you can dive in even further to that.
David, and look at dispersion amongst managers, particularly in markets like the municipal market or the corporate bond market, where you have a tremendous amount of diversification opportunities that if you are active and avoiding some of the pitfalls of either bench are hugging or following the benchmark, you might see a material difference in what performance looked like over
the course of twenty twenty five. And that's really apparent in some of these markets where there are inefficiencies, a lot of opportunities, and bottom up credit fundamentals really matter materially.
I'm glad you brought that up, especially with dispersion and this credit dispersion and we have uncertainty with interest rates. How do you think that's really changing the calculus for active bond managers?
You know right now in today's environment, you.
Know, when you have the amount of interest rate volatility and uncertainty that we've had over the course of the last really several years now, it is really important to think through how can I build portfolios to be resilient against a range of outcomes, whether that outcome is rising
or declining, rates, widening or tightening credit spreads. For active managers, it allows us to make decisions around liquidity risk management, understanding we are an environment where whether it be at times a tweet, a policy shift, a FED view that can drive rates. You want to have some dry powder and liquid to lean into the volatility as it exists.
With the steep yield curve that I mentioned earlier, David, this is an opportunity where active management can really add value by exploiting relative value across yield curves, looking for opportunities that might arise from differing structures, whether that's thinking about hall features, coupon features, and the likes, and then so importantly really underwriting credit at the abboog or level, because you will have dispersion that continues to persist not
just from rate volatility, but as credit evolves as we move through this cycle. Active managers can really dynamically adjust through some of these periods of elevated volatility. Think about how they maintain dry powder lean into different opportunities that arise through time.
And so you're especially is muni bonds and you know, municipals don't always get the same attention as corporates or treasuries.
You know, why do you think that's the case?
And you know what makes it such a compelling asset class in this you know today.
I think municipals have historically not gotten the same focus of corporates because when you look at our market is broadly speaking a retail focused or high net worth focus market. Why should municipals get a lot more attention today? From our perspective, there's several reasons, very straightforward for US tax paying investors, Municipals offer some of the most compelling relative
value versus treasuries, versus agencies versus corporates. Today, the tax equivalent yields easily pick up anywhere between fifty one hundred and fifty basis points, or call it half of a percent to one and a half percent. When you take that a step further, I think historically investors have thought about municipals as.
Being a key ballast.
While we're past peak credit quality, likely within the broad markets, credit fundamentals for municipal issuers are overall quite resilient.
Here what you've seen historically if you look.
At Moody's Who's run a default study going back over thirty years, municipals have historically provided much better credit quality than that of the corporate market, both measured through very low incidents of defaults and higher overall recovery rates. So you have both elevated tax exempt income and yield relative to other asset classes, but then you also have a credit profile that tends to be quite resilient through various
points of the economic cycle. What I would add with municipals, it's an incredibly inefficient market.
It's one of the most diverse markets out there.
Forty thousand plus active issuers, which really gets to that point that through identifying managers that can navigate through the sectors, the ABUCRUZ geographies and structure, you can really add alpha and outcomes for clients by finding bottom up relative value opportunities within the space.
You know, why is it overlooked? I don't know, David.
I've been staring at this market for twenty years, and I do think that increasingly you're seeing investors that are focused on ensuring that they are fully weighted in both the high grade and the opportunistic areas of the market.
So, you know, as I mentioned at the beginning, you know, there was I think twenty four billion in inflows for just mutual funds, and you know, when you look at the passive side, very little and so you know, obviously this is an area where active can provide opportunities. And you know, we you know, we all know about the tax advantages and you kind of went into this a little bit talking about the structural characteristics, but it just seems like it's it's a big, big market for active managers.
You know, what else would you say in terms of the structure that really kind of provides those opportunities. You know, you mentioned the credit dispersion and just you know so much, so many active are so many issuers out there, I should say, well.
I think what's really interesting about our market as well is if you try to peel the onion back a little bit further and look at I mentioned that the number of issues forty thousand plus issuers, and you have a lot of the large global issues that people are quite familiar with that may issue anywhere between a billion
to four or five billion in any given year. But if then you take a step back and you look across states and localities, there's a lot of very small issuers that might be looking for financing that's ten million, twenty million, thirty million, fifty million, and a lot of these smaller bespoke deals don't always get the focus that
the large global issuers get. If you build a team and structure around creating what we like to do as a bit of a bar belled approach, as we're venturing into the opportunistic space.
We have your high grade liquidity risk management.
Think of that as your double A triple A issue, large global liquid names that are a ballast within the portfolio.
But really leaning into some of these bespoke financing opportunities, we liken it a time almost to call it the private credits of the municipal market in acus a format where we can step in and look past benchmarks, look past the rating agencies, and look directly to partnering with issuers that might have unique financing needs that we are able to both underwrite the financials, work with the borrower structure the bond covenants for our investors, and also demand
some level of additional excess yield versus comparable benchmark or rated names. And it really creates a lot of opportunities to lean into excess yield for investors in what otherwise tend to be overlooked. There is the market, and I think at times day of what makes it really interesting in munis in particular, you have some spots in our space that are non rated deals not rated by the agencies that I think generally as investors we think non rated might mean that these.
Are sub investment grade.
The reality means it's just an issue that's not rated because they didn't go through the process.
They might come to me and my team and say, we're looking for financing. Can you underwrite the risk?
If you have the experience and expertise to do that, you can really drive good outcomes for clients, primarily through targeting elevated yield in otherwise good credits.
So if we dig a little deeper, what does doing the work really mean in municipal credit analysis? Can you kind of walk us through the process.
Yeah, I think doing the work combines a whole host of things. It's looking at forensic financials right multi year trends and coverage, liquidity, any obligations that might exist on the pension or the OPEB side. It's looking at governance and management. So what is your budget discipline has been depending on the type of bond you have? Rate setting flexibility? What is your capital planning credibility through time? Looking for
things like demand elasticity and demographics. What have enrollment trends been in higher education? What might the payer mix be in healthcare? For utilities and transport, what is the stability of your user base? When we're looking at call it sales, tax back bonds, what does the economic environment broadly and what does that look like in a specific region. We think a lot about security and structure, what's our seniority for leans as we think through additional bond tests and
rate covenant reserve mechanics. And then we're always thinking about alternative data and different types of site checks, whether that's traffic counts, looking at hospital occupancy as it relates to healthcare system tuition, discounting as it relates to higher education,
water usage, and key areas. So you could see, David, it is a wide expanse given just going back to the diversity of the medicimal market, and I think what you really can appreciate through this, it's the depth of thinking through that bottom up analysis, the depth of considering governance that allows.
Us to really drive outcomes and results for investors.
What about managing risk? Is that just kind of distinguishing between the stronger issuers versus the weaker ones.
It's certainly a key part of it is understanding I view it both as where to lean into opportunities where we might find an issue that from our perspective, high quality issure, mispricedmand to the market at times. Risk management is leaning away from some of the hot spots that others may not recognize and ensuring that you aren't allocating to an issue that we might not believe in their credit fundamentals and we feel like they're pricing is too
tight or spreads are too tight. It risk management for us is also liquidity risk management when you're managing through the market, whether it's because of the volatility that one might anticipate and wanting to ensure that you have some dry powder to lean into those periods of volatility that might be driven from spreads or rates, whether it is also looking through diversification. You heard that from me over
and over. So when we think about sizing any one position across a portfolio, the municipal market, you can hear me over and over diversification, diversification. There's a tremendous opportunity for us to diversify across state sector. Issuer Alburger structures to really sure that as we're making investments, we're protecting clients.
Risk management is at the heart of everything that we do.
And so if we just think, you know, take a step back and think of you know, you kind of went through the whole credit research process. And we've talked about how the market is so large and you know it's fragmented. How does credit research look different with munis versus you know, other types, whether it's treasuries or corporates.
Well, I think you know, it requires a lot more effort given the number of issues that we're trying to canvas.
Certainly on a daily, weekly or quarterly basis.
Price discovery in our market is imperfect as well, because as you have markets that expand, particularly in those areas where it's not a large global issuer, but some of these smaller issues, there might be a lot of off the run q SIPs or issuers that create some level of mispricing. Our view is really simple, if diligent research and proactive sourcing can deliver some level of alpha, then
we want to be there. But that fragmentation of our market really amplifies from our view, the value of relationships. Technology has certainly enhanced a lot of what we do in in identifying opportunities in the market any given day, but relationships with dealers, relationships with issuers, access to markets become critically important for Expanse in terms of what we're able to see day in and day out, just given how diverse the market is today.
So I'll get to technology in just a second, but I did want to ask you first, if we take another step back and just think about the muni bond market as a whole, how should investors kind of think about risk in the muni market, especially during periods of economic stress? Yeah?
Well, the interesting thing there, David, is that in periods of economic stress us where we're heading into call it a broad slow down, which is not our base case today. I think we all see that growth continues to be quite resilient and positive from here, but we might all agree that we're past kind of peak credit fundamentals, both
for corporate issues as well as municipal issues. But what's really interesting, particularly as it relates to some segments like general obligation debt for example, is we tend to see that in a period of the slowdown, municipality hold up quite well. What drives that? Well, if we break down general obligation debt very specifically, a lot of times tax revenues might be derived from things like property tax values, which is not about your market values, about your assessed value.
And I don't know if you're a homeowner David, I certainly am.
I find that in periods where property values are declining, my assessed value tends to say static.
So the math behind that.
Equation tends to be pretty advantageous for municipalities to continue to have stable revenues even in peers that you see a slowdown and declines in the broader macro environment.
And that really speaks to my comments earlier on looking through.
Historical time frames where the economy is sewing, and you saw municipal credit was quite resilient through those periods, stable revenues and the ability to continue.
To pay debt service.
What we also look towards is those where are we in the capital stack. As a debt holder, you tend to be a priority payment. If you're doing your active management, you can see how are the reserve funds and ratios evolving from here? What does my coverage look like? And we take a really active approach in that as well. While the reality as municipals tend to do quite well through periods of economic stress, our responsibility from a risk management perspective is to ensure that Zoe's the case.
Certainly expect that that's going to be no different today.
So I do want to get back to technology because I think you brought up an interesting point. I mean, I'm using technology even just to do fund and ETF research now. And so my question for you is, how has technology really change the way you fixed income teams approach credit research right now, especially in a market like Munie's.
Yeah, David, that's a great question, and I would say it's not just credit research, but also visibility across the market. I think back to when I started in the market and we had moments where we're still kind of writing down buys and sells on paper. What a different world
that we live in today. So technology, from my view, has really meaningfully increased the surface area, whether it's related to research, the amount of automated scraping of disclosures, some of the natural language processing we can use for transcripts.
Local news really allows us to have broader visibility into what might impact unique credits, and it allows us to have even a farther reach in the initial screening from a credit perspective.
On the execution side as well, it's astonishing the execution tools that have really helped improve liquidity across the entire expanse of the municipal market, it's allowed. You can see it certainly within the separately managed account space, which has evolved dramatically in the last fifteen years. You have far more investors today that access municipals not by buying and selling on their own and brokerage accounts, but leveraging managers
for separately managed accounts. Why have we been able to do that so effectively? To customize down to the client level? Technology right is at the center of all of that, within the human oversight, because ultimately that bottom up credit research critically important across high grades and high yield, that will always be the case. And then of course stepping in and ensuring that portfolios are built in a fashion to take advantage of whether it's yield, curve, optimation, sector tilts,
et cetera. That technology really is helping with both breadth and depth across research and portfolio management today.
And I know people across every industry, not just finance industry, are worried about AI and you know, having their jobs taken away. And so my question for you is, you know, where does human judgment and experience still matter, especially in credit research?
Where could that go into the future.
It's it is it is a concern, and I'm happy to report, David, I think in the municipal market in particular, we will continue to keep our jobs, partly because of how diversified the market is. Technology is really wonderful coverage, speed path or pattern recognition, But when we think about judgments, assessing political will, management, credibility, the probability that legislation could shift and then change the dynamics around a sector or geography, I think a lot of that will continue to be
human led. At this point, we really think about using technology to prioritize some of our inquiries and where we want to focus quantify some really high level risk, but we use experience to decide.
When we're going to underwrite and when we're going to step aside.
And we've done a lot of work, David, you can imagine our side to really query how can technology not just improve our judgment, but at times we've seen where it can be faulty, particularly as you get into some of the more bespoke areas of a market that are not just reliant on feasibility studies, but taking a feasibility study and using your own human judgment to say, is this going to move forward?
As planned, well be something to watch. I say, well, thank you, Alex. This is a fun discussion. Thank you so much for joining me.
Absolutely, David, I really appreciate it. I do believe we're back in one of these bond pickers markets. So it's always great to talk about active management.
Definitely, and since it's my specialties, I always love to talk about it. I also want to thank our listeners. If you like the episode, please subscribe and leave a review. And if you'd like to see more of our research on the Bloomberg terminal, go to bi Fund, go for Fund and Active Research until our next episode. This is David Cohne with Inside Active