Transcription:
Lynne Funk (00:03):
Hello everyone and welcome to another Bond Buyer podcast. I'm Lynne Funk, executive editor at the Bond Buyer, and I'm happy to welcome with me today, James Pruskowski, Chief Investment Officer and Head of Business Development at 16Rock Asset Management. Prior to his role there, James spent nearly 30 years at BlackRock, most recently as Head of Institutional and Wealth Management for Municipal Bonds. Welcome James.
James Pruskowski (00:26):
Thanks, Lynne. Great to join you.
Lynne Funk (00:28):
Great. So let's get into this. We have lot to talk about. We're going to talk about taxables, we're going to talk about foreign investors, we're going to talk about ESG, all these exciting topics. But first, the market and the industry itself is kind of going through somewhat a reset this year, perhaps. 2021, record low rates, 2022, massive selloff and reset to higher yields. And now 2023 feels like another adjustment period. Can you talk about how munis are faring and kind of how you see things shaking out in the next few weeks to months?
James Pruskowski (00:58):
Yeah, sure. I love your word of 'reset.' Let's dive into that a little bit. But generally speaking, we're bullish on the asset class for a lot of different reasons. I think generally speaking, absolute rates, trumps rich ratios. So as the market debates, the relative valuation, I think it's important to keep in sight. It's hard to have a view on munis without recognizing the backdrop from a macro sense to gauge sentiment momentum and how that filters through to the asset class. So with that said, I think there's a pretty narrow path to a soft landing. From a rates perspective, we likely think we see lower lows rather than higher highs. And arguably the financial recession that's already started is likely to bleed into the real economy, albeit with heightened volatility, as the market as you see now, is having a tough time trading through a 3.40%.
(01:57)
So given the risks of the Fed inflation and certainly the large layoff backdrop over what that means over the next couple months, I think your reset comment points to a regime shift going on within fixed income. So that's a pretty important component as it means for, or what it means for muni performance. Absolute rates are high, the economy's still dealing with aging demographics and the need for income, and I think from an inflation perspective, likely to come down a lot faster. At the end of the day, technology is still gutting the middle despite the excess reserves in the system, if you will, from the pandemic. I think broadly speaking, the great reset is an important topic. I mean, what we're dealing with and why 2023 will go down as being labeled as such as evaluation boom from the Covid era to now a significant contraction.
(03:00)
I guess I would ask the question is how many businesses were built to whether today's high Fed funds rate, and is the banking system kind of the canary in the coal mine? So maybe not a dire scenario like the roaring twenties that were followed or quickly followed by the Great Depression, but a narrative that you need to be respectful of and be cautious about. For Munis, we have an environment of technical perfection. Flows are stabilizing, we have slow supply growth and challenges I don't think are going away as it relates to the supply side of the equation and the need for fixed income continues to grow. So I think this goes back to why absolute rates matter a little bit more than ratios here. I think from the fundamental perspective, there's been a lot of talk about the golden year for municipalities and I buy into that narrative. Fundamentals are sturdy reserve funds are up or near record levels, but I think it's not to discount the fact that the market is at a peak rating cycle.
(04:09)
There are acute challenges that are going on for certain sectors and credits, and we're thinking about a cyclical defensive credit switch as relates to portfolio construction and somewhat cautious on private education sectors. And not to forget that the economic cycle that California per se goes through given the reliance on capital gains tax receipts. And I'd finish off by just saying that the policy backdrop is pretty favorable. I mean, individual tax provisions sunset in 2025. The regulation and the requirements are slowly and quickly evolving or quickly evolving and leading into the next presidency. Infrastructure is likely to be another top focus. And valuations, as I said before, are focuses on absolute rates more so than ratios. I mean the need for income and safety dominates the demand equation and munis serve up a lot of solutions in that regards. And the fact of an absolute rate focus is really a function of the power of the multiple. The higher the rate, the greater the multiple and the greater the passive income you could generate.
Lynne Funk (05:25):
Well, you laid out a lot out there James and I find it interesting, you know, talk about ratios versus real rates. That's something you've been talking about and some pieces you've written, and a lot of folks I think are like, oh, ratios are so low. Can you expand on that just a little bit why you think that real absolute rates are more important?
James Pruskowski (05:43):
Yeah, I think in part it's the economic backdrop contracting. I think the fact of you have to respect the facts of the components of that longer-term aging demographics and the need for income, the diversification benefits that it provides not only the aging lifestyles, but corporations looking to match liabilities and diversify. And then just simply the way the math works a higher the rate, the greater the multiple is in terms of the exemption and at the end of the day driving the demand base or who is driving the demand of markets.
Lynne Funk (06:24):
So we talked about exempts here. Now I kind of want to pivot over to Taxables and you know, mentioned supply and generals down Taxables supplies down quite a bit as well, but you are focusing on taxable munis as a big part of your portfolios. Can you talk about how you see them fitting into the market right now?
James Pruskowski (06:44):
Yeah, I think it's certainly something really important to recognize. I guess generally speaking, you have to think about the broader economy in terms of the diversification of how goods and services are transmitted throughout the world, what regulation is changing and how that impacts financing and investor preference and certainly the focus on infrastructure and how best is it to drive down interest expense and get best execution. So I think you have to really think about taxable muni supply and solutions from a global perspective when you address the market for opportunities and when you provide client solutions, think about your product platform and how relative value fluctuates and best capturing real returns, if you will. In terms of supply, I mean I think that generally speaking, we're pretty bullish on taxable issuance despite the challenges that exist for overall supply. And I would just say that as a percentage share of a total issuance, we continue to see it growing.
(08:04)
I think it's obviously a function of level of interest rates, so the lower the rate goes, the greater the use of the taxable option will become. I think that you'll see growth initiatives just simply as a result of tax reform and the elimination of the advanced funding option. And I think there's a lot of need by issuers just to manage market access in terms of the diversification of the buyer base in addition to other uses, whether you're hitting your debt cap in the exempt market or you just want to finance for other things that just wouldn't otherwise qualify in the exempt market. I mean overall I think issuance is just going to be challenged, generally speaking due to the inflation headwinds, rich budgets, reserves pretty rich and obviously the refunding option away from that. I mean from a policy perspective, it's important to keep your eye on the ball here.
(09:05)
I think when it relates as it relates to taxables and how we finance as a country and the way the federal subsidy is delivered and arguably is it delivered, I'd ask this question, is it delivered in an inefficient way and does it promote inequality and are taxable munis a solution to some of that over tax exempts? So I'm thinking it's interesting to keep this in mind as you create portfolios and build platforms for client solutions, the Build America age, Build America Bond age in 2009, why and how that was constructed. Was it really a current thought at the time or was it a brainchild of many years ago and into election year? I think that infrastructure is going to be a growing focus. Simply said, we just don't need another bridge to collapse to prioritize our aging infrastructure and modernize it, if you will. And I think given the success of BABs, the taxable option provides a pretty viable solution when you think about subsidies, inequality, and market efficiency.
Lynne Funk (10:16):
James, can you elaborate a little bit more on your comments there about the inefficiency of the exemption and the efficiency of the taxable market for our listeners?
James Pruskowski (10:27):
Yeah, I think it's as simple as thinking about the tax exempt market as an individual's market for high net worth individuals more so today than ever before. Given the corporate tax reform and the lack of grandfathering of the asset class, like what happened in 1986 is tax reform. So if you think about the inefficiencies or efficiencies at times of municipalities bouncing or financing debt off the individual base versus a taxable muni market that's broader in nature in terms and more global financing debt vis-a-vis multinational corporations and what that ultimately means by driving down interest expense.
Lynne Funk (11:17):
That's a nice segue then to talk a little bit about, you know, have through your experience over the years dealt with the growing interest from foreign buyers. I guess first is some of what you've written on recently is how regulatory regimes abroad make taxables a good fit for foreign investors and also just given international interest rates. Can you talk more about those aspects of how Munis can, the base can be broadened?
James Pruskowski (11:47):
Yeah, so I just say thanks for that and I'm fortunate to be one of the few in the market that have actually traveled the world to promote the asset class and I'm really, really thankful for that experience. Munis have many use cases throughout the world. It's not just a market for individual top tax rate payers. And when you think about the aspects of the market, high quality, broader diversification, benefits of long-dated structures, more stable volatility profiles and infrastructure characteristics that in terms of defining all that at corporate equivalent yields, they serve up a lot of opportunities and check a lot of boxes. And financial regulation is constantly evolving and being modernized throughout the world. You saw this domestically here in the states with the NAICS risk-based capital model that's geared towards insurers focuses on capital factors, which is basically the amount of capital that insurer must set aside and it's based on credit rating as well as the portfolio adjustment factor, which is basically amount of capital that can be used, the scoring system that can reduce capital requirements based on portfolio diversification.
(13:24)
So the higher the credit quality, the less capital requirements, the greater the portfolio, the more benefits you get from decreasing the capital charge. So pretty unique that if mostly just affects insurers here domestically, but it's important to jump overseas and think about what's going on at the end of 2016. Solvency too was amended to include infrastructure debt to promote financings not only within Europe but other countries including the United States. And if you think about or look at how infrastructure is financed all over the world, it's done in different ways in both private and public markets and a view on the US as can also be expressed through infrastructure, the economies and some of its parts. And the muni market is its foundations all 50 states and many local municipalities. So that infrastructure receives a lower debt capital charge and munis can serve up a lot of solutions, especially taxable munis.
(14:37)
And we're talking about that specifically with more diversification benefits and availability, excuse me, of non call bonds or calls within a tighter timeframe to the maturity of the bonds. I mean regulations evolving at different speeds. So Asia Pacific area has not fully adopted but is expected to a form of solvency too and it's coming at a different speed and being adopted in different parts of Asia at different rates. But I think it's all commonly forming around the global initiatives. And when you think back to the market, I think the premium assigned to structure and credit and how the bonds that meet a lot of and create a lot of the solutions from a capital's perspective are really not that high or not being discounted quite as they should in the market. So provide opportunity. And then the last piece of this would be just sustainability efforts in the European and with SFD R and how the asset class fits very well or neatly and not aligns with the assist and development goals and the infrastructure qualities of the asset, all their positive externalities in generally speaking the municipal asset class serves up a lot of viable solutions.
Lynne Funk (16:15):
So then that sets us up. Well again, for my next question for you, which is E S G, which clearly you just said that the muni market itself kind of fits neatly into what investors are looking for abroad. But I guess how do you see E S G as the term E, S and G working its way now through the market after perhaps some pretty vociferous pushback from politicians around the country? See, I guess the question is, do you see investor demand for this, not just in the US but globally and how that could benefit the muni market in broadening its investors in this space and do you see that the current political headwinds are going to slow that effort down?
James Pruskowski (17:06):
Yeah, there was a lot in that question.
James Pruskowski (17:11):
Let me try to get at the heart of it. The difference between the international regime Europe specifically and the US is there's a top down need to fulfill sustainable development goals and initiatives in Europe, whereas in the U.S. they don't exist and it's more of a bottom ups, grassroots movement that's going on and it's guess how fast or when or how likely that will change here domestically. So the top-down drivers are a very important component in terms of relative value and regulation, regulatory capital efficiency and portfolio construction. So I think that's a game changer, if you will, for the market both near term and long term. I think one of the things I ran into in my travels is the asset class is often dismissed on the global stage, the initial point of conversation, it's often thought and referred back to the tax exempt market, which is defined by lower yields and occasional lack of liquidity and it's often overlooked these benefits that we're talking about and that the taxable muni market provides.
(18:42)
I think the other part of this too is not to be discounted that caught up with the ESG word is impact investing. And I think this is where I come at it beyond the regulatory benefits that the asset class serves up, but the fact that in today's society, every corporation has social csr, social responsibilities, corporate social responsibilities or just corporate initiatives that policies that they want to fulfill as it relates to physical risk climate or d EI initiatives for example. And let's face it, I mean we could take a more granular look and create more granular portfolios exposures narrowly focused on communities, especially those under-supported that and either do business or support those municipalities and localities from a woman led, minority led and or military veteran led in terms of both broker dealers as well as the fiscal municipality and debt we're financing in its entirety.
Lynne Funk (19:52):
We're going to take a short break, but we'll be right back. And we're back with James Pruskowski, chief Investment Officer at 16 Rock Asset Management. So James, thanks for that. I think that, I guess I want to push you a little harder on maybe even what you think the political environment in the US as it pertains to E S G and impact investing. Will it hurt perhaps the growth of the muni market if certain politicians push, create rules that disallow states and locality from using or moving forward?
James Pruskowski (20:35):
It's a tough question, Lynne, Mom always told me never to talk about politics, sex and religion. So I'll try and address this one. It's obviously turned into a political lightening rod, the topic of ESG, I mean that's no surprise or nothing new to anyone. I come at it just simply from this perspective that economy's a beautiful place. The US economy and world economy for that matter, we're defined by the diversification of our people, our corporations as it relates to ESG, our natural resources. And I just generally think that while risk is likely around the topic is likely to grow given the political light, right lightning rod into the next election. It's important to respect state economies, how they derive revenue from their natural resources, how that plays into the greatness of this country. And I don't think it's business, it's certainly not mine to tell policy makers what to do and how to do it. I look at it more from the perspective of infrastructure which is best financed and prioritized at the local level. And I think we need to just slow down respect what local leaders need in order to get to a greater good for tomorrow.
Lynne Funk (22:08):
Thank you for that. Thanks for answering that question. I think I'd like to go back to, actually, it ties into how issuers are telling their story. You know, mentioned how abroad the asset class can be overlooked because of the exemption, because of the structure. Do you think that perhaps because of 2020 when taxable issuance skyrocketed because of advanced refund or the lack of exempt advanced refundings, do you think that helped issuers get more, do a better job of telling their story abroad?
James Pruskowski (22:45):
I think so, but you know, possibly could, maybe regret or what you asked for, if you will, the taxable market certainly provides a broader universe to manage your market access and at times lower your interest expense. I think it puts a lot of pressure in addition to the topic of ESG just on continuing disclosure and the expense that creates foreign municipality to provide that transparency. The investor base more specifically globally, that's institutional more than individual base like the exempt market is. It's going to require that and what quite frankly in today's age, we should have it at least more in an efficient and efficient transparent manner. So that's one thing. I thought the other part of your question was just valuation specifically. I'll just go back to my point. There's little premium assigned to qualifying debt, whether you're thinking about it from a regulatory perspective or an ESG perspective, a talk about qualifying debt, not just a bond that's labeled as green social or sustainable, but just the qualifying assets and or sectors that have positive externalities. And I think from an investor perspective that's longer, that's spread tightening and great opportunity and from an issuer perspective, certainly down the road benefits of lower interest expense that it's created.
Lynne Funk (24:31):
James, I kind of want to give the floor to you for a minute to tell me what I'm not asking you. What's important that this market should be looking at in the next few months as the rest of this year progresses? What, what's keeping you up at night for good reasons or bad reasons?
James Pruskowski (24:49):
I'd come back to the first part of this, which is the regime shift that's going on within fixed income and the opportunities that are created today. I think broadly speaking, my comment about this year being defined as the great reset, again, referring back to the roaring twenties that were followed by the Great Depression, not something as severe as that, but let's face it, large layoffs, compensation, reset consolidations that are going on all over the place, in my opinion, aren't going to bounce back. What the industry is dealing with is fee compression, a war on junior talent that blew up operating margins across most places and in the face of market declines. And given that fee compression, there is a significant amount of attention being paid, whether you're on the sell side to automation and algorithmic trading or if you're on the buy side process resiliency.
(25:58)
I view this backdrop of what people aren't thinking about is there is no skilled labor shortage and in my opinion, maybe in certain sectors and the service industry, it's a gig economy and the dishwasher is now the Uber driver and the DoorDash driver, and there's just many different options and that the old model needs to be modernized in some sense. And from a broker dealer or asset management position perspective, the excitement today is the skilled labor is actually moving to more niche shops to provide more granular, customized solutions for clients. Similar to the trade and career shift that I've made at 16 Rock, I think clients are demanding that the business is very difficult to scale. You can't really do so unless you're positioned in a smaller, more acute focus shop, especially in Munis with the average deal size being 40 million, it's where you source the best opportunities.
(27:07)
And let's face it, that's pretty tough to scale at larger places. So I think that that's generally one thing. The other thing is just the rates ratio comment. We wrote a couple pieces about this and I think challenge the conversation in different ways. It's not as simple as looking at pure ratios. What are implied tax rates telling you? What's the power of that multiple? Where are we in the seasonal cycle of the market and what opportunities does that create? And I'd come back to say that it's not going to be a straight line towards lower lows, but it's important to think about things a little bit differently and to be smarter about portfolio construction.
Lynne Funk (27:58):
Great. Thank you James for that. This has been a really good discussion. I'm really happy to have you on. Thank you again for joining me today.
James Pruskowski (28:05):
Thanks Lynne.
Lynne Funk (28:06):
Thank you for listening to the Bond Buyer Podcast. I produced this episode with audio production by Kevin Parise. Special thanks this week to James Pruskowski of 16Rock Asset Management. Rate us, review us and subscribe to our content at www.bondbuyer.com/subscribe. From the Bond Buyer, I'm Lynne Funk and thanks for listening.