Transcription:
Mike Scarchilli (00:04):
Hi everyone and welcome to the Bond Buyer Podcast, your essential resource for insights into the world of municipal finance and infrastructure investment. I'm Mike Scarchilli, editor-in-chief of the Bond Buyer, and today's episode features a timely conversation between our senior infrastructure reporter, Caitlin Devitt and Jason Appleson, head of Municipal Bonds at PGIM fixed Income. Together they explore how the buy-side is viewing and reacting to a rapidly shifting economic and policy landscape from the implications of sweeping new tariffs to the growing threat of changes to the tax exemption and broader fiscal policy out of Washington. Jason shares how he and his team are positioning portfolios, reassessing credit exposure, and preparing for the potential transformation of the muni market structure. This conversation recorded April 4th is packed with insight strategy and forward looking perspective. Let's get into it.
Caitlin Devitt (01:03):
Hi Jason. So nice to have you here. Thank you. So we want to talk about sort of the buy side and DC but before we do that, we're talking on Friday, April 4th after what's ran a very rocky week in the markets after President Trump unveiled larger than expected tariffs. So I just want to start talk a little bit about that. I'm curious, what's your strategy during these times of sudden volatility and flux? How do you approach that and also how have you found this week in particular for the muni market?
Jason Appleson (01:36):
Well, I think you described it very well with saying it was very volatile. I think it's rapidly changing and rapidly evolving and the key is to stay plugged into what markets are doing, but also solidify your internal outlook. So coming up with what you think the short term will look like and unfold and based on your best guess and predictions, position your portfolios to insulate yourself as best as possible from volatility and perhaps seek opportunity with a greater dispersion within the market.
Caitlin Devitt (02:16):
Okay, so it's sort of a general strategy. Well, how is this week for the muni market for you? What did you, amid the turmoil, what do you think in particular the impact on the muni market and what was your strategy?
Jason Appleson (02:27):
Yeah, so I mean I think it makes sense to sort of shift to what happened this week. I think there's a regime change that happened on Wednesday night after liberation day. The new tariffs that were announced took many by surprise, certainly by the magnitude and how broad base they were, and that rapidly changed investors' expectations for growth in the economy. With tariffs as high as they are, we could see a 2% growth environment quickly deteriorate to a no growth or even a recession if these tariffs stay in for a long period of time and are maxed out at where Trump announced on Wednesday night. So if that's the case, we're going from a high growth environment to a no growth to recessionary environment and dealing with that is how does the market react? So the initial reaction is a flight to quality, which we've seen despite tariffs being inflationary rates, treasury rates have fallen and munis are along for the ride for the time being.
(03:43):
I think we've seen that, especially yesterday. Today it's getting a little more tricky and it's important to define our expectation of the market here. The municipal market is generally viewed as a rates market, meaning it's highly correlated to the treasury market. When treasuries perform well, munis perform well and vice versa. There is always a breaking point when you get to a credit environment where credit uncertainty is high, where you shift from being a rates market and start looking a lot more like a credit market, maybe like a corporate bond market for example. And the corporate bond market has been widening drastically adjusting to these new tariffs. And although we started off on a path where we're seeing a rally in underlying MMD rates, I think we are getting close to an inflection point where the muni treasury ratios, the relative value starts underperforming significantly because we shift to being a credit market. And we've seen these events in 2008 and during covid 2020 when people were all of a sudden concerned and recognized municipalities do collect revenue, there are things that need to be done, they have credit risk and the market is not properly reflecting the value of that credit base.
Caitlin Devitt (05:08):
So sticking with the credit side, I mean, what do you think about the impact long-term or short-term on the muni market, on muni credits from the shift away from globalization?
Jason Appleson (05:20):
So tariffs themselves directly speaking, they have minimal impact on a lot of state and local governments looking through all the states, for example, there's not a lot of direct imports or exports to Canada and Mexico, who by the way, were left off the reciprocal tariff lists. There might be more exposure to China and Europe in that sense, but directly there may not be in outright effect and dusting off the inflation playbook from 2022 where people were worried about inflation spiraling higher. Obviously a tariff environment means higher prices. That could actually be a benefit for states and local governments. If property taxes are higher because home prices are higher because building materials are higher or the goods that we buy and sell creates higher sales tax and now we have to pay people more because we're onshoring and opening up more factories in the United States. So higher income taxes, so there is some silver lining here, but I think what investors should be most focused on in the municipal market is not necessarily the direct credit impacts, but more on the macro, how the slowing of growth might impact the government's ability to collect revenue or various projects and entities throughout the municipal space, how the slowing economy might affect their particular project.
Caitlin Devitt (06:56):
Interesting. Okay, well we'll have to kind of wait and see. So turning from that uncertainty to the uncertainty on Capitol Hill, a lot of the muni market participants are really feeling on edge about the potential that Congress is going to yank the tax exemption, either the full municipal bond tax exemption or maybe trim it in parts or take away certain private activity bonds. I would say the buy side seems a little bit more relaxed compared to issuers and some other participants, but I'm just wondering how much are you thinking about or even expecting potential tax policy changes out of dc? Is this something that's really front of mind for you? Do you think it's going to happen? Are you feeling like it's probably not going to happen? What's your sense of that?
Jason Appleson (07:44):
Yeah, so as it relates to the exemption itself, we think the probability of a full repeal is pretty remote and there's a number of reasons to think that among them include the wealth destruction that would occur in existing portfolios, certainly has to be contemplated. The tax exemption is an incentive for borrowers and taking away that incentive to states and local governments who represent roughly 80 to 90% of all infrastructure spending in the United States when we've already got a D rating from the American Army poor of engineers, that's not a thing you want to happen. Another argument I've heard too is, oh, it's a tax exemption for the wealthy, but if you look at the income brackets who are actually benefiting from the tax exemption between 200,000 and $500,000 earners is 50% of the usage of the tax exemption. So more than half is coming from those making less than $500,000 and it's not really as much of a benefit for the wealthy as it's advertised to be.
(09:00):
And then finally, a lot of Congress people are former state governors and state politicians themselves, and I think they understand the benefit to having that tax exemption in place and would be hesitant to revoke it, understanding the benefits. So I don't think a full repeal is really the base case, but as you pointed out, there certainly could be a limiting of scope of the tax exemption, which could affect areas like universities and healthcare, which Trump certainly already has in the crosshairs. So that I see as a much more reasonable outcome, certainly as it was kicked around in the 2017 tax cuts and jobs acts. So we've already seen it being discussed. Could they apply it to this bill? Certainly. And the last thing to note on this particular point is you never know what happens. This gets down to the existing budgets and larger tax policies at hand in Washington right now.
(10:07):
The house passed the budget resolution which added four and a half trillion dollars of new spending and then aside it a trillion and a half minimum of cuts. And to achieve those cuts, one of the areas being looked at for example is Medicaid, where 880 billion was instructed to be cut from the Department of Energy and Commerce, which is really healthcare even though the name doesn't make it sound that way. So they're going to have to come up with a lot of dollars to fund this. And on the laundry list of possible pay fors was $250 billion coming from state and local government tax exemption. You never know in the 11th hour when people are sitting around the table, what gets thrown at the end just to fill that plug or plug that hole. So you just never know. There's always that variability, but again, I still believe it's remote.
(11:06):
I think also regarding the larger tax policy, and you talked about credit risk related to the tariffs, I think there's more credit risk potentially coming from these pay fors that will have to occur. For example, states spend roughly 30% of their budget on Medicaid, and that's in a number of things that Medicaid is a program divided between state and federal spending, and if the federal federal government cuts their part of the spending, the states may have to backfill. Right. And states are generally very resilient, that's why they're very highly rated. But what they could do is affect three different areas. We think one would be local governments as they push their issues down to local governments, that could be an issue for them. Two would be healthcare providers like hospitals or senior living providers. Reimbursements are very important to them. So if Medicaid is cut and states decide not to backfill, that would be added pressure to healthcare providers themselves. And three would be universities because universities do receive a significant amount of state aid and generally that's the first thing to get cut out of state budgets when they are feeling pressure. So the pressure sort of trickles down from the federal government to state government and then could ultimately impacting, truly impacting local governments, healthcare providers and universities.
Caitlin Devitt (12:34):
Yeah, so that's a lot. So we're talking not only potential changes to the tax exemption, but the other cuts, the other changes that we know are coming in some package in some form that they're going to do that's also going to have credit impact. So in light of all that, are you making any changes?
Jason Appleson (12:50):
We have been. We've been looking through our portfolios, for example, take healthcare what providers are at most at highest risk. In other words, they're receiving a lot of supplemental funding, which we believe what will be targeted in this. It could be provider tax or something else. And we look through our portfolio and we say, okay, which credits have high exposure here, but in terms of valuation spreads are still relatively tight. They're not taking into account some of these risks and I think if you look across the market, a lot of the market is not pricing in this risk at all. So we've been able to replace some of that credit risk with providers that we do feel would be more resilient in an environment like that.
Caitlin Devitt (13:38):
So mostly healthcare then is where you've been looking,
Jason Appleson (13:42):
Including universities trying to go up in quality. It's interesting on the university front, they're not just being targeted potentially from state puts. The federal government's all over them. We've all seen the headlines about Harvard, Princeton, Johns, Hopkins, you name it. The federal government is revoking grants. They're talking about increasing the endowment tax. The border policy is restricting foreign students who are more profitable for these universities and the list goes on and on and on. We talked about potentially limiting the scope to exclude universities. So universities are dealing with a lot, but we've found that the highest quality universities, even though they're being targeted, they have large endowments, they're very strong, they have good demand profiles. Those are the universities that we like also. So been upgrading quality there as well. So it's really in all the sectors where the federal government, we could see a hand there, we're trying to increase credit quality.
Caitlin Devitt (14:45):
Okay, we're going to take a short break and we'll be right back with Jason Apples and we're back. So just sticking for a second with the idea of potential policy changes and this period we're in right now where nothing has happened yet, we're waiting to see language of a reconciliation bill that will carry some of those changes impacted credit and possibly to the tax exemption. You said that the market, we haven't really seen market moves yet. There haven't really been any pricing, but do you expect to see any fund flow changes ahead of, do you expect to see the retail side, for example, start to get jittery and start to see some fund flow changes ahead of any potential law changes?
Jason Appleson (15:29):
Yeah, well let's give some backdrop here and context with the current environment. So excluding all the noise from Washington, what we saw this year from a technical side is very strong inflows in the month of January and February and they've tapered off just a bit in March. In fact, this week we saw our first high yield outflow of the week. That being said, there are some other technical headwinds in the form of higher supply. We're running 15 to 20% ahead of last year, which was a record year of supply, which is a technical headwind, and then reinvestment tends to slow in this spring time period and we're expected to see net positive supply when several years prior we've been seeing net negative supply and the market hasn't really been growing. So we're not really used to this environment like we saw last year of a growing market where supply just overwhelms the amount of reinvestment coming due.
(16:30):
So with that backdrop in mind, now you pair it with all the noise going on in Washington and now pair that with the tariffs just announced on Wednesday evening. I do expect the fun picture to change materially. I think as I mentioned earlier in my remarks that we shipped from a rates market to a credit market. I think investors will start to get more fearful and we are dominated by retail sentiment. Unfortunately, two thirds of our market is owned by retail and as they open the paper and fear about the consequences of how municipalities might be infected or impacted by growth expectations, they will start to change the flow picture. So I think it's prudent to be a little bit more conservative in this market.
Caitlin Devitt (17:22):
So how do you think if they did go all away and eliminate the exemption or they're talking about capping it under President Obama, they had proposed that 28% cap on interest. So let's say they did something like that, they capped it or they eliminated it. How do you think that would change the buyer base?
Jason Appleson (17:39):
Yeah, so it's interesting, again, remote possibility in the way I'm thinking about it, but we did a back of the envelope analysis. I think tax exempt munis, they'll probably move to a more taxable range. So you'll see spreads whining about a hundred basis points. That's our best guess. And the average duration on the index, the tax exempt index currently is about six and a half years. So you'll see about a six and a half percent decline across the investment grade index. That's my best guess in terms of how that will look. Now, the corporate index is a bigger, deeper pool of buyers, not used to the fragmented nature of our market. I think what you'll see is the larger issuers in our market, like the state of California, which just brought a two and a half billion dollar deal this week, we'll learn to adapt to the structures that are most prevalent in the corporate market, but smaller issuers might get marginalized in the market and we might need to see more pooling structures where we aggregate smaller issuers together so that we can see the structures that the corporate market requires and we won't see a massive penalty to be issuing small deals in the corporate market.
(19:00):
So I think we could see changes in structures. For example, many of our bonds are callable in 10 years for any bond issued later than 10 year. I don't know if that would be doable in the investment grade corporate market. We might have to see that go away and see more bullet structures, less amortization and like I said, more bullet structures. So a lot of changes could occur, but I certainly think there would be significant pain in existing portfolios as those credits adjust knowing that they're not the natural sort of investment for the taxable market.
Caitlin Devitt (19:36):
Yeah, we've heard that a lot for the small issuers that they would probably be hurt the most, they just might be locked out of the market and there would be some more pooling. Would there be any way to short the muni market if it went taxable?
Jason Appleson (19:52):
That's a great question. One thing our market does not have that the corporate market does is the liquidity profile because bonds are much bigger in size and they're easier to source and therefore you can short corporate bonds and provide liquidity in different ways. If we did move to the corporate bond market and we came in larger size, maybe we would see an uplift in, for example, from dealers being able to both long and short municipal bonds, which we don't currently see in our tax exempt market. Good point.
Caitlin Devitt (20:29):
Yeah. So speaking of liquidity, it's been about a year since this is sort of pivoting away from dc it's been more than a year since Citi left. We had UBS leave and Citi left. Have you felt any impact from that? I mean, I've heard people say we haven't been tested yet. They provided a lot of liquidity. There were a lot of people's first calls. Have you felt any impact from their exit?
Jason Appleson (20:52):
So short answer is no, not really. That being said, we've had a pretty normally functioning market so far. We haven't had a big drawdown like we did in Covid or 2008 or even 2022. So Citi had been around for some of those events and I think they supported the market in a big way. They were big relevant player. Now that being said, a lot of the void that they created has been picked up by regional dealers or some of the bulge bracket expanding their operations, and we haven't really seen any liquidity hiccups. The other thing to note is the nature of the market is continuously changing. In the municipal bond space, ETFs are playing a much larger role. So now you have these limited market makers that are more willing to take shares and hold those shares as opposed to dumping bonds onto the market, which changes the structure of the market to a certain extent. We don't see the same sort of drawdowns with bonds just being sold wildly in the marketplace. But I think if we do see a disorderly market, that will be the true test on whether city's absence really has impacted us or to what extent it's impacted us.
Caitlin Devitt (22:17):
So it remains to be seen and it will be seen at some point. We could say we hope we don't get there, but I'm sure we will. Then turning to the high yield market, you mentioned the 2.5 billion deal from California. I think we've seen bigger and bigger deals are getting more normal in the market generally not on the IG side with high yield. We've seen a couple big ones, bright line brought 2.5, I think there's that billion dollar tire deal. I'm not sure if, I don't think they've done that one yet, but is this something that we're going to start to see more of you think in the high yield market, bigger mega deals?
Jason Appleson (22:51):
The short answer, again, I would say no. I don't think that will be the most common type of issuer. And the reason I say that is because the high yield market is still mostly made up of fragmented dirt deals, charter schools, senior living, those are smaller independent deals. Those deals will get bigger in size because it's getting more expensive to build, certainly with tariffs in place and the inflation that we've experienced already. So those will grow in size, but I don't think they're going to transform into these multi-billion dollar deals. I think Brightline was more of the exception and it was tough, but to get these deals done and you really need a large pool of demand, and case in point was a TW, which is the American Tire Works factory that they were trying to build that tried to come to market, and despite changing some of the credit factors and pricing, they just couldn't develop the demand they needed to get that deal done. And I'm not saying it won't ever get done, but there is still a breaking point in the market where you can get some demand at some levels, but people aren't just waving the stuff in. You need the pool of demand deep enough to support it. And the whole high yield market right now is only 150 billion in Munis.
(24:16):
So many high yield funds invest in not only high yield but also investment grid. So they do have levers to pull away from just high yield. So again, I don't think we'll start to see a ton of these deals coming. I think issuers know that there's still sensitivities in our market or high yield deals of that size, but we will see them on occasion.
Caitlin Devitt (24:41):
That tire deal seems like it was a test of appetite for sure. So what's your outlook for the high yield market for the rest of the year? And then maybe just give me your outlook. I mean, I know we've gone over a lot and it's like in this time where it's impossible to predict things are so fast moving, but what's your outlook for high yield and what's your outlook in general for the market the rest of the year?
Jason Appleson (25:00):
Yeah, so that's probably changed since Wednesday. As I pointed out, I think the tariffs here could weigh significantly on growth. And we started this year and our base case outlook was a soft landing, which means we still would see normal growth slowing, but something along trend growth and then inflation would be a little bit stickier just above the fed's 2% target. Now with these tariffs in place, and I'll caveat this by saying there's a lot of unknowns we've had on, and again off again conversations about the tariffs, but just knowing what I know today, if this tariffs stay in force at these levels and the retaliatory tariffs stay in force at these levels for the next 12 months, we could see growth decelerate all the way to a no-growth environment or even a recession. And that recessionary type environment could break and weigh on the municipal bond market.
(25:59):
We talked about the technicals earlier, that does not pair well with the technicals. So we are taking a more defensive positioning through the next 12 months as we learn more about how these tariffs will affect the overall market. Now it's interesting, the last two days since the tariffs have been announced, MMD rates have rallied. So we had Thursday where rates have rallied and let's call high yield unchanged. Today what we're seeing, and this is fresh off the press, right from today's markets, you're seeing the very high end of investment grade rallying, but you're actually seeing high yield weakening today. I think some of that infection that I was talking about is already starting to take place in the riskiest areas of our market. So I think you're going to see it hit high yield first and then it will broadly mutate into an investment grade situation as well. So my best guess, if I were to look 12 months forward, I think despite the silver lining of higher muni treasury ratios that we see today, I believe they will move higher in the next 12 months assuming this backdrop stays in place. And again, everything is very fluid at the moment, but that's what I can tell you about with the information that I had today.
Caitlin Devitt (27:19):
And if they do something with the tax exemption, you're going to see supply jump way up as everybody tries to hit the market, assuming it would take place the beginning of next year. Okay, Jason, well thank you so much to be continued. We have a lot coming at us, so we'll see what happens next. So I appreciate your time. Thank you so much. Bless
Jason Appleson (27:37):
You. Thanks for having me.
Mike Scarchilli (27:39):
We hope you enjoyed this episode of the Bond Buyer Podcast. A big thank you to Jason Appleson for joining the show and sharing his insights and to Caitlin for guiding such a relevant and detailed discussion. Here are three key takeaways from today's episode. One, a shift from a rate driven to a credit driven municipal market may already be underway, particularly as volatility and policy uncertainty increase two potential changes to the tax exemption and broader fiscal policy cuts could have significant knock-on effects across sectors like healthcare, higher education, and local governments. And three, even amid volatility, discipline, portfolio positioning and ongoing credit surveillance are essential as buy-side institutions prepare for a potentially very different second half of the year. Thanks again for listening to the Bond Buyer Podcast. This episode was produced by the Bond Buyer. If you found this episode informative and insightful, please click subscribe on your favorite podcast platform, leave us a review and check out our ongoing coverage at www.bondbuyer.com. Until next time, I'm Mike Scarelli signing off.