October 20, 2025 • 47 mins
In the wake of underperforming municipal bonds this year, portfolio managers Bill Housey and John Wilhelm of First Trust highlight why they believe fresh opportunities for tax-free investors have emerged.
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Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Ryan (00:08):
Hi, welcome to this episode of the First Trust ROI
Podcast.
I'm Ryan Isakinen, ETFstrategist at First Trust.
Today I'm joined by BillHousey, Managing Director of
Fixed Income at First Trust, andJohn Wilhelm, Senior Portfolio
Manager of the First Trustmunicipal securities team.
Today we're going to talk aboutbonds.
We're going to discuss theimpact of Fed rate cuts.
(00:31):
We're going to talk about theyield curve.
We're going to talk aboutgovernment shutdowns.
And we're going to discuss whythe municipal bond market has
underperformed this year andwhat they what that might mean
going forward.
Thanks for joining us.
So as I was preparing for thispodcast, I got to thinking what
would be more fun than talkingto a bond portfolio manager.
Bill (00:56):
It's not much.
Ryan (00:57):
It's talking to two bond portfolio managers.
Twice the fun.
So twice the fun.
I'm glad you guys uh glad youguys made it.
Um so I was I was thinkingabout um the Fed, as I often do
as I'm driving around justcontemplating interest rate
policy, as I'm sure you guys do.
And um I guess what I waswondering is do you have a sense
(01:23):
of where the Fed stops cuttingrates?
They've already begun the ratecutting cycle.
Where do you think we end?
And and I guess when?
Bill (01:33):
Well, I guess I can start with that.
I mean, the framework that wetypically use to approach that,
and it the market refers to thisas what's the ultimate terminal
rate.
For us, it really hinges backto those inflation expectations,
because in a normal market,there should be an appropriate
(01:54):
real yield.
Like what's the amount aboveinflation that the Federal funds
rate should be?
And I think a big part of whythe Trump administration has
argued that rates should belower is that inflation isn't 9
percent anymore, it isn't 8percent, it's not 7 percent,
right?
It's been stickier in themid-twes, let's call it,
(02:15):
bouncing around, around thatnumber.
But what's the appropriateFederal funds rate above that?
And we've had a Federal fundsrate that's been, call it 200
basis points above inflation,and that's restrictive by most
accounts.
Most people would say that'srestrictive.
Now, some people would say, butlook at the stock market, and
(02:37):
we can debate whether high stockprices are indicative of
whether it's restrictive, or wecan look at delinquencies on
credit cards and how it squeezesvarious parts of the economy.
So there's a lot you coulddebate around that.
But for us, that is what itwould typically come back to.
And so when we look forward andwe say, where do we think
inflation will be, let's justsay by the end of next year,
right?
By the end of 2026, where do wethink inflation will be?
(03:00):
And I think in thosediscussions I have had with Bob
Stein, our Deputy ChiefEconomist, Brian Westbury, our
Chief Economist, theexpectations are for inflation
to work its way back downtowards that 2 percent.
So normally we would say thebond market today is pricing in
around a 3 percent terminal Fedfunds rate.
So the Fed cuts rates fromwhere they are today, 4 to 4 and
(03:24):
a quarter, down to that 3percent level between now and
the end of next year, and holdsthem there.
That is what is priced into thecurve.
And we would say that'sprobably a pretty reasonable
middle-of-the-fair way bet basedon the data we have today.
Obviously, a recession wouldcause something different.
A higher inflation would causea different path, but what for
what we know today, ahundred-basis point real rate
(03:45):
over our expected inflationseems like a reasonable set of
circumstances.
Ryan (03:50):
So, John, uh what do you think that does to the yield
curve and what as the Fed hasbegun to cut rates in this cycle
so far?
I mean, how how has thatimpacted the yield curve thus
far?
John (04:04):
Well, we've seen uh the short end of the Treasury curve
decline quite a bit as the ratecycle or the Fed cutting cycle
began, and we've seen that aswell in the municipal bond,
let's say one to five year partof the curve.
And where we've seen uh morestickiness, I think partially
(04:24):
because of inflation, but alsoyou could add in things like the
U.S.'s structural budgetdeficit, is when you get to 10
years to maturity and beyond inthe U.S.
Treasury curve and as well themunicipal bond curve.
And I I think there we're alsowe're gonna be looking at
employment, we'll be looking atwhat we would expect as well as
(04:45):
the decline inflation over thenext 12 months, but we'll also
have to look at the size andmagnitude of the structural
budget deficit in the U.S.
Is it gonna stay at 6.5% or 6%,or what's the trajectory of it
and how does that affect uhborrowing by the U.S.
government?
Ryan (05:02):
Yeah.
So the fundamentals of the U.S.
Treasury market, that the theuh ability of the U.S.
government to to pay for itsits debts.
I mean, no one really callsthat into question, right?
We we all kind of think thatthat's gonna happen.
Is that that's a fairstatement, right?
Um but it's fair.
But eventually the marketstarts to charge us more for uh
(05:26):
in interest, despite the factthat the Fed is lowering rates
at the front end.
Is that what your expectationis that the if if we don't
address some of the budgetdeficits, that you could see
rates drift higher at the longerend?
Bill (05:40):
The way I would tend to think about that might be a
little different.
It would just simply be thatwhen we look at what's in in the
market today, we we have a viewon what the deficit is.
Now I can tell you coming intothis year, no one had a view
that the administration wouldgenerate $350 billion of added
revenue from tariffs.
Right?
That wasn't in the equation.
(06:00):
And so there are otherdimensions to this that that one
has to consider, the unknowns,if you will, but it has more to
do with the unknowns in thesense that there's a price today
for what is known.
And if we were to show up towork tomorrow and the budget
deficit were to ramp up fromhere, well, that's that's that
would be a new variable, andthat would have to be priced.
(06:23):
But when we think about today,it's not like the budget deficit
today is a surprise.
So the way we think about it,it's in the price.
The deficit today is in theprice, right?
Because it's it's alreadyknown.
It's the unknowns that aren'tin the price.
So if you have a materiallylarger deficit, well, then you
would have to reset rates higherto accommodate larger supply,
(06:44):
treasury supply.
And if you have a smallerdeficit, right, when in and
increased revenues coming in andincreased growth in the U.S.
economy because of, let's say,pro-growth um you know
pro-growth policies that haven'tbeen sort of priced into SIBO
scoring and things like that,obviously that's not in the
equation.
So there's a number ofvariables, so we want to be
careful with the sort of alwaysthis happens or never that
(07:07):
happens.
But in reality, I think it hasmore to do what's in the price
today, what's known versuswhat's unknown, and how that
will drive the equation goingforward.
Ryan (07:16):
John, I was also wondering about labor market dynamics and
and how that plays into whatthe Fed is doing in conducting
policy.
Um have you been surprised athow resilient the labor market
has been?
Because it's I think mostpeople, if you would have asked
them a couple years ago, youknow, where uh the unemployment
rate would be today, given allthe variables that we've seen, I
(07:38):
don't think anyone would haveguessed that the unemployment
rate would still be this low.
So um what do you think aboutthat?
John (07:46):
Yeah, I think when you saw job growth, uh the initial
numbers, especially last year,they looked robust.
Uh various reasons were putforth for that, everywhere from
the amount of immigrants lookingfor jobs, uh stimulus payments,
(08:10):
uh another potential source.
Uh however, when you get tolook at this year, there's a
couple of items.
One, when you look at thepayroll numbers over the last
four months, you know, much moremuted growth.
Whether you look at the ADPfigures or the payroll numbers
that now we're not seeingbecause of the government
(08:30):
shutdown.
So I think that has really ledto the Fed having a much more
balanced approach than they hadin January of this year, where
they seem much more concernedabout the inflation outlook and
the potential impact on tariffs,to where they sit today, where
they seem much more concernedabout now what uh the job growth
(08:52):
numbers will be in the upcomingmonths.
And also the revisions thatthey do when they adjust
previous statistics that theyput out have showed
significantly uh weaker andfewer jobs.
And I think those revisionsplus the actual uh previous four
months data really paint adifferent picture of very muted
(09:15):
job growth.
Ryan (09:17):
You mentioned the government shutdown, and you
know, there's always a risk whenyou're recording a podcast that
by the time it airs, maybe theshutdown will be over.
But assuming it's not over, Iguess I wanted to talk a little
bit about that because it seemslike at least the equity markets
have kind of shrugged it offand said this isn't a big deal.
Uh maybe it's because ithappens pretty much every year
(09:39):
lately.
So do you have any thoughts onuh the impact of the government
shutting down for a period oftime, what impact that has on
the economy or or markets?
John (09:50):
Yeah, historically we've looked at the data from a
municipal bond perspective.
And when you look back at theduration of government
shutdowns, the five most recent,let's say, they've been short
in nature and have had limitedimpacts uh long term.
Uh what gave us a little bitmore pause from a municipal bond
(10:11):
fixed income perspective wasthe potential of more federal uh
job losses.
That was one point that wasdiscussed, perhaps just as a
negotiating tactic.
But to the extent that that wasrealized, especially if it was
those federal job losses were incertain uh specific areas,
(10:31):
whether it's Washington, D.C.
or parts of Maryland orVirginia, for instance, that
could have a longer-term impacton municipal bond credit quality
where those workers arelocated.
Bill (10:42):
Yeah, and I mean I think you know, as you look back and
empirically and think about whatthe impacts have been to the
market, I mean it's very rarelythere's a de minimis impact to
the economy from a GDPperspective when you've had
government shutdowns.
And just like anything else,the longer a shutdown lasts, the
more uncertainty will build.
And you could see that spillover.
(11:04):
But empirically, what we'vegenerally seen is that interest
rates have typically come downin government shutdowns, a
little bit of a flight toquality, right?
A little bit of a flight tosafety under those
circumstances.
But I think the market ispretty comfortable with
government shutdowns by now.
And so again, just like youknow, most things, the longer
they last, the more uncertaintybuilds around them.
So it really will come down tohow long it lasts before we get
(11:28):
the the appropriate signaturesto to sign the bill.
John (11:31):
Yeah.
When you look at the last fivegovernment shutdowns, Muni
returns were positive and fourout of the five.
The only one where they werenegative was during the taper
tantrum.
So you could really say therewere other factors overwhelming
the nature of the governmentshutdown.
Ryan (11:47):
So do you guys have a sense as to where we are in the
economic cycle?
Because you know, the Fed iscutting.
We have a relatively lowunemployment rate.
We've got I mean, at least thelast couple prints have been
fairly strong in terms of GDP.
So it doesn't it doesn'tnecessarily seem like we're in a
(12:07):
you know about to tip into arecession.
And you know, our chiefeconomist Brian Westbury um has
some other thoughts on that andmaybe a higher probability of a
recession.
But um where do you guys thinkwe are in the economic cycle
today?
Bill (12:22):
Well, I think just looking back, the reality of where
we're at in the cycle is alwaysunknown, right?
It's it's never easier inhindsight to know.
Always easier in hindsight toknow, and nobody really knows.
But what I would say is, wereally haven't had a true
recession since 2008 and 2009.
We had a government-inducedshutdown, obviously with COVID.
(12:45):
It was very short-lived.
And the inflation thatfollowed, the stimulus that was
injected in caused the yieldcurve to invert.
Clearly, you know, even Ithought that would lead to that
ultimate recession at the time,but it was dwarfed by the
stimulus that came in.
I mean, we put it we put atrillion dollars into people's
(13:07):
checking accounts and you know,trillions more into the economy
with a T, right?
These were massive, massivenumbers.
And they had a really bigimpact.
And today, where's that comingfrom?
Well, clearly that's comingfrom AI spend.
That capital spend is enormous,and it goes beyond a data
(13:27):
center build in the sense ofbuying semiconductors, GPUs, the
things that are needed.
It goes all the way down to theHVAC, the cooling, the the you
know, the contractors that arethat are constructing.
There's a tremendous amount ofripple effects through the
economy.
And these things are verysupportive right now.
But with that being said, itdoesn't have to be a hard
(13:51):
recession eventually, but itwould be very normal after such
a big uh capital spend toeventually get to that point.
So is it 2025?
Probably not.
It's almost over, right?
Um it's uh it's hard to knowexactly how that plays through,
but we have seen, you know, theysay history rhymes.
(14:11):
It rhymes.
It rhymes with 01 and 2002 andthe capital spending that took
place, obviously, through thedot-com build.
Um, in reality is we haven'teven had a 5 to 10 percent
pullback in stocks since theApril low.
So that's something we shouldbe mindful of as well.
It would be very normal to havea 5 to 10 percent pullback,
which would then spill throughto credit markets and the things
(14:34):
that we're focused on after a35-plus percent recovery from
the April low, you know, that wehaven't had yet.
So, you know, it's more likelythan not we get a correction
before we get a recession.
I don't think there is anythingtoday that says that imminent
recession is coming.
We're looking for the canariesin the coal mine all the time.
Bankruptcy is making someheadlines recently, things like
(14:56):
that that we want to pay veryclose attention to to see are
they idiosyncratic or are theymore pervasive throughout the
economy?
Ryan (15:03):
So, Bill, you spend a lot of time with uh financial
advisors and your your travels.
What are the questions thatyou're not getting today that
you should be getting?
It's a really good question.
Bill (15:15):
I I think that it's maybe a question, but asked
differently.
So a lot of advisors today havethey're being shown a lot of
new and innovative products,right?
The world has changeddramatically in the last 10
years.
For everything from leveredproducts, um, you know, we used
to just think about leverage inthe market as margin.
(15:37):
Now you've got to look atlevered ETFs and all these
different ways that investorsget levered into the market.
Um, and there's a lot ofquestions, especially after
2022, about whether advisorsthink that bonds even belong in
their book anymore, right?
Because they have got all theseother alternatives and
substitutes.
And you know, I look back overthe last few years, so let's
(16:00):
think about this three years,and I actually counted.
In the last three years, therewere still nine rate hikes that
came through the numbers, right?
We've obviously had some cutsas well in there, but there were
nine rate hikes that still camethrough.
There were 21 in total hikesfrom the tr from you know, zero
in the Fed started raising.
But when you start to look atthe cumulative returns in the
(16:22):
bond market over the last threeyears, I think advisors, the
most advisors that I'm talkingto are surprised by the numbers.
You know, high yield up 36percent, bank loans up 32
percent, Munis tax adjusted 26percent over the last three
years, investment gradecorporates 23 percent, MBS 16
percent, the ag core bonds up 15percent, even treasuries are up
(16:44):
11 percent in the last threeyears.
So, you know, when you thinkabout numbers like that and the
importance of the bond market,especially when you think about
where valuations are in thestock market today, Dave
McGarrell, our CIO, talks aboutthis all the time.
Valuation multiples are high,forward returns statistically,
empirically, um, they're not asgreat when you enter the at
these levels.
(17:04):
And you start to overlay thebond market durability that that
we've got today, because rateshave set reset higher, and
whether it's taxable ortax-free, I think it's really
compelling, and I think it'sgoing to continue to be
compelling, and I and I think itneeds to be understood more
about how durable these returnshave actually proven to be, with
(17:26):
that rare exception of what wesaw in 2022, which was just the
resetting back to normal, right?
That's already taken place.
And I think that is going to besomething that should be really
much more topical.
Ryan (17:36):
So do you think that advisors maybe have avoided
rebalancing back into their bondportfolios, given the strength
of the equity performance?
Bill (17:45):
Yeah, I mean, when we talk about what we have seen in
terms of just just talk aboutcash balances, you know, I see
the numbers, we all see thenumbers, they're kind of
staggering over $7 trillion incash balances.
Um I ask most advisors, manywill tell me that they have
larger cash balances, maybe inaggregate they're about the
same, but some have certainlymore.
Um, if you have money marketexposure, your income is already
(18:06):
down over 20 percent just fromthe cuts that have already taken
place.
It's already fallen by 20percent.
So when we think about incomeand how to position and the
duration that we add toportfolios, it's to build income
durability.
And so if you haven't thoughtabout it as an advisor or uh as
an investor, if you haven'tconsidered why that's important,
(18:26):
it's because on a path of lowerfederal funds, right, money
market rates are likely tocontinue to fall, and that
income durability is going to bereally important to kind of
supporting your portfolio overtime.
And so we think that that's a areally significant
consideration that has to bemade.
Ryan (18:45):
Okay, John, what questions are you not getting from
financial advisors?
John (18:51):
In the in regards to municipal bonds, really the
question has been why have Munisso underperformed other fixed
income asset classes for a goodportion of the year, really
until September and performanceuh really turned around.
And I think when you look at ituh with the benefit of
hindsight, I think Munis wereparticularly impacted by the one
(19:16):
big beautiful bill act and someof the fears that were out in
the marketplace about how our$4.2 trillion asset class might
be affected.
So, first you had thepossibility of the diminishment
in the tax exemption.
So, would the full couponpayment that you receive on a
(19:37):
municipal bond be tax free?
And then the conversation wouldturn would certain kinds of
municipal credits not be able toissue bonds on a tax exempt
basis in higher education oruniversities were talked about,
um, hospitals, private what wecall private activity bonds.
And as we know, up with thepassage of the act, none of
(20:00):
these potential fears came tofruition.
There was no uh substantialchange uh in the value of the
exemption.
There was no change really, andthen there were certain nuances
or changes in tax laws wherenew municipal entities could
issue.
But what I think the effect waswas it brought forward new
issues supply by highereducation institutions, by
(20:24):
healthcare institutions thatwere concerned about whether
they might lose access to thetax-free market.
And I think this bulge in newissues supply has really been
one of the reasons why themunicipal market has
underperformed year to date, butalso creates the opportunity
when you look out that over thenext 12 months.
Ryan (20:44):
So, what you're saying is that borrowers, municipal
borrowers, instead of maybeborrowing in October or
November, they weren't reallysure that the same provisions in
the tax code would would stillbe enforced.
And so instead they wanted toborrow earlier in the year, and
as a result, there was moresupply of those bonds that hit
the market, and that had a lotof supply, and that had, you
(21:08):
know, supply and demand causeprices to drop.
John (21:10):
Is that yeah, it's that fundamental.
If you went through the end ofSeptember, new issue supply was
up 12% to $435 billion.
That was compared to 2024,which was a near record year of
supply.
If you compared that to thefive-year historical average,
it's a lot higher percentagethan that.
(21:31):
So, what our expectation is iswe'll have a fairly robust
October for new issue supply,but the bulge bracket
underwriters are expecting it touh new issue supply to be
diminished in November,December.
So, really, there's been thisbelief of buying the dip this
month.
If you, to the extent you getsome lower prices, higher
(21:52):
yields, wider spreads, youshould buy into it because there
will be less new issue supplyas we get into the last two
months of the year.
Bill (22:00):
It really did seem to set up sort of a perfect storm.
We were talking about thesupply-demand dynamic and the
points John made.
I think through July wemeasured it, and there was it
was 55 percent higher, $100billion more supply than the
last five years.
I mean, that's a big number forthe market to absorb, all you
know, largely driven because ofthis fear of losing the tax
(22:23):
exemption.
But there were other factors,and one of those was also tied
up in the one big beautiful billon the credit side.
And that's something that Johnand I spent a lot of time
working on last year because BobStein was talking all around
the country about how hebelieved that Donald Trump would
win the election and howRepublicans would sweep.
And one of the big policypoints that he felt like the
(22:44):
administration would go afterwas Medicaid funding.
And Medicaid funds a lot ofhospitals, right?
Hospitals depend on thosepayments as they treat patients.
And so last summer, before theelection, we had brought
together our analysts acrossfrom health care, from high
yield, you know, senior loans,investment grade corporates,
municipal bonds, John, myself,and working through where our
(23:08):
Medicaid exposure was topreemptively clean the book to
ensure that we were prepared toplay through that.
And that was another variablebecause we did see a bit of baby
with the bathwater in a lot ofpockets of the credit markets,
from munis through corporatecredit, where there was so much
uncertainty about what bit whatone big beautiful bill would do,
and that has an impact onpricing.
(23:28):
And let's not forget what theadministration was doing or has
been doing with universitiesalso funded the municipal bond
market.
So it really was a perfectstorm and has been uh throughout
the course of the year that haskind of led to some of this
volatility and candidly theopportunity that we see.
John (23:43):
Yeah, and it that's a great point.
And what we saw in Septemberactually was hospitals
outperformed versus otherrevenue bond sectors in our
market.
And I think now uh it's beenthat collective analysis by the
market of, well, who will besuccessful hospitals?
It's obviously a very importantsector, healthcare in general.
(24:06):
So we did the same thing afteryou know a lot of conversations
with our research team andtalking with Bill's team about,
well, what do you prune?
You know, what have youreduced?
And it's the safety nethospitals that have high
Medicaid exposure, a lot ofself-pay exposure, focus on
those stronger credits that arenumber one or number two market
(24:28):
positions in their geographicfootprint, growing populations,
better payer mixes, highercommercial payers, for instance,
stronger balance sheets.
And now I would expect thoseproviders, those that show great
ability to survive and thrivein a reduced Medicaid
reimbursement market, will seebetter returns and credit spread
(24:50):
compression for them.
Ryan (24:52):
Okay, so you've got an environment where prices drop as
a result of the dynamics youtalked about, yields go up, they
get more attractive, demand hasthat come back?
Have investors, what have fundflows looked like for Munis?
Has that been an area whereyou've seen some strengthening
demand?
John (25:11):
It's actually been a surprise, but a positive
surprise because when you lookedat how much the municipal yield
curve steepened beyond 10 yearsfor a good portion of the year,
historically you would think,well, we're going to be in an
outflow cycle because as aretail-driven asset clash,
you'll get more selling of fundshares and mutual funds or
(25:31):
exchange traded funds or othertypes of products.
But we've really seen thecontrary.
So just this past week, forinstance, we had 1.1 billion of
inflows into the municipalmarket.
Year to date, we've had 31billion of inflows into mutual
funds and ETFs.
That doesn't take into accountseparately managed accounts for
SMAs.
(25:52):
Uh and we've seen 21 of that 31billion come into municipal
ETFs as municipal uh exchangetraded funds take greater market
share.
And to kind of fill out thepicture, within that 31 billion
of positive fund flows, 8.6billion have come into high
(26:14):
yield.
So I think what what that showsis that with this rise in
yields, especially in 10 yearsand beyond, uh you see taxable
equivalent yields for thoseclients in the highest tax
bracket that are veryattractive.
That's sound equity, likethat's something that Bill and I
have talked a bunch about.
And that uh investors areresponding to that.
(26:37):
A unique opportunity wheremunicipal bonds have cheapened
for, I would say, reasons thatnow we can see what reality is.
There were fears that didn'tcome to become realized, and now
you have the opportunity, andthere's been more buying of
mutual funds, exchange tradedfunds, and SMAs.
Bill (26:56):
And usually what you see in the market is, you know, you
get these periods in the market,supply-demand technicals, as we
just talked about, andeventually the smoke clears, the
dust settles, the focus shiftsback to valuations,
fundamentals, and that's whereit tends to mop itself up.
So the, you know, I it's one ofthose opportunities where we
think that as it's plays throughinto next year, I think we're
(27:16):
gonna all look back and say,boy, that was a really good
opportunity because it's notlikely to persist based on the
way that perfect storm that kindof developed this year, that's
not really likely to exhibititself.
And when you think about,especially where the Muni
opportunity is is m has beenmost attractive, as John pointed
out on the long end of thecurve.
So think about that from tensout to 30s in particular, right?
(27:38):
A lot of some some activitiestaking place in the U.S.
Treasury curve as well, whereyou know, if you think about
foreign yields relative to U.S.
Treasuries, you know, this isone of the things that's often
overlooked.
A lot of the headlines andnarratives are typically tied to
the Treasury curve sayingthings like deficit spending is
a big driver of that, um, fearsaround auctions and the like.
(27:59):
But if we looked around theworld, we'd see that you know
Japanese government bond yieldsare up over 80 basis points this
year, um, places like Germanyand France up you know 60 plus
basis points this year on 30s,um, the U.K.
uh.
So this dynamic, this relativevalue dynamic that's taken place
(28:22):
has caused some upward pressurein my mind, at least on the
outskirts of the curve.
And then you factor in what'shappened in Munis with this
supply-demand technical and it'screated tech uh taxable
equivalent yields, you know,that would most of us, if you
look at, I think we were lookingat double A taxable
equivalence, we're at double Ataxable equivalence right now,
would you say, and that back endof the curve, sort of tens to
(28:44):
thirties.
John (28:45):
It's still very commonplace with A and triple B
rated bonds in 15 to 20 years toget you know well over four
percent yields.
And it once you're at a 4.12percent, that's a 7% taxable
equivalent yield.
So to me, if you're buying goodstructure and call protection
and you can lock that in for anumber of years, as you're
(29:07):
suggesting with an A or A ratedbond, you know, I think I asked
you earlier about the uh theyield curve and and uh you and I
were talking last week aboutthe roll down, the the
importance of the roll down inin uh contributing to your
returns.
Ryan (29:26):
For those that don't know what that means, give me some
some bond nerd talk.
John (29:31):
Yeah, so to go into a little bit more detail, I
hesitate, but uh my bond geekdomfor sure.
But when you look in the 10 to12 year part of the municipal
yield curve, and you you look atthat bond a year from now,
it'll be 11 years to maturityand two years, 10 years to
maturity.
So the yield curve uh has aslope that's upward sloping, so
(29:56):
you get more yield in generalfor the longer out you go.
Right now, if you look from 10to 12 years to maturity, there
are 46 basis points of rolldown.
So about 15 basis points ayear.
And the you know, the withoutdo if I do finger math, that's
potentially a point and a halfpercent of performance just from
(30:18):
roll down from that 15 basispoints plus your coupon income.
The coupon income for a 12-yearbond that's A-rated is 3.56% or
thereabouts, right?
3.5%.
So to me, to lock that in wherein the steepest low part of the
curve where you're gonna rolldown about 15 basis points a
year for three years with agood, pretty good starting
(30:40):
yield, that's a place toallocate some income.
And then as Bill said, furtherout the curve, if you look out
16 to 18 years to maturity, youdon't get as much roll down.
It's not 46, but it's still 33basis points.
So still about 11 basis pointsa year or a percent.
If you're buying a bond with along embedded call structure,
you really don't want to go intobond structures.
(31:02):
But then your starting yieldfor an A-rated bond is 4.26% in
that for that 18-year bond.
So that's to me theopportunity.
You get this really attractivenominal yield, highest tax
bracket client, that 4.26 iswell over 7%.
And you've embedded, if theslope of the yield curve rolls
(31:24):
down at the today's rate, you'vebuilt in performance.
And if rates go up, you'replaying good defense, because at
least you'll offset some ofthat increase in rates by the
bond rolling down the yieldcurve.
Ryan (31:38):
Um it strikes me that a lot of what you're talking about
positioning on the yield curve,selecting credits, you don't
really get that in an indexfund.
You guys are both activemanagers.
So, you know, it when you whenyou're managing a fund, are
these things that you're lookingfor opportunities to add value?
Bill (31:57):
Well, absolutely.
And it and this is one of thethings that we've always talked
about why in terms of why webelieve active wins over time,
especially in fixed income, it'sbecause the indices are
literally just constructed basedon where the debt issuance is.
And so it doesn't considerwhere the better opportunity on
the curve might be.
The indices don't consider howmuch credit risk you're taking
(32:20):
and when you want to take thatcredit risk, for example.
Um it's simply based on thatdebt issuance.
So from our perspective, yourisk management is really the
nature of fixed income.
And so, you know, you start tothink about, hey, I want to own
bonds for the income, I want tocarry, clip that coupon, and I
want to sleep at night.
Most bond investors think likethat, right?
(32:41):
They want to capture income,avoid loss.
And there's just no riskmanagement takes place in a
passive index.
It's simply representative ofwhere the debt is issued, the
more debt that's issued, whetherit's the ag, where 44 percent
of the ag today is treasuriesbecause the government is
funding large deficits.
That wasn't always the case.
That's probably 20 percenthigher than it was 15 years ago.
(33:02):
That doesn't mean you shouldhave more treasuries just
because the government hasborrowed more, or in the
municipal bond or corporatecredit market, you know, a large
issuer borrowing a lot ofbonds.
And we can go down a list ofcredits that that we have
avoided that have borrowed a lotof money, both on the taxable
and tax-free side, because theyhave borrowed a lot of money,
we've avoided them.
And they become large weightsbecause they've borrowed a lot
(33:25):
of money, so in a passive index.
And those are really criticaldistinctions, we think, with
respect to active in fixedincome versus passive.
And it's particularly differentwhen you think about it
relative to equities, where yourlarge capitalizations might
tell you something about thefundamental health of the
business.
You might want to own more of abig company on the equity side
(33:46):
because its market cap may tellyou something about the
fundamentals.
In the bond market, it's thereisn't a market cap, it's a debt
cap wherever the largest debtissuance is.
And these are very different.
John (33:56):
Yeah, and I would say uh during certain periods of time
through the economic cycles, theamount of debt you can issue is
not merit-based.
Sometimes you get into veryspeculative investment
opportunities that find an open,uh, well-received market by
purchasers.
(34:16):
And I think of that especiallyin the high-yield context,
whether you're in the municipalmarket or the corporate
high-yield market.
And Bill and I have talkedquite a bit about a name that's
in both of our markets, uh, theBright Line East Railroad.
And this is a project that wasuh in Florida to finance
railroads from the Miami areaout to Orlando and eventually
(34:39):
Tampa.
Well, there's been a lot ofdebt issued, and they have been
increasing ridership, but whatthey're seeing is that they're
not raising ridership at arevenue per passenger that now
covers debt.
And to me, that's just anexample of a capital market that
(35:01):
was very receptive to uhletting borrowers sell them
bonds, that then you build it,and then the build and they will
come part of this.
Is will you have enoughridership?
Will you have enough revenuesper writer to cover all that
debt that's now in the publicmarket?
Ryan (35:20):
So let me play devil's advocate because I've heard this
from some uh passive bond fundum managers where they suggest
that yes, it's debtcapitalization weighted, but
those that's a good thingbecause those big debt issuers
um have their more liquidholdings.
How would you respond to that?
That those you know, the yes,they have got a lot of debt, but
(35:42):
but it's liquid.
Bill (35:43):
It's to me, this has always been one of the most
common misconceptions in thebond market.
In the most extreme sense, someof the largest issuers that
have come to the market toborrow on the credit side have
filed for bankruptcy.
And so quality, we would argue,drives liquidity.
In 2008 and 2009, during thefinancial crisis, if I needed to
(36:07):
sell a bond to meet aredemption in a fund, for
example, during hemorrhaging offund flows and the volatility
that ensued the market, therewas always a bid for a bond
where it was a quality bond,because I can open a 10 Q, I can
open a 10K, I'll bid the bondbecause I know what it's worth.
If it's a distressed situationbecause it was big and they
(36:31):
borrowed too much, good company,bad balance sheet, or whatever
the circumstances were, badcompany, too much debt, that
doesn't mean you're going to geta bid for it.
So where's the liquidity?
Where's liquidity in thatsituation?
Because distressed buyersaren't lining up in that
environment to take outdistressed debt.
So the reality in thosecircumstances is quality drives
(36:52):
liquidity, and that's when youwant it most.
It's what's the quality of theholding, and that's what
provides durable liquidity.
And what we spend all of ourtime doing is thinking about
what is the quality of thiscompany, what is the quality of
this bond to prove that it willbe liquid when we need it to be.
John (37:13):
I love your term durable liquidity.
Yeah.
Because initially you may gainsome liquidity benefit from very
large bond issues in themunicipal market.
There may be more participantsthat may be supporting the
market, but ultimately it's cashflow in your ability to cover
your interest and principalpayments and how much leverage
(37:35):
you have and what your balancesheet liquidity looks like.
And that's really what'simportant.
So to us, it's really thatupfront review of looking at the
prospects of the business andtrying to do sensitivity
analysis of what is theirultimate leverage and ability to
cover debt service look like.
Ryan (37:55):
So everyone's talking about AI these days.
Um you guys are portfoliomanagers.
You know, we hear that AI isgoing to displace all the
white-collar workers eventually.
Is AI impacting the way thatyou do your jobs?
And are you using it or isthere a use case for you to use
it today?
Bill (38:14):
We're using it quite a bit right now, and we've been
developing tools to use it morerobustly.
I think it has been aphenomenal innovation for what
we do on a daily basis.
It has absolutely empowered ourteam to process a far greater
volume of data expeditiously.
(38:35):
The ability to source theinformation through the tools
that we've developed, developedhave been spectacular.
It's really going to be sort offascinating in our careers to
see where this takes us, um, andespecially our ability to, as I
point to, like custom developsome of these tools that have
been really robust in what we'redoing.
(38:56):
Now, it's going to impact us intwo ways, right?
The tools we use, but also thebusinesses we invest in.
So we want to be reallythoughtful about the risk of AI
to a company that we'reinvesting in.
So how does AI displace whatthey do, or how can it?
Because what we've seen is thata simple narrative of it could
(39:17):
displace what they do is causeprice volatility in certain
credits.
So we want to be really, reallythoughtful about where that
risk is and how we size thatrisk.
Um, you can have really solidfundamentals, good performance,
but if somebody's afraid of AIrisk, you have selling pressure
in that company.
So we've got to be thinkingthrough that.
Um it's gonna have a uh areally big impact in a number of
(39:39):
ways, in both in terms of howwe're investing and the thought,
um the risks that we have tomitigate when we look at various
companies, but also um as areally powerful tool.
And the development we're doingthere, I think, has has been
extraordinary.
John (39:54):
Yeah, I think for us uh early days as an additional
municipal bond research tool,it's come in very handy.
You've read through the bonddocuments, you've um looked at
things like feasibility studies,you've done your article
searches.
Well, what have you missed?
What other things can you lookat?
And I think artificialintelligence is a way of then
(40:18):
being another set of eyes forsomeone that's taking the lead
on a new municipal bond issue tosee, okay, well, what else?
It gets into well, you got tobe crafty and ask the right
questions to be able to reallydig and and have this broader
view of data out there.
That's to me like the power ofit is you you can't get really
(40:39):
wider in terms of finding dataand presenting it to a research
analyst or a portfolio managerand hopefully making the best
decisions.
I think where we're we're alittle bit earlier, DIDs, on the
municipal side is how do weincorporate that more in the
portfolio management side tomake sure we're seeing the
broadest array of, for instance,secondary market offerings as
(41:02):
quick as possible so that we canmake decisions with research
about what we want to buy, sell,and hold.
Ryan (41:09):
You know, one of the things that's always fascinated
me about the municipal bondmarket is just sort of the
mismatch between the way thecredit rating agencies evaluate
muni bonds versus corporatebonds in terms of you know the
the uh default rates forrelatively similar credit
ratings.
Can you talk about that uh abit?
(41:30):
Because I I I've listened toyou talk about it before and
really kind of enjoyed thecomparison.
John (41:36):
Well, I think the municipal bond versus corporate,
you can look at feasibility orstudies by rating agencies that
go over the past 50 years or so,and you can look for a given
credit rating, let's say anA-rated MUNI versus an A-rated
corporate bond.
And Munis have had a lowerhistorical default rate when you
(41:58):
look at 10-year compound annualgrowth rates and higher
recovery rates if there is adefault.
I think there's potentiallyvarious reasons for that,
including the degree ofessentiality in basic municipal
finance.
You know, it's it's hard tomake an electric utility or
water and sewer system or aleading healthcare provider not
(42:21):
be able to cover debt service.
And I'm sure that there arelots of parts of the investment
grade corporate market in myexample that have a high degree
of essentiality, but maybe notas fulsome, not maybe not across
all the different industrysectors.
So I think that's uh animportant component of why high
net worth investors that maybeare looking at municipal bonds
(42:44):
as a as a source of ballast, soit's not going to generate the
returns of other parts of theportfolio like a high-yield
corporate fund.
But what it can do is providestability, knowing that you have
things like lower incidence ofdefault and high degree of
essentiality.
Bill (43:01):
And I think, you know, when we when I look at ratings,
it's a little bit differentbecause a lot of people look at
a rating and see a letter.
I look at a rating and I see anumber.
Because ratings, as John wasputting to, are really about
empirical research.
If you look at a rating, ittells you uh there's a numerical
number associated with theseratings that give you an element
(43:23):
of what a cumulativeprobability of default is for a
given issuer with that rating.
So for example, a mid-single Bhas got something like a 27%
cumulative probability ofdefault in the next five years.
So understanding what thoseratings really mean from the
probability or statisticalprobability empirically of a pro
(43:44):
of a default is is reallyimportant.
So it isn't linear, right?
There isn't a linearrelationship between a double A
and a single A and all the waydown the rating scale.
It's logarithmic.
Your probability of defaultstatistics change dramatically
when you're moving up inquality, and you know, they move
all the way to a hundredpercent probability of default
(44:05):
as you get into the lowestratings.
So ultimately D4 default.
But understanding that, Ithink, is really, really
important.
John (44:13):
I think to the I totally agree.
And one of the areas that we'vetried to do differently than
what you would see if you werelooking at the rating agencies
is our research team has to comeup with a numerical score for
credit quality momentum.
So we use a numerical score, wedon't call it stable, for
(44:33):
instance, or declining orpositive.
Those are the normal terms forthe rating agencies, but we make
them put a number on it.
So which shows the strength ofcredit quality improvement or
declining, and that helps us inour surveillance meetings decide
which credits are we going tofocus on for buying additional
power amounts of those with thestrongest credit rating momentum
(44:56):
and those that have theweakest.
Well, those are bonds thatyou're more likely to engage in
a sell discipline and decide,well, is this something that we
want to continue to hold or dowe want to pair back?
And the last thing I'll I'llsay about this is the rating
agencies can do a good job onthe initial review of a
municipal borrower.
(45:17):
But what we found is oftentimestheir ability to do
surveillance on an existing bondthat they have provided a
rating on isn't always timely.
And that's one of the areasthat we really try and
differentiate as a researchteam, too, is make sure that not
only have you done the creditwork, but you've done the
follow-up work to see if thatparticular borrower is doing
(45:40):
what they said they were goingto be able to do.
Ryan (45:44):
All right.
John, since it's your firsttime joining us on the podcast,
I'm going to ask you the uh thefinal question because I've I've
already gotten some bookrecommendations from Mr.
Housey over the years.
I've I've read about uhShackleton and uh his his
adventures.
Uh but one of the things that Itend to ask guests of the ROI
podcast is what's your readinglately, or if there's anything
(46:05):
you've read recently that youwould recommend us checking out.
It doesn't have to be uh a bookabout bonds as as scintillating
as I'm sure that would be.
Um is there anything that youwould recommend that we add to
the book list?
John (46:18):
Well, I've got uh three adult uh daughters, and my wife
and I traveled actually to winecountry in California the last
couple of years, and at one ofthe places we visited, they
recommended a book called WineFolly Magnum Edition.
And this book I have found willnot only tell you a lot about
(46:41):
wine and grapes, but alsogeographic regions across the
world, as well as then how youmight pair specific types of
wine with different types offood.
So for someone that's wanted tolearn more about this important
topic, I'm not surprised at allthat John's following.
Ryan (47:00):
I don't think we've gotten um that sort of book
recommendation yet, but um I Ireally like it.
I'm gonna check it out.
Thank you for that.
Well, guys, I appreciate you uhspending some time with me on
the podcast today.
Um, like I said, it's alwaysfun having two bond portfolio
managers join me.
So thanks.
We'll have to do this againvery soon.
(47:20):
Um, and thanks to all of you aswell for joining us on this
episode of the First Trust ROIpodcast.
We'll see you next time.
Hi, welcome to this episode of the First Trust ROI
Podcast.
I'm Ryan Isakinen, ETFstrategist at First Trust.
Today I'm joined by BillHousey, Managing Director of
Fixed Income at First Trust, andJohn Wilhelm, Senior Portfolio
Manager of the First Trustmunicipal securities team.
Today we're going to talk aboutbonds.
We're going to discuss theimpact of Fed rate cuts.
(00:31):
We're going to talk about theyield curve.
We're going to talk aboutgovernment shutdowns.
And we're going to discuss whythe municipal bond market has
underperformed this year andwhat they what that might mean
going forward.
Thanks for joining us.
So as I was preparing for thispodcast, I got to thinking what
would be more fun than talkingto a bond portfolio manager.
Bill (00:56):
It's not much.
Ryan (00:57):
It's talking to two bond portfolio managers.
Twice the fun.
So twice the fun.
I'm glad you guys uh glad youguys made it.
Um so I was I was thinkingabout um the Fed, as I often do
as I'm driving around justcontemplating interest rate
policy, as I'm sure you guys do.
And um I guess what I waswondering is do you have a sense
(01:23):
of where the Fed stops cuttingrates?
They've already begun the ratecutting cycle.
Where do you think we end?
And and I guess when?
Bill (01:33):
Well, I guess I can start with that.
I mean, the framework that wetypically use to approach that,
and it the market refers to thisas what's the ultimate terminal
rate.
For us, it really hinges backto those inflation expectations,
because in a normal market,there should be an appropriate
(01:54):
real yield.
Like what's the amount aboveinflation that the Federal funds
rate should be?
And I think a big part of whythe Trump administration has
argued that rates should belower is that inflation isn't 9
percent anymore, it isn't 8percent, it's not 7 percent,
right?
It's been stickier in themid-twes, let's call it,
(02:15):
bouncing around, around thatnumber.
But what's the appropriateFederal funds rate above that?
And we've had a Federal fundsrate that's been, call it 200
basis points above inflation,and that's restrictive by most
accounts.
Most people would say that'srestrictive.
Now, some people would say, butlook at the stock market, and
(02:37):
we can debate whether high stockprices are indicative of
whether it's restrictive, or wecan look at delinquencies on
credit cards and how it squeezesvarious parts of the economy.
So there's a lot you coulddebate around that.
But for us, that is what itwould typically come back to.
And so when we look forward andwe say, where do we think
inflation will be, let's justsay by the end of next year,
right?
By the end of 2026, where do wethink inflation will be?
(03:00):
And I think in thosediscussions I have had with Bob
Stein, our Deputy ChiefEconomist, Brian Westbury, our
Chief Economist, theexpectations are for inflation
to work its way back downtowards that 2 percent.
So normally we would say thebond market today is pricing in
around a 3 percent terminal Fedfunds rate.
So the Fed cuts rates fromwhere they are today, 4 to 4 and
(03:24):
a quarter, down to that 3percent level between now and
the end of next year, and holdsthem there.
That is what is priced into thecurve.
And we would say that'sprobably a pretty reasonable
middle-of-the-fair way bet basedon the data we have today.
Obviously, a recession wouldcause something different.
A higher inflation would causea different path, but what for
what we know today, ahundred-basis point real rate
(03:45):
over our expected inflationseems like a reasonable set of
circumstances.
Ryan (03:50):
So, John, uh what do you think that does to the yield
curve and what as the Fed hasbegun to cut rates in this cycle
so far?
I mean, how how has thatimpacted the yield curve thus
far?
John (04:04):
Well, we've seen uh the short end of the Treasury curve
decline quite a bit as the ratecycle or the Fed cutting cycle
began, and we've seen that aswell in the municipal bond,
let's say one to five year partof the curve.
And where we've seen uh morestickiness, I think partially
(04:24):
because of inflation, but alsoyou could add in things like the
U.S.'s structural budgetdeficit, is when you get to 10
years to maturity and beyond inthe U.S.
Treasury curve and as well themunicipal bond curve.
And I I think there we're alsowe're gonna be looking at
employment, we'll be looking atwhat we would expect as well as
(04:45):
the decline inflation over thenext 12 months, but we'll also
have to look at the size andmagnitude of the structural
budget deficit in the U.S.
Is it gonna stay at 6.5% or 6%,or what's the trajectory of it
and how does that affect uhborrowing by the U.S.
government?
Ryan (05:02):
Yeah.
So the fundamentals of the U.S.
Treasury market, that the theuh ability of the U.S.
government to to pay for itsits debts.
I mean, no one really callsthat into question, right?
We we all kind of think thatthat's gonna happen.
Is that that's a fairstatement, right?
Um but it's fair.
But eventually the marketstarts to charge us more for uh
(05:26):
in interest, despite the factthat the Fed is lowering rates
at the front end.
Is that what your expectationis that the if if we don't
address some of the budgetdeficits, that you could see
rates drift higher at the longerend?
Bill (05:40):
The way I would tend to think about that might be a
little different.
It would just simply be thatwhen we look at what's in in the
market today, we we have a viewon what the deficit is.
Now I can tell you coming intothis year, no one had a view
that the administration wouldgenerate $350 billion of added
revenue from tariffs.
Right?
That wasn't in the equation.
(06:00):
And so there are otherdimensions to this that that one
has to consider, the unknowns,if you will, but it has more to
do with the unknowns in thesense that there's a price today
for what is known.
And if we were to show up towork tomorrow and the budget
deficit were to ramp up fromhere, well, that's that's that
would be a new variable, andthat would have to be priced.
(06:23):
But when we think about today,it's not like the budget deficit
today is a surprise.
So the way we think about it,it's in the price.
The deficit today is in theprice, right?
Because it's it's alreadyknown.
It's the unknowns that aren'tin the price.
So if you have a materiallylarger deficit, well, then you
would have to reset rates higherto accommodate larger supply,
(06:44):
treasury supply.
And if you have a smallerdeficit, right, when in and
increased revenues coming in andincreased growth in the U.S.
economy because of, let's say,pro-growth um you know
pro-growth policies that haven'tbeen sort of priced into SIBO
scoring and things like that,obviously that's not in the
equation.
So there's a number ofvariables, so we want to be
careful with the sort of alwaysthis happens or never that
(07:07):
happens.
But in reality, I think it hasmore to do what's in the price
today, what's known versuswhat's unknown, and how that
will drive the equation goingforward.
Ryan (07:16):
John, I was also wondering about labor market dynamics and
and how that plays into whatthe Fed is doing in conducting
policy.
Um have you been surprised athow resilient the labor market
has been?
Because it's I think mostpeople, if you would have asked
them a couple years ago, youknow, where uh the unemployment
rate would be today, given allthe variables that we've seen, I
(07:38):
don't think anyone would haveguessed that the unemployment
rate would still be this low.
So um what do you think aboutthat?
John (07:46):
Yeah, I think when you saw job growth, uh the initial
numbers, especially last year,they looked robust.
Uh various reasons were putforth for that, everywhere from
the amount of immigrants lookingfor jobs, uh stimulus payments,
(08:10):
uh another potential source.
Uh however, when you get tolook at this year, there's a
couple of items.
One, when you look at thepayroll numbers over the last
four months, you know, much moremuted growth.
Whether you look at the ADPfigures or the payroll numbers
that now we're not seeingbecause of the government
(08:30):
shutdown.
So I think that has really ledto the Fed having a much more
balanced approach than they hadin January of this year, where
they seem much more concernedabout the inflation outlook and
the potential impact on tariffs,to where they sit today, where
they seem much more concernedabout now what uh the job growth
(08:52):
numbers will be in the upcomingmonths.
And also the revisions thatthey do when they adjust
previous statistics that theyput out have showed
significantly uh weaker andfewer jobs.
And I think those revisionsplus the actual uh previous four
months data really paint adifferent picture of very muted
(09:15):
job growth.
Ryan (09:17):
You mentioned the government shutdown, and you
know, there's always a risk whenyou're recording a podcast that
by the time it airs, maybe theshutdown will be over.
But assuming it's not over, Iguess I wanted to talk a little
bit about that because it seemslike at least the equity markets
have kind of shrugged it offand said this isn't a big deal.
Uh maybe it's because ithappens pretty much every year
(09:39):
lately.
So do you have any thoughts onuh the impact of the government
shutting down for a period oftime, what impact that has on
the economy or or markets?
John (09:50):
Yeah, historically we've looked at the data from a
municipal bond perspective.
And when you look back at theduration of government
shutdowns, the five most recent,let's say, they've been short
in nature and have had limitedimpacts uh long term.
Uh what gave us a little bitmore pause from a municipal bond
(10:11):
fixed income perspective wasthe potential of more federal uh
job losses.
That was one point that wasdiscussed, perhaps just as a
negotiating tactic.
But to the extent that that wasrealized, especially if it was
those federal job losses were incertain uh specific areas,
(10:31):
whether it's Washington, D.C.
or parts of Maryland orVirginia, for instance, that
could have a longer-term impacton municipal bond credit quality
where those workers arelocated.
Bill (10:42):
Yeah, and I mean I think you know, as you look back and
empirically and think about whatthe impacts have been to the
market, I mean it's very rarelythere's a de minimis impact to
the economy from a GDPperspective when you've had
government shutdowns.
And just like anything else,the longer a shutdown lasts, the
more uncertainty will build.
And you could see that spillover.
(11:04):
But empirically, what we'vegenerally seen is that interest
rates have typically come downin government shutdowns, a
little bit of a flight toquality, right?
A little bit of a flight tosafety under those
circumstances.
But I think the market ispretty comfortable with
government shutdowns by now.
And so again, just like youknow, most things, the longer
they last, the more uncertaintybuilds around them.
So it really will come down tohow long it lasts before we get
(11:28):
the the appropriate signaturesto to sign the bill.
John (11:31):
Yeah.
When you look at the last fivegovernment shutdowns, Muni
returns were positive and fourout of the five.
The only one where they werenegative was during the taper
tantrum.
So you could really say therewere other factors overwhelming
the nature of the governmentshutdown.
Ryan (11:47):
So do you guys have a sense as to where we are in the
economic cycle?
Because you know, the Fed iscutting.
We have a relatively lowunemployment rate.
We've got I mean, at least thelast couple prints have been
fairly strong in terms of GDP.
So it doesn't it doesn'tnecessarily seem like we're in a
(12:07):
you know about to tip into arecession.
And you know, our chiefeconomist Brian Westbury um has
some other thoughts on that andmaybe a higher probability of a
recession.
But um where do you guys thinkwe are in the economic cycle
today?
Bill (12:22):
Well, I think just looking back, the reality of where
we're at in the cycle is alwaysunknown, right?
It's it's never easier inhindsight to know.
Always easier in hindsight toknow, and nobody really knows.
But what I would say is, wereally haven't had a true
recession since 2008 and 2009.
We had a government-inducedshutdown, obviously with COVID.
(12:45):
It was very short-lived.
And the inflation thatfollowed, the stimulus that was
injected in caused the yieldcurve to invert.
Clearly, you know, even Ithought that would lead to that
ultimate recession at the time,but it was dwarfed by the
stimulus that came in.
I mean, we put it we put atrillion dollars into people's
(13:07):
checking accounts and you know,trillions more into the economy
with a T, right?
These were massive, massivenumbers.
And they had a really bigimpact.
And today, where's that comingfrom?
Well, clearly that's comingfrom AI spend.
That capital spend is enormous,and it goes beyond a data
(13:27):
center build in the sense ofbuying semiconductors, GPUs, the
things that are needed.
It goes all the way down to theHVAC, the cooling, the the you
know, the contractors that arethat are constructing.
There's a tremendous amount ofripple effects through the
economy.
And these things are verysupportive right now.
But with that being said, itdoesn't have to be a hard
(13:51):
recession eventually, but itwould be very normal after such
a big uh capital spend toeventually get to that point.
So is it 2025?
Probably not.
It's almost over, right?
Um it's uh it's hard to knowexactly how that plays through,
but we have seen, you know, theysay history rhymes.
(14:11):
It rhymes.
It rhymes with 01 and 2002 andthe capital spending that took
place, obviously, through thedot-com build.
Um, in reality is we haven'teven had a 5 to 10 percent
pullback in stocks since theApril low.
So that's something we shouldbe mindful of as well.
It would be very normal to havea 5 to 10 percent pullback,
which would then spill throughto credit markets and the things
(14:34):
that we're focused on after a35-plus percent recovery from
the April low, you know, that wehaven't had yet.
So, you know, it's more likelythan not we get a correction
before we get a recession.
I don't think there is anythingtoday that says that imminent
recession is coming.
We're looking for the canariesin the coal mine all the time.
Bankruptcy is making someheadlines recently, things like
(14:56):
that that we want to pay veryclose attention to to see are
they idiosyncratic or are theymore pervasive throughout the
economy?
Ryan (15:03):
So, Bill, you spend a lot of time with uh financial
advisors and your your travels.
What are the questions thatyou're not getting today that
you should be getting?
It's a really good question.
Bill (15:15):
I I think that it's maybe a question, but asked
differently.
So a lot of advisors today havethey're being shown a lot of
new and innovative products,right?
The world has changeddramatically in the last 10
years.
For everything from leveredproducts, um, you know, we used
to just think about leverage inthe market as margin.
(15:37):
Now you've got to look atlevered ETFs and all these
different ways that investorsget levered into the market.
Um, and there's a lot ofquestions, especially after
2022, about whether advisorsthink that bonds even belong in
their book anymore, right?
Because they have got all theseother alternatives and
substitutes.
And you know, I look back overthe last few years, so let's
(16:00):
think about this three years,and I actually counted.
In the last three years, therewere still nine rate hikes that
came through the numbers, right?
We've obviously had some cutsas well in there, but there were
nine rate hikes that still camethrough.
There were 21 in total hikesfrom the tr from you know, zero
in the Fed started raising.
But when you start to look atthe cumulative returns in the
(16:22):
bond market over the last threeyears, I think advisors, the
most advisors that I'm talkingto are surprised by the numbers.
You know, high yield up 36percent, bank loans up 32
percent, Munis tax adjusted 26percent over the last three
years, investment gradecorporates 23 percent, MBS 16
percent, the ag core bonds up 15percent, even treasuries are up
(16:44):
11 percent in the last threeyears.
So, you know, when you thinkabout numbers like that and the
importance of the bond market,especially when you think about
where valuations are in thestock market today, Dave
McGarrell, our CIO, talks aboutthis all the time.
Valuation multiples are high,forward returns statistically,
empirically, um, they're not asgreat when you enter the at
these levels.
(17:04):
And you start to overlay thebond market durability that that
we've got today, because rateshave set reset higher, and
whether it's taxable ortax-free, I think it's really
compelling, and I think it'sgoing to continue to be
compelling, and I and I think itneeds to be understood more
about how durable these returnshave actually proven to be, with
(17:26):
that rare exception of what wesaw in 2022, which was just the
resetting back to normal, right?
That's already taken place.
And I think that is going to besomething that should be really
much more topical.
Ryan (17:36):
So do you think that advisors maybe have avoided
rebalancing back into their bondportfolios, given the strength
of the equity performance?
Bill (17:45):
Yeah, I mean, when we talk about what we have seen in
terms of just just talk aboutcash balances, you know, I see
the numbers, we all see thenumbers, they're kind of
staggering over $7 trillion incash balances.
Um I ask most advisors, manywill tell me that they have
larger cash balances, maybe inaggregate they're about the
same, but some have certainlymore.
Um, if you have money marketexposure, your income is already
(18:06):
down over 20 percent just fromthe cuts that have already taken
place.
It's already fallen by 20percent.
So when we think about incomeand how to position and the
duration that we add toportfolios, it's to build income
durability.
And so if you haven't thoughtabout it as an advisor or uh as
an investor, if you haven'tconsidered why that's important,
(18:26):
it's because on a path of lowerfederal funds, right, money
market rates are likely tocontinue to fall, and that
income durability is going to bereally important to kind of
supporting your portfolio overtime.
And so we think that that's a areally significant
consideration that has to bemade.
Ryan (18:45):
Okay, John, what questions are you not getting from
financial advisors?
John (18:51):
In the in regards to municipal bonds, really the
question has been why have Munisso underperformed other fixed
income asset classes for a goodportion of the year, really
until September and performanceuh really turned around.
And I think when you look at ituh with the benefit of
hindsight, I think Munis wereparticularly impacted by the one
(19:16):
big beautiful bill act and someof the fears that were out in
the marketplace about how our$4.2 trillion asset class might
be affected.
So, first you had thepossibility of the diminishment
in the tax exemption.
So, would the full couponpayment that you receive on a
(19:37):
municipal bond be tax free?
And then the conversation wouldturn would certain kinds of
municipal credits not be able toissue bonds on a tax exempt
basis in higher education oruniversities were talked about,
um, hospitals, private what wecall private activity bonds.
And as we know, up with thepassage of the act, none of
(20:00):
these potential fears came tofruition.
There was no uh substantialchange uh in the value of the
exemption.
There was no change really, andthen there were certain nuances
or changes in tax laws wherenew municipal entities could
issue.
But what I think the effect waswas it brought forward new
issues supply by highereducation institutions, by
(20:24):
healthcare institutions thatwere concerned about whether
they might lose access to thetax-free market.
And I think this bulge in newissues supply has really been
one of the reasons why themunicipal market has
underperformed year to date, butalso creates the opportunity
when you look out that over thenext 12 months.
Ryan (20:44):
So, what you're saying is that borrowers, municipal
borrowers, instead of maybeborrowing in October or
November, they weren't reallysure that the same provisions in
the tax code would would stillbe enforced.
And so instead they wanted toborrow earlier in the year, and
as a result, there was moresupply of those bonds that hit
the market, and that had a lotof supply, and that had, you
(21:08):
know, supply and demand causeprices to drop.
John (21:10):
Is that yeah, it's that fundamental.
If you went through the end ofSeptember, new issue supply was
up 12% to $435 billion.
That was compared to 2024,which was a near record year of
supply.
If you compared that to thefive-year historical average,
it's a lot higher percentagethan that.
(21:31):
So, what our expectation is iswe'll have a fairly robust
October for new issue supply,but the bulge bracket
underwriters are expecting it touh new issue supply to be
diminished in November,December.
So, really, there's been thisbelief of buying the dip this
month.
If you, to the extent you getsome lower prices, higher
(21:52):
yields, wider spreads, youshould buy into it because there
will be less new issue supplyas we get into the last two
months of the year.
Bill (22:00):
It really did seem to set up sort of a perfect storm.
We were talking about thesupply-demand dynamic and the
points John made.
I think through July wemeasured it, and there was it
was 55 percent higher, $100billion more supply than the
last five years.
I mean, that's a big number forthe market to absorb, all you
know, largely driven because ofthis fear of losing the tax
(22:23):
exemption.
But there were other factors,and one of those was also tied
up in the one big beautiful billon the credit side.
And that's something that Johnand I spent a lot of time
working on last year because BobStein was talking all around
the country about how hebelieved that Donald Trump would
win the election and howRepublicans would sweep.
And one of the big policypoints that he felt like the
(22:44):
administration would go afterwas Medicaid funding.
And Medicaid funds a lot ofhospitals, right?
Hospitals depend on thosepayments as they treat patients.
And so last summer, before theelection, we had brought
together our analysts acrossfrom health care, from high
yield, you know, senior loans,investment grade corporates,
municipal bonds, John, myself,and working through where our
(23:08):
Medicaid exposure was topreemptively clean the book to
ensure that we were prepared toplay through that.
And that was another variablebecause we did see a bit of baby
with the bathwater in a lot ofpockets of the credit markets,
from munis through corporatecredit, where there was so much
uncertainty about what bit whatone big beautiful bill would do,
and that has an impact onpricing.
(23:28):
And let's not forget what theadministration was doing or has
been doing with universitiesalso funded the municipal bond
market.
So it really was a perfectstorm and has been uh throughout
the course of the year that haskind of led to some of this
volatility and candidly theopportunity that we see.
John (23:43):
Yeah, and it that's a great point.
And what we saw in Septemberactually was hospitals
outperformed versus otherrevenue bond sectors in our
market.
And I think now uh it's beenthat collective analysis by the
market of, well, who will besuccessful hospitals?
It's obviously a very importantsector, healthcare in general.
(24:06):
So we did the same thing afteryou know a lot of conversations
with our research team andtalking with Bill's team about,
well, what do you prune?
You know, what have youreduced?
And it's the safety nethospitals that have high
Medicaid exposure, a lot ofself-pay exposure, focus on
those stronger credits that arenumber one or number two market
(24:28):
positions in their geographicfootprint, growing populations,
better payer mixes, highercommercial payers, for instance,
stronger balance sheets.
And now I would expect thoseproviders, those that show great
ability to survive and thrivein a reduced Medicaid
reimbursement market, will seebetter returns and credit spread
(24:50):
compression for them.
Ryan (24:52):
Okay, so you've got an environment where prices drop as
a result of the dynamics youtalked about, yields go up, they
get more attractive, demand hasthat come back?
Have investors, what have fundflows looked like for Munis?
Has that been an area whereyou've seen some strengthening
demand?
John (25:11):
It's actually been a surprise, but a positive
surprise because when you lookedat how much the municipal yield
curve steepened beyond 10 yearsfor a good portion of the year,
historically you would think,well, we're going to be in an
outflow cycle because as aretail-driven asset clash,
you'll get more selling of fundshares and mutual funds or
(25:31):
exchange traded funds or othertypes of products.
But we've really seen thecontrary.
So just this past week, forinstance, we had 1.1 billion of
inflows into the municipalmarket.
Year to date, we've had 31billion of inflows into mutual
funds and ETFs.
That doesn't take into accountseparately managed accounts for
SMAs.
(25:52):
Uh and we've seen 21 of that 31billion come into municipal
ETFs as municipal uh exchangetraded funds take greater market
share.
And to kind of fill out thepicture, within that 31 billion
of positive fund flows, 8.6billion have come into high
(26:14):
yield.
So I think what what that showsis that with this rise in
yields, especially in 10 yearsand beyond, uh you see taxable
equivalent yields for thoseclients in the highest tax
bracket that are veryattractive.
That's sound equity, likethat's something that Bill and I
have talked a bunch about.
And that uh investors areresponding to that.
(26:37):
A unique opportunity wheremunicipal bonds have cheapened
for, I would say, reasons thatnow we can see what reality is.
There were fears that didn'tcome to become realized, and now
you have the opportunity, andthere's been more buying of
mutual funds, exchange tradedfunds, and SMAs.
Bill (26:56):
And usually what you see in the market is, you know, you
get these periods in the market,supply-demand technicals, as we
just talked about, andeventually the smoke clears, the
dust settles, the focus shiftsback to valuations,
fundamentals, and that's whereit tends to mop itself up.
So the, you know, I it's one ofthose opportunities where we
think that as it's plays throughinto next year, I think we're
(27:16):
gonna all look back and say,boy, that was a really good
opportunity because it's notlikely to persist based on the
way that perfect storm that kindof developed this year, that's
not really likely to exhibititself.
And when you think about,especially where the Muni
opportunity is is m has beenmost attractive, as John pointed
out on the long end of thecurve.
So think about that from tensout to 30s in particular, right?
(27:38):
A lot of some some activitiestaking place in the U.S.
Treasury curve as well, whereyou know, if you think about
foreign yields relative to U.S.
Treasuries, you know, this isone of the things that's often
overlooked.
A lot of the headlines andnarratives are typically tied to
the Treasury curve sayingthings like deficit spending is
a big driver of that, um, fearsaround auctions and the like.
(27:59):
But if we looked around theworld, we'd see that you know
Japanese government bond yieldsare up over 80 basis points this
year, um, places like Germanyand France up you know 60 plus
basis points this year on 30s,um, the U.K.
uh.
So this dynamic, this relativevalue dynamic that's taken place
(28:22):
has caused some upward pressurein my mind, at least on the
outskirts of the curve.
And then you factor in what'shappened in Munis with this
supply-demand technical and it'screated tech uh taxable
equivalent yields, you know,that would most of us, if you
look at, I think we were lookingat double A taxable
equivalence, we're at double Ataxable equivalence right now,
would you say, and that back endof the curve, sort of tens to
(28:44):
thirties.
John (28:45):
It's still very commonplace with A and triple B
rated bonds in 15 to 20 years toget you know well over four
percent yields.
And it once you're at a 4.12percent, that's a 7% taxable
equivalent yield.
So to me, if you're buying goodstructure and call protection
and you can lock that in for anumber of years, as you're
(29:07):
suggesting with an A or A ratedbond, you know, I think I asked
you earlier about the uh theyield curve and and uh you and I
were talking last week aboutthe roll down, the the
importance of the roll down inin uh contributing to your
returns.
Ryan (29:26):
For those that don't know what that means, give me some
some bond nerd talk.
John (29:31):
Yeah, so to go into a little bit more detail, I
hesitate, but uh my bond geekdomfor sure.
But when you look in the 10 to12 year part of the municipal
yield curve, and you you look atthat bond a year from now,
it'll be 11 years to maturityand two years, 10 years to
maturity.
So the yield curve uh has aslope that's upward sloping, so
(29:56):
you get more yield in generalfor the longer out you go.
Right now, if you look from 10to 12 years to maturity, there
are 46 basis points of rolldown.
So about 15 basis points ayear.
And the you know, the withoutdo if I do finger math, that's
potentially a point and a halfpercent of performance just from
(30:18):
roll down from that 15 basispoints plus your coupon income.
The coupon income for a 12-yearbond that's A-rated is 3.56% or
thereabouts, right?
3.5%.
So to me, to lock that in wherein the steepest low part of the
curve where you're gonna rolldown about 15 basis points a
year for three years with agood, pretty good starting
(30:40):
yield, that's a place toallocate some income.
And then as Bill said, furtherout the curve, if you look out
16 to 18 years to maturity, youdon't get as much roll down.
It's not 46, but it's still 33basis points.
So still about 11 basis pointsa year or a percent.
If you're buying a bond with along embedded call structure,
you really don't want to go intobond structures.
(31:02):
But then your starting yieldfor an A-rated bond is 4.26% in
that for that 18-year bond.
So that's to me theopportunity.
You get this really attractivenominal yield, highest tax
bracket client, that 4.26 iswell over 7%.
And you've embedded, if theslope of the yield curve rolls
(31:24):
down at the today's rate, you'vebuilt in performance.
And if rates go up, you'replaying good defense, because at
least you'll offset some ofthat increase in rates by the
bond rolling down the yieldcurve.
Ryan (31:38):
Um it strikes me that a lot of what you're talking about
positioning on the yield curve,selecting credits, you don't
really get that in an indexfund.
You guys are both activemanagers.
So, you know, it when you whenyou're managing a fund, are
these things that you're lookingfor opportunities to add value?
Bill (31:57):
Well, absolutely.
And it and this is one of thethings that we've always talked
about why in terms of why webelieve active wins over time,
especially in fixed income, it'sbecause the indices are
literally just constructed basedon where the debt issuance is.
And so it doesn't considerwhere the better opportunity on
the curve might be.
The indices don't consider howmuch credit risk you're taking
(32:20):
and when you want to take thatcredit risk, for example.
Um it's simply based on thatdebt issuance.
So from our perspective, yourisk management is really the
nature of fixed income.
And so, you know, you start tothink about, hey, I want to own
bonds for the income, I want tocarry, clip that coupon, and I
want to sleep at night.
Most bond investors think likethat, right?
(32:41):
They want to capture income,avoid loss.
And there's just no riskmanagement takes place in a
passive index.
It's simply representative ofwhere the debt is issued, the
more debt that's issued, whetherit's the ag, where 44 percent
of the ag today is treasuriesbecause the government is
funding large deficits.
That wasn't always the case.
That's probably 20 percenthigher than it was 15 years ago.
(33:02):
That doesn't mean you shouldhave more treasuries just
because the government hasborrowed more, or in the
municipal bond or corporatecredit market, you know, a large
issuer borrowing a lot ofbonds.
And we can go down a list ofcredits that that we have
avoided that have borrowed a lotof money, both on the taxable
and tax-free side, because theyhave borrowed a lot of money,
we've avoided them.
And they become large weightsbecause they've borrowed a lot
(33:25):
of money, so in a passive index.
And those are really criticaldistinctions, we think, with
respect to active in fixedincome versus passive.
And it's particularly differentwhen you think about it
relative to equities, where yourlarge capitalizations might
tell you something about thefundamental health of the
business.
You might want to own more of abig company on the equity side
(33:46):
because its market cap may tellyou something about the
fundamentals.
In the bond market, it's thereisn't a market cap, it's a debt
cap wherever the largest debtissuance is.
And these are very different.
John (33:56):
Yeah, and I would say uh during certain periods of time
through the economic cycles, theamount of debt you can issue is
not merit-based.
Sometimes you get into veryspeculative investment
opportunities that find an open,uh, well-received market by
purchasers.
(34:16):
And I think of that especiallyin the high-yield context,
whether you're in the municipalmarket or the corporate
high-yield market.
And Bill and I have talkedquite a bit about a name that's
in both of our markets, uh, theBright Line East Railroad.
And this is a project that wasuh in Florida to finance
railroads from the Miami areaout to Orlando and eventually
(34:39):
Tampa.
Well, there's been a lot ofdebt issued, and they have been
increasing ridership, but whatthey're seeing is that they're
not raising ridership at arevenue per passenger that now
covers debt.
And to me, that's just anexample of a capital market that
(35:01):
was very receptive to uhletting borrowers sell them
bonds, that then you build it,and then the build and they will
come part of this.
Is will you have enoughridership?
Will you have enough revenuesper writer to cover all that
debt that's now in the publicmarket?
Ryan (35:20):
So let me play devil's advocate because I've heard this
from some uh passive bond fundum managers where they suggest
that yes, it's debtcapitalization weighted, but
those that's a good thingbecause those big debt issuers
um have their more liquidholdings.
How would you respond to that?
That those you know, the yes,they have got a lot of debt, but
(35:42):
but it's liquid.
Bill (35:43):
It's to me, this has always been one of the most
common misconceptions in thebond market.
In the most extreme sense, someof the largest issuers that
have come to the market toborrow on the credit side have
filed for bankruptcy.
And so quality, we would argue,drives liquidity.
In 2008 and 2009, during thefinancial crisis, if I needed to
(36:07):
sell a bond to meet aredemption in a fund, for
example, during hemorrhaging offund flows and the volatility
that ensued the market, therewas always a bid for a bond
where it was a quality bond,because I can open a 10 Q, I can
open a 10K, I'll bid the bondbecause I know what it's worth.
If it's a distressed situationbecause it was big and they
(36:31):
borrowed too much, good company,bad balance sheet, or whatever
the circumstances were, badcompany, too much debt, that
doesn't mean you're going to geta bid for it.
So where's the liquidity?
Where's liquidity in thatsituation?
Because distressed buyersaren't lining up in that
environment to take outdistressed debt.
So the reality in thosecircumstances is quality drives
(36:52):
liquidity, and that's when youwant it most.
It's what's the quality of theholding, and that's what
provides durable liquidity.
And what we spend all of ourtime doing is thinking about
what is the quality of thiscompany, what is the quality of
this bond to prove that it willbe liquid when we need it to be.
John (37:13):
I love your term durable liquidity.
Yeah.
Because initially you may gainsome liquidity benefit from very
large bond issues in themunicipal market.
There may be more participantsthat may be supporting the
market, but ultimately it's cashflow in your ability to cover
your interest and principalpayments and how much leverage
(37:35):
you have and what your balancesheet liquidity looks like.
And that's really what'simportant.
So to us, it's really thatupfront review of looking at the
prospects of the business andtrying to do sensitivity
analysis of what is theirultimate leverage and ability to
cover debt service look like.
Ryan (37:55):
So everyone's talking about AI these days.
Um you guys are portfoliomanagers.
You know, we hear that AI isgoing to displace all the
white-collar workers eventually.
Is AI impacting the way thatyou do your jobs?
And are you using it or isthere a use case for you to use
it today?
Bill (38:14):
We're using it quite a bit right now, and we've been
developing tools to use it morerobustly.
I think it has been aphenomenal innovation for what
we do on a daily basis.
It has absolutely empowered ourteam to process a far greater
volume of data expeditiously.
(38:35):
The ability to source theinformation through the tools
that we've developed, developedhave been spectacular.
It's really going to be sort offascinating in our careers to
see where this takes us, um, andespecially our ability to, as I
point to, like custom developsome of these tools that have
been really robust in what we'redoing.
(38:56):
Now, it's going to impact us intwo ways, right?
The tools we use, but also thebusinesses we invest in.
So we want to be reallythoughtful about the risk of AI
to a company that we'reinvesting in.
So how does AI displace whatthey do, or how can it?
Because what we've seen is thata simple narrative of it could
(39:17):
displace what they do is causeprice volatility in certain
credits.
So we want to be really, reallythoughtful about where that
risk is and how we size thatrisk.
Um, you can have really solidfundamentals, good performance,
but if somebody's afraid of AIrisk, you have selling pressure
in that company.
So we've got to be thinkingthrough that.
Um it's gonna have a uh areally big impact in a number of
(39:39):
ways, in both in terms of howwe're investing and the thought,
um the risks that we have tomitigate when we look at various
companies, but also um as areally powerful tool.
And the development we're doingthere, I think, has has been
extraordinary.
John (39:54):
Yeah, I think for us uh early days as an additional
municipal bond research tool,it's come in very handy.
You've read through the bonddocuments, you've um looked at
things like feasibility studies,you've done your article
searches.
Well, what have you missed?
What other things can you lookat?
And I think artificialintelligence is a way of then
(40:18):
being another set of eyes forsomeone that's taking the lead
on a new municipal bond issue tosee, okay, well, what else?
It gets into well, you got tobe crafty and ask the right
questions to be able to reallydig and and have this broader
view of data out there.
That's to me like the power ofit is you you can't get really
(40:39):
wider in terms of finding dataand presenting it to a research
analyst or a portfolio managerand hopefully making the best
decisions.
I think where we're we're alittle bit earlier, DIDs, on the
municipal side is how do weincorporate that more in the
portfolio management side tomake sure we're seeing the
broadest array of, for instance,secondary market offerings as
(41:02):
quick as possible so that we canmake decisions with research
about what we want to buy, sell,and hold.
Ryan (41:09):
You know, one of the things that's always fascinated
me about the municipal bondmarket is just sort of the
mismatch between the way thecredit rating agencies evaluate
muni bonds versus corporatebonds in terms of you know the
the uh default rates forrelatively similar credit
ratings.
Can you talk about that uh abit?
(41:30):
Because I I I've listened toyou talk about it before and
really kind of enjoyed thecomparison.
John (41:36):
Well, I think the municipal bond versus corporate,
you can look at feasibility orstudies by rating agencies that
go over the past 50 years or so,and you can look for a given
credit rating, let's say anA-rated MUNI versus an A-rated
corporate bond.
And Munis have had a lowerhistorical default rate when you
(41:58):
look at 10-year compound annualgrowth rates and higher
recovery rates if there is adefault.
I think there's potentiallyvarious reasons for that,
including the degree ofessentiality in basic municipal
finance.
You know, it's it's hard tomake an electric utility or
water and sewer system or aleading healthcare provider not
(42:21):
be able to cover debt service.
And I'm sure that there arelots of parts of the investment
grade corporate market in myexample that have a high degree
of essentiality, but maybe notas fulsome, not maybe not across
all the different industrysectors.
So I think that's uh animportant component of why high
net worth investors that maybeare looking at municipal bonds
(42:44):
as a as a source of ballast, soit's not going to generate the
returns of other parts of theportfolio like a high-yield
corporate fund.
But what it can do is providestability, knowing that you have
things like lower incidence ofdefault and high degree of
essentiality.
Bill (43:01):
And I think, you know, when we when I look at ratings,
it's a little bit differentbecause a lot of people look at
a rating and see a letter.
I look at a rating and I see anumber.
Because ratings, as John wasputting to, are really about
empirical research.
If you look at a rating, ittells you uh there's a numerical
number associated with theseratings that give you an element
(43:23):
of what a cumulativeprobability of default is for a
given issuer with that rating.
So for example, a mid-single Bhas got something like a 27%
cumulative probability ofdefault in the next five years.
So understanding what thoseratings really mean from the
probability or statisticalprobability empirically of a pro
(43:44):
of a default is is reallyimportant.
So it isn't linear, right?
There isn't a linearrelationship between a double A
and a single A and all the waydown the rating scale.
It's logarithmic.
Your probability of defaultstatistics change dramatically
when you're moving up inquality, and you know, they move
all the way to a hundredpercent probability of default
(44:05):
as you get into the lowestratings.
So ultimately D4 default.
But understanding that, Ithink, is really, really
important.
John (44:13):
I think to the I totally agree.
And one of the areas that we'vetried to do differently than
what you would see if you werelooking at the rating agencies
is our research team has to comeup with a numerical score for
credit quality momentum.
So we use a numerical score, wedon't call it stable, for
(44:33):
instance, or declining orpositive.
Those are the normal terms forthe rating agencies, but we make
them put a number on it.
So which shows the strength ofcredit quality improvement or
declining, and that helps us inour surveillance meetings decide
which credits are we going tofocus on for buying additional
power amounts of those with thestrongest credit rating momentum
(44:56):
and those that have theweakest.
Well, those are bonds thatyou're more likely to engage in
a sell discipline and decide,well, is this something that we
want to continue to hold or dowe want to pair back?
And the last thing I'll I'llsay about this is the rating
agencies can do a good job onthe initial review of a
municipal borrower.
(45:17):
But what we found is oftentimestheir ability to do
surveillance on an existing bondthat they have provided a
rating on isn't always timely.
And that's one of the areasthat we really try and
differentiate as a researchteam, too, is make sure that not
only have you done the creditwork, but you've done the
follow-up work to see if thatparticular borrower is doing
(45:40):
what they said they were goingto be able to do.
Ryan (45:44):
All right.
John, since it's your firsttime joining us on the podcast,
I'm going to ask you the uh thefinal question because I've I've
already gotten some bookrecommendations from Mr.
Housey over the years.
I've I've read about uhShackleton and uh his his
adventures.
Uh but one of the things that Itend to ask guests of the ROI
podcast is what's your readinglately, or if there's anything
(46:05):
you've read recently that youwould recommend us checking out.
It doesn't have to be uh a bookabout bonds as as scintillating
as I'm sure that would be.
Um is there anything that youwould recommend that we add to
the book list?
John (46:18):
Well, I've got uh three adult uh daughters, and my wife
and I traveled actually to winecountry in California the last
couple of years, and at one ofthe places we visited, they
recommended a book called WineFolly Magnum Edition.
And this book I have found willnot only tell you a lot about
(46:41):
wine and grapes, but alsogeographic regions across the
world, as well as then how youmight pair specific types of
wine with different types offood.
So for someone that's wanted tolearn more about this important
topic, I'm not surprised at allthat John's following.
Ryan (47:00):
I don't think we've gotten um that sort of book
recommendation yet, but um I Ireally like it.
I'm gonna check it out.
Thank you for that.
Well, guys, I appreciate you uhspending some time with me on
the podcast today.
Um, like I said, it's alwaysfun having two bond portfolio
managers join me.
So thanks.
We'll have to do this againvery soon.
(47:20):
Um, and thanks to all of you aswell for joining us on this
episode of the First Trust ROIpodcast.
We'll see you next time.
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