Capital Markets Coaching Clinic: Municipal bond market outlook 2018: What’s ahead?

Join Macquarie Investment Management as we review the past year in the municipal bond market and present a current outlook to help you prepare for the new year.

In this webinar event, we will discuss:

  • Technical and fundamental factors that have driven investment performance in 2017
  • The impact of the tax reform proposal, the current rate environment, and the credit landscape in the municipal market
  • Seasonal patterns in the asset class and an outlook for 2018.

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Good afternoon. My name is Erica Kay, head of Value Add Programs at Macquarie Investment Management, and on behalf of the team, I'd like to welcome you to our Capital Markets Coaching Clinic this afternoon. You will hear a timely update on the Municipal markets and outlook for 2018. Whether it's keeping you ahead of the curve when it comes to technology and social media trends, helping major work be more efficient, or learning more about the market from our team of experts, we strive to be your partner in growing your business and serving your clients. We'll get started. Our discussion this afternoon features Greg Gizzi, Senior Portfolio Manager, Municipal fixed income. Greg, welcome. Thanks, Erica. And I want to welcome everybody to our call. It's been quite an interesting year, to say the least, for Municipal participants. It seems like a long time ago but just about a year ago we were coming off the Trump tantrum that followed the surprise election results. And arguably, the Municipal asset class was potentially the most vulnerable based on the policy initiative that the Trump administration put forth. And we all know the story by now, the attempt at repealing the ACA and now working through tax reform, some of the expectations were recalibrated as the year ensued and that's definitely translated into the market. As far as an agenda goes today, I thought we'd go through the Municipal market, talk about performance and some of the drivers, and then really get to the meat of, I think, what most people have interest in, and that is tax reform and the potential implications for the Municipal market. I will say at the outset that there's a lot really we don't know at this point. We have a House bill. We have a Senate bill. There are some similarities and some differences. There's some presumptions being made by the market, but I can tell you emphatically that, whether or not tax reform actually happens, whether it actually passes, it's already having an impact on the market. We're having a very, very interesting December and we'll talk about that. So without any further delay, why don't we just go to slide three? And as I said, a confluence of factors really changed the projection for the Muni market. The Fed had begun normalization at the beginning of the year. I think most people thought finally after three or four years of looking for higher rates, we would get that. We all know what happened. A combination of less than stellar economic data and geopolitical events and again, a recalibration of policy expectation all played into a positive technical for the market.

When we talk about technicals in the Muni market, what we're referring to is the supply-demand technical. So supply as a function of slightly higher rates and a lot of the pre-refunding activity being pulled forward. Supply's down about 15% year-to-date and we have about $18 billion in positive flows going into tax-exempt bond funds. And I would argue that is only just a small segment of the cash that's actually entering the marketplace because of the prevalence and the popularity of SMA type platforms, and ladders. And I think the amount that's going into those products is a multiple of what we've seen into the fund. So a very positive backdrop to the marketplace. And you can see from the slide that I have here we're using the Bloomberg Barclays Municipal Bond Index. For those of you that aren't regulars to our marketplace, that would be the equivalent of the S&P 500 for an equity manager. It is the, basically, the fundamental benchmark of our marketplace, and you can see the year the date return as of the end of November was the 436. I can tell you somewhat surprisingly that today, as we enter the trading day, that index is up five and a quarter. So in the face of what I'm going to talk about, which is a significant pickup in supply, because of the potential tax reform we've actually rallied into that supply. And as I think back to the Trump tantrum, and what could have been for the market, I think this is a very handsome and respectable return for the asset class, and it's not over yet, we still have a couple of weeks. This slide, by the way, and it's one of my favorites, and it's really the heart of, I think, what Municipal investments should really think about in today's market. 2007 was a really transformative event for our marketplace. We tell them that because we went from essentially a race market, because at that time with the proliferation of monoline insurance, about two-thirds of our market, both primary and secondary together, about two-thirds was AAA wrapped insured. And this really was a commoditized rate market. We all know what happened during the crisis. Literally, overnight we became a credit market, and the task is different for us. And when we go through the actual-- look at the numbers for the year there is a lot of alpha to be garnered but you need a skill set to assess those credits. So As and BBBs is really how we make our bread and butter here. And this life demonstrates to me-- you can see the different time periods. This is that indexed life into its two components, the price return and the income return. The income return dominates total return. So for us, getting this security selection correct is really the key. And that's what I think you should be focusing on. Going forward, let's just take a snapshot on where we are. And again, because of the stellar performance we've seen here in December so far, I'm going to revise some of these numbers on the fly. But we essentially had a great rally. I mean, except for if we look at the treasury, 2, 5, 10, and 30 are rates on the change, only the 2-year is up. And a rising rate environment with the Fed tightening, you would expect that, but essentially-- sorry, the 2 and 5-year are up. The 10-year and 30-year are actually lower. And they're a little bit lower than these yields are on the chart because we've seen rallies in not only treasuries but Munis as well. In the Muni market, 2, 5, 10 and 30-year, we've seen only the 2-year rise in rates this year. And really, from 5-year sign out we've seen a rally. And so Munis have outperformed treasuries. And we can see by the ratio box, for those of you, that aren't regular participants in the market, one way to assess relative value is to look at Muni ratios. And that would simply be where a 10-year or 30-year AAA Municipal GO trades relative to its US Treasury counterpart.

And you can see on the year that-- I mean, keep in mind, I refer to the Trump tantrum, Munis have gotten very cheap a year ago in December. People were trying to figure out ultimately what was the tax rate be? Would the tax exemption even stay? There were many questions in the marketplace that we got cheap. So, we started the year and what I would say from a recent history perspective, relatively cheap and we've tightened in. This shows you a little over 5 ratios in the 10 year and a just little less but a ratio in the 30 year. But revising that for the recent activity we've seen in December so far, we've actually we've outperformed treasuries here in the midsts of this supply bulge we're down 10 ratios in 10 years, and down almost 5 ratios now in 30 years, demonstrating that outperformance. That bottom chart on the right, the curve, that's gonna be crucial in some of the issues we're gonna be talking about going forward. We've seen a flattener. Treasuries showing 82 basis point in 61, from Munis that's the 2-30 curve. Those numbers are actually today, as we enter the trading day, are actually 95 basis points flatter for treasuries and 75 basis points flatter for the Muni curve. So despite what looked like pretty ominous odds for the market at the outset of 2017, we've actually seen most of the curve experience a rate rally. So why don't we just take a look at some of the drivers that cause this, as I said, as we enter today, a five and a quarter percent return so far, year-to-date in the index?

And on slide five, we're looking at the quality segment of that Barclay index, Bloomberg Barclay's new bond index. And you can see as you go down, just look at the blue bars at this point as you go down the credit spectrum, as you go from AAA to BBB, the lowest investment grade category, there's a substantial increase in performance. Going from a 3.40 to almost a 7 and a half percent BBBs. When we put the Barclays high-yield index on the page, we get many questions almost weekly about potential systemic impacts from Puerto Rico on the high-yield market. I'll just want to make a couple of points. What this does is shows you that the overall index has an 8.29 return as of the end of November. If you strip out the Puerto Rico components, most of which by now are out, by the way, because once they started developing back in June, the next month they come out of is high-yield index, you get a substantial increase in the returns. So Ex-Puerto Rico high yield is up. That's telling you that it really hasn't had an impact, that Puerto Rico has been ranked since, and that's been for a while. Last year was a similar situation where the index Ex-Puerto Rico was actually up. I also want to tell you that if you look at flows in the marketplace year-to-date, the high yield segment, national-- Muni high-yield segment has taken in the largest percentage of flows as a percentage of their assets under management. So again, in this lower for longer environment that we've been in for three or four years now, investors have not been shy about allocating their money to the Muni high-yield space. We spent a little bit of time last year in talking about really how Muni high yield is somewhat of a misnomer due to the lack of really below investment grade paper in the marketplace. And I'll just remind you that the average national high-yield Muni fund actually has an investment grade rating because of that, because of the lack of supply in the marketplace.

So we've been proponents of Munis, and given our outlook - I'll share with you a little bit later - we think that that continues to work as you go through 2018. We'll flip the page to slide 6, and we're going to chop off that index. Instead of by credit segment, we're going to chop it up by maturity. And again, you can look and see the longer on the curve that you invested, the higher the return. And it's interesting because as I think back to almost a year ago today, where the market had bottomed post-Trump-tantrum. I think back to the unenviable job that most new strategists had in trying to predict where investors should go. And quite frankly the vast majority got it wrong. I mean, most strategists were telling investors to shorten their duration and to upgrade their credit quality. And as I've demonstrated here that's actually been the exact opposite of what's happened. Being longer on the curve and being down the credit spectrum has actually rewarded investors. Page seven and eight I just include because we touched on this in our last few web ex's that we've done. This is a trend that actually has been in the marketplace for a while now, so. You can see that the credit segment's broken out over different time frames: one, three, and five years. Again it's paid to be invested in the lower investment grades here; the A's and BBB's particularly in the investment grade index. And on page eight it demonstrates the same thing we just showed you on slide seven which is it pays to be longer. In the various time frames-- one, three, and five years; the longer on the curve, the better the return over the last five years. So we're not going to go onto tax reform just yet. I want to talk about supply and the outlook for supply. And as I mentioned earlier we're in the midst of a little supply bulge based on potential tax reform. And the issue really comes down to two factors: advanced refundings-- and, again, I'll do a very simplistic analysis of what a refunding is, for those of you that don't normally participate in a Muni market. I'll throw an analogy to yourself when you've gone to a bank and you've taken out a mortgage. You never should relinquish the right to refinance that mortgage if mortgage rates drop and you can lower your monthly expense. Right? You would basically refinance that loan, go to the bank, take out a new loan, and lower your debt expense. Well, that's exactly what many issuers have done. Munis are a little bit different than other fixed-income asset classes because the issuers always maintain their optionality. And the typical Municipal structure will typically have some kind of level debt service that exists in what are called serial maturities. So a one year, a two year, a three year. Typically up to 20 years. And then two terms. Either a 30-year term or a 35-year term or a 40-year term. Anything beyond 10 years, the issuer puts a 10-year call option on it. And they do that for that reason. So in that 10-year time frame if in fact rates fall and it is economically advantageous to refinance that issue they're able to do that without penalty to the issuer. There are two types of refundings. One is a current refunding. And by definition a current refunding is a refunding that takes place with the call date within three months of the trading date. And advanced refunding is anything longer than that.

So what we've seen over the course of the last two or three years is, bonds that maybe at this point have gone from a 10-year call down to a 5-year call or a 4-year call, those things can be advance refunded if the curve and the rate dynamic works in the issuers favor. The existing tax bills, both the Senate and the House, both eliminate advance refundings. So the presumption the market is making is that that will be in the final bill. That they'll keep that in there, that no longer will issuers be able to advance refund. So we've seen here in December a lot of deals that are coming as refunding bonds. It's because they're going to lose that capability once the calendar turns. The second segment of bonds and this is where the proposals are split, the House bill has the Elimination of Private Activity Bonds. And private activity bonds can cover different sectors. The two big sectors that provide a lot of alpha to the market quite frankly are private education and non-for-profit hospital. If you take these two segments, if you take advance for fundings and private activity bonds and you make the assumption that they are leaving the marketplace in 2018, no longer can these issuers access the tax-exempt market. Over the last 10 years, the run rate of that volume has been about 25%. So if these two parts of the bill become law, if you can no longer do advance refunding and you can no longer issue private activity bonds, a it's good assumption that 25% of our volume is going to leave the market. There seems to be a lot of chatter about exactly what's going to survive. There are some segments within private activity bonds that I think may survive, may not survive. The fact of the matter is that the market doesn't know and that's really been the impetus for the supply goals that we've seen here in December. Regardless of whether tax reform happens or not, it's already had an impact, because issuers are not taking the chance that they lose the capability to access the market, so they're coming now. And so if you look at what's called our 30-day visible, 30-day visible supply that is on the calendar, you can see our 30 days. It doubled this month to 21 billion dollars: it's actually a little bit higher now. That is actually probably half of what the actual number is because a lot of days are coming in a shorter time frame than 30 days. So, there are estimates that range in the 50 billion dollar range of supply, and the reason that's significant is because that's going to have a direct impact what's going to come in 2018. So, as we sit here, heading in at the end of November, we had 365 billion in [average?] supply, year-to-date. Let's throw 50 billion on there, let's say we do it all. So, we're up to 415 billion. The question becomes: what do we see next year? And I think that the market-- and the reason that I started out with the anecdote we're rallying pretty strongly in the face of all the supply because the market believes and I think there's some truth to it, that the first quarter of next year, there could be a [dearth?] official. And a really good opportunity considering the fact that if you look at calls, maturities, and the amount of money that's being returned to investors in January of '18, it's going to be larger than what we saw in January of '17. And we put up a really strong month January of '17.

So the question is, so where are we in 2018? Let's presume that we did 415 billion, we're sitting there at December 31st celebrating New Years, what's 2018 going to bring? And it really comes down to whether or not we get both advanced refundings and private activity bonds included. And the bill eradicated from issuer's capabilities or whether we just get advance refunding? If it's just advance refunding, you will see a downtick and you're going to see a downtick because again we've seen supply pull forward already. Also, we can only do advanced refunding so-- I'm sorry. We can only do current refunding so all the advance refunding which is about 10% of that 25%. So that's going to go. And presumably if the Fed is going along it's normalization path and we start to see rate's rise, depending on the shape of the curve-- for refundings to be effective you really want a flat curve. Depending on the shape of the curve refunding maybe doable or may not be doable. So we will see a distinct downtick in supply. If. Just looking at estimates that have been put out there and I don't envy the analysts and the research folks that have tried to put a number on this, I would say comfortably you're looking at somewhere around the down 15 to down 20 percent range pretty comfortably. And a lot will be predicated on a lot of all those other factors, where rates are and ultimately what's in the final tax bill.

So if you turn the page to slide 10, this is the slide we included last year and I just bring it up because when we market going around in different territories we get a question all the time about, "Can you tell me if there's any empirical evidence on when's the best time on when is the best time to invest in the Muni asset class?" And so what we did is we went back and looked at a 15-year period and looked at the returns of that index, Bloomberg Barclay's index over different months. And there is a distinct pattern. And those patterns happen to coincide with week technical periods during the marketplace. So March-June and October historically has been the months that has been opportunistic for investors to purchase the asset class. Last year, as a result of the Trump tantrum, where we had a significantly negative return in the index, November made its way in. And, ironically, 2017 was a little bit of a different pattern as well. We had a slight positive return in March. We did have a negative return in June. The October return, the typical negative October return was a negative September return, and we had a slight, about a 50 basis point negative return in November. So if your investors are asking you, "Is there a time?" These historically coincide with weak technical periods, typically march is people preparing for taxes, and there's typically outblows in the market. June is a little bit of a supply bulge. Ahead of the summer month, it starts to slow down. And then people literally go on vacation. And then October is that pre-fourth quarter purge, typically, and pre-October corporate tax payments, so that typically is a weak technical period as well.

So I want to transition over to the Fed, let's talk about the Fed, and give you a little bit of overview. As I said, we're well on the way to normalization. It's an interesting time, considering we're going to get a transition at the chairperson level. Chairperson Yellen will be leaving in February, Gerome Powell taking over, Marvin Goodfriend was named as a potential governor last week. Trump has three more appointments to make after Yellen leaves, so it's going to be very interesting to see if the complexion of the Fed changes at all, because the one thing the market has benefited from is the open comMunication and the consistency of the message coming out of the Fed. I have box on this chart, WIRP. WIRP stands for World Interest Rate Probabilities. And you can see the December probability for a rate hike is 98.3%. So arguably the December rate hike is in the market. And we concur with that. I think that that's fully expected in the marketplace. Next week we'll see a rate hike. The question then becomes, what happens beyond that? And what seems to be-- whether it's coming off of the natural disasters that we've had. Recovering from that. But we seem to be going through a-- what is a rare synchronous positive growth story globally at this time. There are some-- the normal set speak where there seem to be conflicting views. I saw something last night where we had a governor talking about even questioning raising rates in December now but I do think that's baked in. The point we want to make about the Federal Reserve is that many fixed-income investors believe that if you're in a rising rate environment you don't want to invest in bonds. And we use this chart. This is a time period for 2004 through 2006, the last significant interest rate hike cycle. And very interesting time frame.

The Fed raised rates 425 basis points in this time frame. And the best returning asset class was mainly high yield. There's some differences that period of time versus now. We were coming off of three quarters of 5% plus growth. There were concerns about the Fed being behind the curve. What's interesting from a Muni flow perspective is from April of '04 to June of '04 we had significant outflows. About eight and a half billion dollars of outflows from the marketplace. The rest of the cycle from August '04 through June of '06 positive eleven and a half billion. So there was almost a reversal. And what happened was the Fed turned out to be premature and the curve flattened. And the curve flattened substantially. And so, the consensus view, quite frankly, is that the curve will continue to flatten here, and I mentioned at the outset that we've seen some significant flattening already this year. And I think that the market is making that presumption with good reason. If you look at the last six interest rate hike cycles, five of those six interest rate hike cycles resulted in significant flattening. 3 of them were very substantial, over 150 basis points. The only one that did not result in flattening was in the '86, '87 Volcker rate hikes where the market believed that the Fed was behind the curve on inflation and we got a steepener. But I think with good reason the market actually is expecting the Fed to continue to normalize and get a flattening curve because of the lack of inflation. And that's really I think the key. Keep your eyes on the data, keep your eyes on the core PCE and what's happening. There will be some questioning of whether or not Powell will change the complexion, the direction, of the Fed, and it remains to be seen who the other appointees will be, but I don't think you're going to get any dramatic change in what's happened already, quite frankly would be my opinion. I think you're going to get a fairly consistent message, and my advice is to keep your eyes on the data as far as of what's expected going forward.

So let's get to tax reform which is really the bulk of the presentation today, and we were chatting on the desk yesterday about how quickly this bill has come together, almost in a haphazard fashion. And Politico had an interesting article this morning about the unintended consequences of this bill because of that fact, because this seems to be happening at a break-neck pace, almost sloppily, was the implication. And there are unintended consequences in here. Page 12 and 13, actually, what we've done here, is taken a chart from the Joint Committee of Taxation and Morgan had to send a piece last week. These are the Muni-centric issues. And we're not going to go in the interest of time through each one of them, but we're going to hit on the significant issues, I believe, that you should be thinking about. And keep in mind that this tax bill is being attempted under reconciliation, not needing two-thirds vote in the Senate, it only needs the majority. And as a result, the [Berg?] amendement, which was introduced by Senator Berg, prohibits any increase in the deficit after the 10-year period. And as a result of that, any break that is given in the form of tax reform has to be paid for. And that's really the crux of the matter. How do some of these proposals get financed so that we don't wind up with a significant increase in the deficit? And the Freedom Caucus has been very quiet on the issue so far. But we're also entering into a situation where we have continuing resolution coming up on December 8th. I don't suspect they're going to stay quiet, I think we could hear some noise out of the Freedom Caucus.

But that's why if you've been reading stuff on the Tax Bill, certain provisions will sunset. They'll go away. They won't be permanent because if they were, they would add to the deficit after the 10-year period. So the real issue for the conference right now that exists in DC is, how do you come up with the right combination of breaks and revenue-raisers [inaudible]? [inaudible] less of an opportunity. The question is, how many deals do they fit into the last two weeks of trading, and whether we continue to rally or whether we pause here and create some opportunities? And that remains to be seen. Don't worry about the two big charts, but let's talk about unintended consequences. I'll use AMT as an example. AMT was completely repealed in the House bill. That's a cost of close to 700 billion dollars. It's a big-ticket item. There's been talk recently, post-Senate bill, that the corporate AMT would not be repealed. I'm sorry, would be repealed. The private, the individual AMT would not be repealed, there would be some kind of scaling of the AMT. It was unintended consequence because of some of the incentives that are out there. Some corporations, which are already paying in the low 20s, would actually see their rate get lowered into the high teens, but because of AMT, they would have to pay the higher AMT rate, the 20% rate. I don't think that was an intended consequence when the content of AMT was discussed. We'll see where this comes out. Ultimately, it is a big-ticket item.

From a Muni market perspective, when the House bill was released, we saw the spread between AMT, bonds that are subject to the alternative minimum tax. And bonds that are not, we saw that spread narrow. It had spent most of the years in the 40 basis point range, it got down to 15 on the last AMT bill that was priced. They had both the AMT and non-AMT. So we will have to see where this goes but ultimately if AMT is repealed, then AMT paper trades on top of non-AMT paper, and that's a windfall for investors. So we'll have to wait and see ultimately what happens on the AMT but already there're issues surrounding that. So if you flip the slide to page 14, let's start with rates. And so let's look at the two bills and from a rates perspective, there's not much difference. The good news for the market right away, both plans, the exemption is tax. And I don't say that lightly. We've had incidences in the past where there has been an a attack on tax exemptions. You recall the third part of president Trump's platform or policy initiative was the infrastructure program. I believe there's a huge infrastructure problem in the United States, we've talked about the American Society of Civil Engineers report on this call before. It seems almost counterintuitive to eliminate private activity bonds which many of those infrastructure sectors fall into, and not give cheaper tax-exempt finance to issuers when you're talking about improving the infrastructure in the US. But that being said, and recall during the fiscal cliff during 2012 in the eleventh hour we almost had a 28% cap on the exemption of Munis that luckily did not get passed. But the market did breathe a sigh of relief when we realized the exemption was being maintained. I do believe the solid lobbying from many organizations, and education of congressmen made that less of a probability going forward that we would see exemption get totally eliminated. But I never say never.

But from a rate perspective, really not much change. The rate under the House bill look exactly the same as upper income 39.6. It goes down slightly to 38.5% in the Senate bill. If you flip the page to 15, let's take a look at a real bond. What does it do, right? Well, not much of a change in tax rate. So we're using a AAA Taxes water bond here that's in the marketplace. This is the evaluation as of yesterday. It will be about 10 lower in yield today based on the rally. You can see under existing tax situation we're at a 4.91 gross up yield. Under the Senate bill, we've lost a 38 and a half percent, it's slightly lower to 42. Again, House bill stays the same, so 4.91. Just to put that in perspective, a 30-year AAA corporate bond is yielding around a 3.30 to a 3.40 today. So literally 160, 150 basis points lower in Muni than where the Muni grossed up yield is. So from a rate perspective, really no impact for the investor. Next slide, quickly, just showing you the same thing. A 10-year Muni using the AAA Muni MMD scale against 10-year treasuries and corporates. Same story. You still get pick-up in the asset class. So the market, really, from a rate perspective, just an effective tax rate for individuals, really is unscathed in either plan. Whichever plan is inacted, whether it's keeping the rates the same of 38 and a half percent. The House bill by the way even had a surcharge-- where talking about putting a surchage on certain incomes. Which didn't make it into the final bill but rates could have actually gone up.

On page 17, we talked a little about AMT, the unattended consequences of corporate AMT, which would have nullified some of the incentives under the Senate bill. But the significance of corporate tax rates for the Muni market comes from the supply-demand technical. Banks, insurance companies, both property and casualty, and [writers?] have been active participants in the marketplace. About 25% of our market is helped by those 3 entities. The presumption was, if you lower corporate tax rates from 35% down to 20%, or companies were originally talking 15%, there'll be wholesale selling of Muni bonds. Well, emphatically, we didn't think so. We didn't think so because these investors have been opportunistic investors, and quite frankly, we're very opportunistic at much higher yield levels. So I think that while the demand going forward might be compromised at new tax rates, the concept of the market being flooded with selling from these entities, I think, is an overstatement, oversimplification. And if you turn the page-- so if you turn the page--by the way, both are talking about a 20% tax rate, both the House incentive bills, the difference being the Senate delays the implementation of that 20% tax rate for 2019. That's something the Trump administration does not want to happen, so we'll have to wait to see what happens. We balanced this for a corporate investor. You can see the 35% bracket. There's a substantial decrease in yield going down at 25 and 20 percent, and 20% that goes from a 42.8 gross up yield for corporate entity to a 3.48, which I've said, that's only slightly higher than the 3.40 yield I told you for a AAA corporate bond right now on the marketplace.

The reality is that most corporations don't pay 35%, they probably in the 27,28 percent range based on some of the things I've read. But, there will be a compromise demand path, no question about it. Muni's will be more opportunistically purchased come, I would say property and accounting companies first and then life insurance companies. Life insurance companies really, because of their relationship between tax-exempt Munis and taxable Munis have primarily been in taxable Munies. They'll be buyers of tax-exempt Munis when we get into periods of severe stress and volatility, where Munis cheapen to over 100% of treasuries. We're currently not there. But certainly I think that the market will see a change in demand going forward. The concept of the wholesale, sale out of Municipal credit, I think, is overstated. I want to spend some time on, really, three aspects of this and talk about the implications of these proposals on supply, which we touched on already, credit, and structure of the market. As I said, already expect a portion of supply to be compromised, and that's really going to come down to whether it's just advanced for fundings, or whether it's advanced for fundings and private activity bonds. So, some elements of the market will leave the tax-exempt market. Where will it go? It will go, if it's able, to access the Municipal taxable market, and will go over the taxable market. However, you guys that are participants know that this is a very stratified market, there are tens of thousands of issuers, while many large authorities like the New York City Water, or Bay Area Transit Authority.

There are many recognizable names that global investors recognize and they'll buy. John C. Lincoln Hospital in Nebraska probably isn't going to feel out of demand from a foreign investor, maybe not even a domestic life insurance investor. So the question is, how much of that private activity market actually successfully accesses the market, at what cost? And what I think you'll see is what we saw during the crisis is some of these entities accessing private banking loans and having to do more banking directly as opposed to using the financial market. So again, supply is going to be down, the question is just by how much and how permanent is that. I do believe advance for funding go but the question is how much [negotiating?] they do on behalf of private activity bonds and what do we wind up with at the end of the day. They give what's the implications for credit. Let's talk about that. The salt provision, the state-local tax revision, and mortgage insurance are somewhat related. Understand that state credits are backed by revenues that essentially come from two sources, income tax, and sales tax. So anything that takes money away from investors' ability to spend or invest is a negative for those state credits. Right, if you're paying more than the Federal Government and you have less to put into your own pocket, that's bad for the local sales tax. You have less to spend, less disposable income. The mortgage interest deduction is another interesting thing because in certain marketplaces where there are million-dollar, million-dollar-plus mortgages only being able to deduct 500,000 under the House Bill, could be somewhat problematic and hurt values.

So the reason that's significant is unlike the state-level, where it's driven by income tax, and sales tax, local revenues, local GOs are primarily driven by property tax. 38% or revenues are property tax. So anything that hurts assessed evaluations which theoretically lower mortgage deduction capability could filter into negative price action. I've already seen quotes from National Association of Realtors and a bunch of organizations putting estimates down two to three, four, seven percent depending on where you are in the country. And again, I want to stress this. We don't expect any immediate impact to correct. In fact, credit as we sit here today is in a very strong state. Right, we've seen job growth. Job growth translates to more income which translates to consumption. Tax revenues throughout the one of the larger parts of income tax for states is capital gains tax. We've had a good market, we have a good equity market going this year. So revenues next year when people pay their tax should be strong. This is something that will filter in if in fact the sole induction is eliminated or even capped at 10,000, high-tax states with high real estate values New York, New Jersey, California's for sure. Those states could have negative credit momentum from lower assess values over top and I want to stress that overtime. Certainly the ability to advance free funding to their street fund issues is the negative on credit. Think about your own situation If you can turn you $2,000 mortgage payment to $500 payment, but you're prohibited from doing that. That's a substantial hit.

We exist in a world where I said this I think in our very first web ex, the only thing Meredith Whitney got right was the conflict between pensioners, debtors, and the citizens within a government that are looking for services, the government providing services to the citizens. That's being magnified. We all know that there are pension issues in certain states. The good news is that virtually every state has enacted some kind of reform, and we're certainly for future pensioners, the landscape is different than the demographic that's causing the issue right now. But certainly, one way to help alleviate some of the expense on the debt side is by refinancing. If you can't advance refund, that is certainly a negative for Muni credit. And lastly, I think there is some evidence of this. We've seen certain none tax states like Florida and Texas gain population through migration. You could see out migration theoretically in some of these high tax states where people just say, "I've had enough," and decide they're going to sell their home and retire to Florida or Texas. I think that's again a longer-term trend. And I want to stress again we don't expect any immediate credit intact from any of these proposals, but there's something to keep your eye on going forward. Structure of the market maybe something that you're not thinking about. So if you can advance refunder bonds, first, leave the preferred coupons, for many reasons, there's a 5% coupon with a ten-year call for an institutional investor. If you lose the ability to advance refund bonds, we think two things will happen.

One, you're probably going to see this market coupon adjust downwards. You'll see lower coupons in the marketplace and you'll see shorter calls. So if a 10-year call-- if I can only currently refund a bond and my ability to advance refund is diminished or eliminated, I'm going to shorten my call. And, we're already seeing different states have been fairly aggressive issuing bonds with five-year calls. And I think that that's something you should think about from the perspective that it will, over time, shorten the duration in the marketplace. There could be a shortage for those of you that like pre-refunded bonds. there could be a shortage of pre-refunded paper on the market. You're losing about 10% of supply annually that comes from advanced refundings. Do we see more bullish financings where there are instead of serial maturities with 10-year calls or 5-year calls, they're just doing bullets like corporate bonds do. That might offset some of the duration impact but these are factors that you have to think about. The one thing I want to warn you, if we start to see more par-ish coupons, again, we're probably, call it 80-100 basis points off the lows of this cycle in the Muni world, but certainly I think there are many bears out there that think that we're on borrowed time as fixed-income investors and higher rates is inevitable. Not so sure that's the case or not, but some people really strongly feel that way. There is something called a diminitive tax in the Muni world and there is a situation upon which a tax-exempt bond can actually create taxable income. Don't have the time to go through it now, but if you have par coupons or lower coupons, you can cross that de minimis threshold very quickly relative to having a premium bond. And, we think the incentive gone for issuers to issue premium bonds that may, in fact, become more normal than not.

Slide 20, just to go through quickly, again, this is a very high-quality asset class. The Muni asset class is a doubling asset class. This is a study that Muni's puts out every year. This is the last study published, a 10-year average cumulative issue or weighted default rate study. I always point out the triple Bs, the lowest investment grade category, defaulting at .4% versus corporate's at almost 4%. This is the reason why Muni's has become a bonafide asset class for foreign investors. There are a lot of foreign investors, according to the Fed V one report, record number of holdings by foreign investors in our asset class, and I expect that to grow. The only thing holding back the demand is the size of the marketplace, quite frankly. The reason they appreciate the asset class is this chart. Is the inherent safety of the Muni bonds roll up into corporate, and if you're able to, in the taxable world, get equivalent or slightly better yields on a Municipal product that's inherently safer, that's a very good value proposition for anyone that's looking to match up long data liabilities with long data cash flows. I see I'm running out of time here. Let's quickly go through the outlook. First quarter of '18, technical impacted without a doubt. We've already seen a bulge in supply. It's been an opportunity. It's becoming less of an opportunity as we have rallied strongly into this supply, but keep your eyes out the last two weeks. There could be a lot of supply and things could get cheaper again. Curve dynamic will be key. We're expecting a flattener, the market's expecting a flattener. It's what drove the results in the '04 through '06 period. We can have rising rates, we can have gradually rising rates in a flattening environment and still put out positive returns.

We're looking for basically a coupon plus minus return next year. Using that index it puts up about 35 basis points in income a month that's 420 yield of 4.2% return. Depending on ultimately, do we see inflation? Do we not see inflation, does the Feds stop? Does the curve steepen, does it not? We were looking for this last year we're looking for it again. We're obviously getting coupon plus this yea, coupon plus 1%. Structural changes to the market. Keep your eyes on what happens. If ultimately we lose two said segments of the market advanced refunding and we lose private activity bonds, the Muni market will basically shrink by 25% percent. Keep your eye on the structure. So what are we focusing on in the near term? We are in the middle of it. Of the value proposition of all these deals coming to the market, again, not to beat a dead horse, look at the bills. We have seen a significant rally but I still think there will be some opportunity in the next two weeks. Keep your eye on the said governors being appointed. I don't think they are going to upset the existing viewpoint of the Fed. I think that [tow?] is going to be well received and essentially act as a disciple of Yellen as far as comMunication goes. And as I said, December rate hike is pretty much built into the market, the market is a little bit less hawkish than the Fed is. Fed looking for three rate hikes next year, market looking for one to two in that range. We are going to focus on the curve. We are certainly not shy about duration because we think the curves going to behave with the lack of inflation that exists or that is missing.

I mentioned one thing about banks with respect to corporate tax reform. The Senate banking finance committee has recommended that Munis become HQLA to be eligible assets. Recall that under vocal rules, banks are going to have to calculate liquidity coverage ratios. They can do that with certain assets. Munis were excluded from high-quality liquid asset classification. There's been intense lobbying and ultimately it looks like we're going to get acceptance as BB assets, which essentially puts them in line with corporate. We can be 15% of the assets that go towards that LCOR calculation at a 50% haircut. Last thing I want to mention-- just give a quick shout out to Phil Fisher at Bank of America. He's been on top of this. There's a court case that going to come out next summer. The opinion on the court case-- Janus versus the AFSCMA. It has to do with the work-to-right laws. Essentially, just to put it in a nutshell, this is going to tie directly to the ability to renegotiate pensions. In 1977, there was a ruling in Abood versus the Board of Education of Detroit, which essentially compelled non-union workers to pay union dues, under the theory that they benefitted from some of the union activities, such as collective bargaining and other aspects. Right-to-work states do not require non-union members to pay those dues. And if you look at pension performances in those states, right to work states actually have better-funded pensions than non-right-to-work states. There is a fairly strong view that with Gorsuch that-- they were about to rule on this and Scalia passed away.

Gorsuch has taken his place, who is conservative. The feeling is, is that Abood will be overturned and that this could essentially turn the US into a right-to-work country, which means that there will be a negative impact on unions; particularly the finances of unions as non-union members will no longer pay union dues. That could hurt the negotiating capability and collective bargaining power of unions. Just something to keep an eye on. I think that's something that not a lot of people have focused on, still have. I've been following it. That could help as far as some of the tension issues go.

We do have a minute or two left, just to kinda round out our hour here. I think Greg was with me on our very first one, in this series three years ago, and I feel pretty confident saying that we have had the most questions from our audience. So it's pre-submitted and during the presentation today. So, thank you for being engaged and curious about the profit we presented today. So, we'll just take three questions here and the rest we can follow up with you all online since we do have your information. So, Greg, what do you perceive as the biggest risk in the Municipal Bond Market? Rates, credit, liquidity?

Yeah, so, liquidity and credit, as I said. Credit is strong right now; it's definitely rates. And there's one thing to look at as Muni investors. There's a very high correlation between bond fund flows and unexpected spike in interest rates like the Taper Tantrum. We tend to get outflow cycles when treasury rates spike unexpectedly. So anything that causes that, could cause the ugly cycle of outflows which beget selling from bond funds which lowers NAB's, which just accelerates that cycle. So anything that causes an unexpected rise in rates, a spike in treasury rates, could make for a volatile market.

Thank you, Greg. The next one we'll go to is, how large has recent supply increase been, and how much has that impacted current prices?

So, as I said, we probably have seen, at the end of this week it'll be close to 20 billion, if not 20 billion dollars in supply price through the month, and it actually has not hurt prices. We've actually seen aggressive buying in here, and I think the philosophy behind that, again, is the girth of funding that may occur in the first quarter due to the prohibition of advanced refundings, and potentially private activity bonds. And again, some of these sectors in private activity bonds, we ourselves invest in, are alpha generating sectors. They're lowing credit rating, higher yielding, and you may not be able to buy them again. So, I think that people are being fairly aggressive in trying to position themselves in some of these credits, in case they can't come anymore.

And I think, finally, an excellent to close on for the audience today would be, what do you think could cause voltality in the Muni market in 2018?

I think it's the spike in rates. If all of a sudden this somewhat synchronist growth cycle that's going on globally, takes off-- if China, which is showing a little bit of weakness here in the recent past, starts to take off, and we start to see inflation pick up, the core PCE, and the curve besides that. Now the Fed has to get more aggressive, that could cause some volatility.

Well, as we approach the top of the hour here, I will thank you Greg for sharing this conversation with us. If you are, [Kit?], I want to wish everybody a Happy Holidays, a healthy and prosperous New Year and I hope you got something from the call.

Thank you again. So for more information from Greg and the rest of our investment team, please visit our dedicated financial advisor website where more full versions of our 2018 Global Investment Outlook can be accessed. For more regular commentary from the team you heard from today, please visit the Insight section of our site and feel free to subscribe to receive updates when new content is available. Thank you again for your participation and have a great evening.

The views expressed represent the Manager's assessment of the market environment as of December 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

This webinar is for educational purposes and for  financial professional use only.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and summary prospectuses, which may be obtained by visiting or calling 877 693-3546. Investors should read the prospectus and the summary prospectus carefully before investing.


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