Municipals in focus: Fundamentals, technicals and a look ahead

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

Highlights include:

  • Factors that have contributed to investment performance in 2018
  • The impact of the Tax Cuts and Jobs Act
  • Today's credit landscape and what's driving supply in the municipal market

Capital Markets Coaching Clinic:

Municipal market 2018

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 fourth quarter Capital Markets Coaching Clinic event today featuring our annual review of the municipal markets.

Now, we'll get started. Our discussion this afternoon features senior portfolio manager Greg Gizzi. Greg has been our end-of-year closer on these events for the past four years, and we look forward to hearing the team's perspective on the state of the municipal market as we head into 2019. To introduce Greg is my colleague in product management Mei Baiocchi.

Thanks, Erica. Hello and welcome to the annual year-end webinar on municipal bonds. My name is Mei Baiocchi, and I'm the muni product manager here at Macquarie, and I'd like to introduce to you our guest speaker, Greg Gizzi. Greg is a senior portfolio manager across all the Delaware muni funds by Macquarie. He has over 34 years of municipal experience on both the sell and buy side. And Greg has been doing this webinar ever since we started five or six years ago. I believe he has done the first one. And during today's session, Greg will provide a detailed overview of the muni markets, discussing fundamental and technical factors that drew a performance in 2018. There will be a segment on credit as it relates to the current market environment as well as a discussion on the impact of the Tax Cuts and Jobs Act on the muni market. Greg will also provide a case for municipal bonds and end with a market outlook. We thank you again for tuning in. And at this time, I'd like to hand it off to Greg.

Thank you, Mei. And thank all of you for joining us this afternoon. Hopefully, you'll find some value in our discussion. 2018 has certainly not turned out to be a boring year for municipal bonds, which is typically the case as the impact of tax reform. And I'll remind you that we spent a lot of time talking about the potential impact and probable impacts from tax reform a year ago on this call. We'll discuss some of the direct impacts from some of the changes we've seen. And just want to remind you that it's been a year where for the first time in a long time, we've seen volatility in a major way come back to the market share late in the year. I've traveled recently, and talking to a lot of advisors like yourselves, there's a fair amount of confusion out there. And as Mei said,, hopefully, we'll provide you with some ammunition and some comfort that you could be in an environment that makes sense to start reallocating to the asset class.

I'll start off by saying that 2018 ticked off in a very similar way to really the last four years. And what I mean by that is the predominant or consensus view from the analysts heading into 2018 told investors to do two things again. And that was to shorten duration in their portfolios and go up in credit quality. And that advice really, up until this year, had been incorrect where credit and curve were the drivers of performance. This year, we've got a mixed result for the consensus view. We certainly got performance — by shortening duration, you increase your performance. We'll get to that shortly. But credit did once again perform. So going up in credit quality was not the right call. What I want to do is start on slide 3 and just bring you back to the 2004-2006 rate hike period. And the reason I'm starting here is because this was the rate-hike period back in 2015 when Chairwoman Yellen embarked on normalizing rates. This was the time period we felt would best approximate what we thought the current rate-rise environment would bring for the market.

And I want to remind you what we're looking at here is the individual fixed income indices, the Bloomberg Barclays Indices, and their returns over this 2004-2006 period. And what you'll notice is the top three performing segments in this fixed income asset class, number one by far and away was high yield muni, putting up 10.75% return, and that's not tax-adjusted, but the actual return. That was followed by corporate high yield, followed thirdly by overall investment grade munis, the Bloomberg Barclays Aggregate Index. And I want to remind you that the driver of return during this period was a phenomenon that impacted the curve, which was the curve-flattening trade. And heading into 2018, we were looking for the curve to flatten as the Fed raised short-term rates. Looking at the economy, looking at what I believe is a fairly muted inflation picture, we thought that that, in fact, would again be the case in 2018; we would see the curve flatten. And what we'll see here is that we got the flattening in the Treasury market. We did not get the flattening in the muni market, and I want to walk through those factors that impacted that. On the next slide, we have the results from heading into the fourth quarter of this year. And what you can see is the top three performers are once again those three categories that happened in that '04 through '06 period. Number one by far and away is high yield muni. Ending the third quarter, we were up 3.86%. I can tell you we're only six days into December here, and that's improved since the end of the quarter. We're now up 4.25%. Second is overall muni. That was third in that 2004-2006 period. That's up 46 basis points followed by corporate high yield up 32.

And again, we've gotten the benefit of income. Income's been the driver of return in the muni space. If you go back to our view last year, we thought it would be a coupon plus/minus year predicated on how much of an impact rising rates would have on the price component of total return; and in the high yield space, in particular, there's been enough income in the market to offset any price degradation, and we've got a handsome return on the high yield side. So going a little bit deeper into this Bloomberg Barclays Index — and for those of you that are unaware, we use the Bloomberg Barclays Municipal Bond Index. For those of you who are less experienced in munis, it would be the equivalent of the S&P 500 in the equity world. This is the primary benchmark that most muni funds, non-high yield or non-intermediate funds are benchmarked to. So it's kind of the industry benchmark if you would. What we're going to do is take a look first at the maturity segmentation within that index and look at the returns. And this is what I referred to before. You can see that the two-year segment has risen 36 basis points on the year. If you go out to 30 years, we've risen 68 basis points. So we haven't seen the curve flattening on the muni side. In fact, the shorter part of the curve has outperformed. The best performing parts are 1-,3-,and 5-year parts of the curve, and those returns range from a 144 in one year down to a 91 basis-point return in five years. The worst performing part in the muni curve is the long end. We've got a negative return in the 22-plus. That's the long end of the muni curve. That's negative 47 basis points followed by just the return of 16 basis points in 20 years and 40 basis points in 15 years.

Rates have risen dramatically. And that's something that, as I've traveled around and talked to FAs — I want to remind you guys where we've come from. Those of you that have been in the business for a while, you can remember the AAA MMD GO scale used to be predicated on retail wanting a 5% yield, a 5% yield. I think fours are the new five if you would. A 4% yield out long would be considered value in this market given the inflation situation that we see in the economy right now. But just to put it in perspective on the rate move, the low for the AAA MMD GO scale, which is the benchmark for our market in the 10-year segment, was on June 26, 2016, we hit a 129. We're currently today at a 243. So we're up 114 basis points. And I want to add, that's after a 30-plus basis-point rally since the beginning of November. So we've seen munis rallying here over the last month pretty hard. And we're still, I would argue, fairly high relative to where we hit back in that 2016 timeframe. The same stat for the 30-year. We reached a low of 193 for 30-year AAA GOs on June 7, 2016, and we reside heading into today at a 314. So we're up 121 basis points. And again, that long end has rallied 33 basis points from its all-time high on the year. So I would argue that people have been waiting for rising rates, and we've seen them. Rates have risen a fair amount, again, against the backdrop of what I think is a fairly muted inflation return. We used to talk about real rates of return and that seems to get lost that there is not a lot of inflation in the economy, and investors are actually earning most of their gross return.

Let's flip the slide, and we're going to take a look at the credit segmentation return. And as I said before earlier, the prognostication from analysts about going up in credit quality was the wrong part of the analysis. And you can see here definitively that while the moves haven't been dramatic, if you look at the best performers, it'd be that very light blue bar, which is showing up 12 basis points heading into the fourth quarter; and then the orange bar, which is the BBB segment, that's up 90 basis points. The dark gray represents high yield. Again, that's up 386, the best performing fixed income asset class, muni high yield. And if you stripped out Puerto Rico, which has been edited this year, your return is 271. So we've gotten about a hundred basis points, 100-plus basis points added to Puerto Rico exposure in high yield. A's and BBB's have been the outperformer of the index. A's have put up a 51 basis-point return year-to-date. Again, year-to-date, the index is up 46 basis points, and then BBB's have put up a 131. So if you invest the way we do in our funds, which is to overweight the lower investment grade quality of the credit tiers, you've had a handsome return from those credit segmentations.

And just taking a snapshot, that's something we talk about as we talk about investing from the philosophical standpoint. How do you position yourself from a credit standpoint? This is something that's been a trend in the market. It has paid to go down in credit quality. It has paid to overweight A's and BBB's. This is that same breakdown over different time periods, one, three, and five years. And you can see that light blue A bar and the orange BBB bar, the low-investment grade categories are dominating return. I put the gray box all the way to the right because that's that 2004-2006 rate-rise period we started with this conversation; and it was the same story back then where your low-investment grade, your A's and BBB's, were leading the way followed by the high yield return. Again, the difference being we did get a flattening in that environment, and that's why you have a real handsome return. Not only did you get income return in that 2004-2006 period, but we also got a curve flattening on the muni side. The question is do munis catch up at some point? And then we'll get to that a little bit later in the discussion.

The return is slide 8. What I've done here is to take a look at muni ratios, and I've told you that we think the long end of the curve has gotten to an attractive point. Tax reform has played a major role in the demand quotient for muni bonds. And I'm going to go into detail on this in a second. What we're looking at on the left side is what are called muni ratios. And we look at where AAA munis are trading relative to AAA Treasury. And you can see that the 10-year ratio is up slightly on the year. After the third quarter, we're up one ratio. That's now up three. We've cheapened up a little bit more as Treasurys have rallied and outperformed munis here. In the 30-year segment, we're up about five ratios heading into the fourth quarter. That's now seven. We're up seven ratios. So we've continually got cheaper. And I'm going to tell you that the long end of the curve, the demand technical has been impacted by tax reform namely in the form of corporate entities have diminished the amount of participation they normally have in our market, and we'll go through that in detail in one moment. And this is what I've been talking about is the curve differentiation. If you look at the Treasury curve heading into the fourth quarter, we've tightened 30 basis points. This is the 2 to 30 curve we're talking about. The muni curve is steep in 30. That's a 60 basis-point difference. So despite the fact that we've seen that the credit has performed, if you've invested in the long end of the curve, you've watched us on a relative basis cheapen relative to Treasurys. I think we're at an inflection point with a shift here in psychology in the markets where that's going to change.

So let's talk about the demand quotient I'm referring to, and I want you to flip the page. Recall during tax reform, there was a marginal change in the top tax bracket for individuals. We went from 39.6% to 37%. On the corporate side — and the reason I'm highlighting the corporate side is because 30% of our market was owned by corporations heading into 2018, 30% of the muni market, a fairly significant component of the demand. From the long end of the curve's perspective, banks — the number one holder of bonds on the long end is individuals, and that's either directly or through indirect purchases [inaudible] mutual funds or SMAs. The other constituent which really dominates the long end are banks. And banks own 15% of our market heading into 2018. Property and casualty companies owned about 9%. That's that light blue slice of the pie. And if you go just to the left of the light blue slice, the dark gray slice, that's life insurance companies. That's about 5% of the market. So roughly 30% of the market was owned by banks, and I'm going to pick on banks because banks have been the culprit as far as the demand quotient goes. Banks became net sellers in 2018. And it's really three fundamental reasons why banks have shifted their focus.

The first and obvious one is the relative-value quotient change, right? So for all taxable entities, whether it's P&Cs or corporations or life insurance companies or banks, their tax bracket has shifted from 35% down to 21%. So the relative-value proposition has changed, and we'll take a look at that in a little bit more detail here in a second. The second thing that's happened is there was an accounting change. And effective December 15, in a week or so, is an accounting rule change which now makes banks amortize premiums. Premium bonds, bonds that are longer-dated in maturity and priced back to a call, they can no longer amortize those bonds on their books to maturity. They now have to amortize bonds to the worst case. So the call date, like you and I do when we buy bonds, okay? Banks were allowed to amortize to maturity prior to the change in this law. What we saw was if you think about tax reform, the most significant thing from a technical standpoint in the marketplace was the eradication of advance refundings from the marketplace. And I want to remind you, a lot of our supply comes from a refunding trade. And the refunding trade just very simply — if you use the example of a homeowner that owns a house with a mortgage, if you go to the bank and take a 30-year loan out and your mortgage is 6% and rates fall to 4%, you'll go to the bank, take a new loan out, refinance that existing mortgage, and save yourself money. And that's what municipal issuers do. The typical structure of a muni bond, the issuer keeps optionality, typically with a 10-year call. Okay?

So prior to tax reform, you could advance refund a bond when it became economically feasible to do so. Post-tax reform, we all know that advance refunding bonds now have been prohibited. And so you can only currently refund bonds. And by definition, a current refunding, must occur within 90 days. So if that call date is not 90 days or shorter, effectively, the value of that call date is worthless until it becomes refundable in that 90-day window. So banks started selling longer-dated bonds, a lot of paper in the 15- to 20- to 30-year part of the curve that was priced back to a call, 2-year, 4-year, 5-year, 7-year calls simply because they've lost the ability on that optionality until that bond becomes callable within 90 days. So that started the selling. And just to put it in perspective, in Q1 and Q2, banks sold about $27 billion worth of paper. In Q3 and Q4, they've added about $16 billion. So close to $45 billion of muni holdings have been sold by banks here in 2018. We believe that with the accounting rule change going into effect, those banks that wanted to sell that shorter-call paper have done so already; and now it becomes, like all corporations, a relative-value trade as far as when banks participate in the market, i.e., munis will have to be cheaper, and we'll see this in the comparison I make here in a second. Munis are going to have to be cheaper to attract the attention of corporate entities.

The last reason banks became sellers is a fairly obvious one. Banks don't only own paper on the long end, but they own it on the front end. And as the Fed has raised rates, their funding cost has increased internally as well. And as a result of those increased funding costs, some of those investments became economically upside down. So we saw not only the long end gets sold but other parts of the curve, as well as funding costs, have risen at banks. So we go onto page 10, what we've done here is simply take a look at a corporation relative to an individual. So on the left-hand side of the chart on the bottom, it shows the taxable equivalent yield for a bond. We've used Colorado RTDs here. Colorado 5's at 46 with a tax-exempt yield of a 305. Under the old marginal tax brackets, just using the federal tax and the Medicare tax, you grossed up to a 539. With your decrease to 37% marginal tax bracket, that goes to a 5 — what's that look like? A 515. So that's a 24 basis-point difference. I would argue not a substantial enough difference to discourage retail from participating in the long end with that change in taxable-equivalent yield. They've been told to go to the front of the curve, and I think that's actually worked. If you look at where the front end of our curve has traded, it's been very, very rich from a ratio standpoint and from a spread standpoint. As some of you know, that you build portfolios, particularly in that 1- to 10-year part of the curve, it's been a very, very crowded space and one that in my opinion does not represent a lot of value at this point if you're trying to add income to your portfolio.

On the right side, we're doing the same analysis with the same bond but for a corporation. And you can see under the old 35% tax bracket, that grossed up close to a 470 whereas at the new 21% rate, that falls to a 386. So that's almost 90 basis-point difference. That is meaningful. That is meaningful when you're running a multi-billion-dollar portfolio, 90 basis-point difference in your taxable-equivalent yield. I just want to highlight — we're picking on banks because banks are the most active. Life insurance companies, lifers have a different business model. They tend to participate — since they're dealing with long-dated liabilities, they are trying to liability match. They want consistent and they want yield, consistent returns and yield. They buy high-quality long-taxable munis, which from a relative-value standpoint and a yield basis are trading a lot higher. They will participate in the tax-exempt markets during periods of dislocation; but certainly, in 2018, they haven't had the ability to do that unless they were going to go way down in coupon, which we didn't see a lot of quite frankly. So they've been fairly consistent in buying that taxable muni market. P&Cs are the interesting one to look at because P&Cs, their model as you know, is based on claims paying. So in a year where there are very few catastrophes and their claims-paying experience is very low, they're very profitable, and they're looking for tax-exempt income. They become very active players in the market.

And if you look at the most recent Fed data, which is being highly refuted, by the way, it looks like they've added to their portfolios, but I've had other studies that I've read that say actually portfolios at P&Cs have actually fallen. And I tend to be in that camp myself. But if you look at historically the ratio of where P&C companies would buy munis versus corporates, so just the corporate yield over a — a muni yield over a corporate-yield ratio, at about 69% was the breakeven. Anything cheaper than 69%, they would favor munis. Anything through that, they would favor corporates. That's now up to 85% based on the new tax bracket. So again, a substantial difference in the relative-value proposition of the asset class. All of this just pointing to the fact that the reason we haven't gotten a flattening in the curve is a combination of less demand from corporations, namely banks in 2018 which have actually been sellers, and the fact that we've had — the other main buyer, retail really run and hides in the front of the curve, really buying 1 to 10 years, and that's been the advice of strategists here for the last few years.

Another thing I want to talk about is flows. The way we judge retail demand indirectly, which is through funds, is to look at the Lipper fund flows that come out weekly. And there's an interesting phenomenon that's very common in our market. And I want you to look at the shaded area all the way to the right on the slide. At the peak during the summer, we had positive inflows into bond funds, tax-exempt bond funds, of about 12, $13 billion, in that range. In that shaded period of time you're looking at on this chart where that dark blue line plunges, those are flows. So flows are leaving the muni space. We lost about $9 billion of that $13 billion. So we've seen outflows. We've seen outflows in 21 weeks. Out of the 48 weeks we had so far, we've had outflows. 27 weeks, we have inflows. But I want you to carefully look at the slide because a phenomenon that typically happens is happening right now, and that is I believe we could be at an inflection point where we've already seen the highs on the Treasury side. And you can see the 10-year in the orange line and the 30-year on the gray line turn over. You can see them start to point down. Their yield's coming down, yet our outflows are still accelerating. And that's typical in the muni market. You'll typically get outflows for two or three weeks after the market's already turned, and we're seeing that phenomenon right now.

I think we've been marketing the last month in different cities and telling people — it may not be the bottom but from a relative-value standpoint, if you look at munis, it certainly makes sense to start to spend some money when you've had ratios as cheap at 103% in 30 years, that means tax-exempt munis trading at 103% of Treasurys. We've seen that where we've been sending around a hundred. We've gotten just inside 100. I think anywhere around 100 or cheaper makes sense for individuals. And one last thing that I'll bring up with respect to reviewing the markets, on the next slide, here's some good news, and you keep this in the back of your mind. So there's been another distinct change this year. As the Fed has raised rates consistently and LIBOR has increased, we've seen SIFMA rates increase. So 7-day, monthly SIFMA rates increase. And you can see the blue line which tracks tax-exempt money market flows. As SIFMA rates have risen, this market that has come out, these $9 billion worth of outflows, I believe a lot of that is being parked in money market funds, in tax-exempt money market funds. And you can see there have been — not dollar for dollar, but there have been somewhere between $6 billion and $7 billion worth of inflows into tax-exempt money market funds during this outflow period. And we'll get another data point tonight.

My guess it'll be the 11th straight week of outflows we'll get tonight. We'll have another negative number. But that money is temporarily being parked into money market funds because now you're earning something, right? We all know SIFMA rates were single digits for a very long time. We got to low double digits, and then as rates started to accelerate, we saw SIFMA rates get as high almost a 190 this year. I think we're around a 168 or so now. People are earning to weight now. So you don't have to buy 2- or 3-year paper anymore and take on any risk. But I caution you because that's a lot of money that I think's going to come back in the market at some point if you're trying to time this thing, which I'm never an advocate of. But if you are, I think there's a shadow amount of demand that's sitting in tax-exempt muni funds waiting to reenter the market. So I covered a lot. Just very quickly, if we go to slide 13 — let's just review.

Munis have done what they've typically done in the bear market, right? We've outperformed other fixed income asset classes. By far and away, high yield's been the star. And I think you can attribute that to the amount of income that's generated in high yield funds offsetting the price degradation. Technical conditions have gotten less favorable, right? The long end has been cheap as a function of the demand side of the equation being compromised. As the demand side of the equation's been compromised, retail has been told to go to the front end of the curve. We've seen the amount of direct-retail tickets down year-to-date, the number of actual tickets that are being written, and the banks have become net sellers which is the biggest part of the corporate demand for our marketplace, and we went through those reasons why the bank became sellers. The good news is we've seen the supply drop, and we're going to talk about supply in detail here in a moment. But supply is down about 16% as of last weekend year-to-date, down 16%, and that's been an offset to the falling demand. Equity market rally, one other thing that's contributed to the outflows and to the negative performance. We're in many platforms. I've seen trades being done. A lot of gains and rebalancing has been done along the way. Yes, we've hit volatility in equity markets and seen some of the performance go away, but prior to that, a lot of gains were realized.

So we've seen a lot of tax-loss harvesting which has contributed to the market trading off. And lastly, the midterm elections, I believe, will give the market a little bit of clarity; and I'll get to that in a moment too. But that's something that we're focusing on, what the midterm elections mean for the market as we go forward here. Let's talk quickly about a case for munis. I've been saying that I think they're attractive. This is the same — just a blown-up version of a taxable-equivalent yield. We use Texas Waters here. You can see, again, not a big enough difference in taxable-equivalent yields to really deter retail from buying the long end of the curve. And I want to say, we're just not in love with the long end. I think the front end of the curve, as I said, has gotten rich as people have crowded the funding of the curve. We find value in the curve right now basically in that 13- to 17-year part of the curve, and we like the long end of the curve. And I think that's where you find your best-expected return and best roll-down value. As maturities roll one year to the next, you typically pick up in performance. And those are the areas where we think you're going to capitalize if you involve yourself.

But one of the things I like doing when I talk to FAs is to make relative comparisons, and we'll do that on the next slide. We're going to use 30-year bonds here just to keep it simple. But here's a credit segmentation, and we used actual spreads and yields to calculate taxable-equivalent yields for AAA through BB. And these are some of the sectors that — in the lower-quality charter schools — we're a fairly big investor in charter schools that we like, but just walk through some of these comparisons. If you look at AAA GOs, which would typically be yielding around a 330 right now in 30 years, and you gross that up just using federal taxes and your ACA tax, you're talking about close to a 560 taxable-equivalent yield. That's 149, roughly 150 basis points more than AAA Microsoft is yielding, right? If you're looking at where your taxable comparison is. A 408 yield on Microsoft versus an almost 560 gross-up yield on a AAA GO, something like Texas Waters. AA revenue bonds, 583 versus a 428, 155 basis points. Education, 701 gross-up versus a 433, over 250 basis points. You're picking up substantial yield going into munis on a taxable-equivalent yield basis; and if you flip the page, I want to remind you — and I've told you guys the last five times we've spoken, this should be on your desk because this is really the one study that I believe has been the main impetus for the amount of foreign demand we've seen in our market.

And we've talked about in the past during the crisis as — particularly as taxable munis through Build America Bonds became very popular as a way for municipal issuers to tap markets and open up the new-issue market, banks went global and pitched munis. And at that time, you were getting very, very handsome returns. Not only were you getting handsome returns; but then when investors realized the inherent credit-quality difference between munis and corporates, it almost was an aha moment that they should be owning these things. And it wasn't until much later, a few years later, where foreigners became big investors in the market. But this is the Moody's 10-year Average Cumulative Issuer-Weighted Default Study. It comes out every year since 1970, and it goes by credit segmentation, AAA all the way down to below investment grade and looks at the incidents of default in the muni category versus the corporate category. And when I always show FAs this, it's pretty astounding. I mean, if you go to just the A — I like going to the lower investment grade, the A's and the BBB's. The A category, if you look at the default rate just over 0.10% versus 2.16% versus corporates. That's almost 20 times as much, it's 19.6 times as much at a default rate much higher than muni bonds.

In BBB's, 1.15% versus 3.76%. That's over three and a quarter times. Munis are inherently safer than corporate bonds. You're getting on a grossed-up basis, a significantly more taxable-equivalent yield in the current marketplace. And we've talked about some of the factors that have driven — the technical effect is they have driven munis cheaper. We've been advocates here over the last several weeks of telling people to start to buy into this market. I think it's an opportune time. And this is before the psychology shift we've seen here in the recent past few days here, which we can talk about too. I think there's a lot of short covering going on on the Treasury side. But certainly, growth expectations as both the equity and bond markets are telling you are being lowered finally. I think the IMF has had it right. They've downgraded growth expectations globally twice this year already. So I think it's a fairly simple case for munis. It's having the fortitude to lead that front end of the curve with your money market and shifting some money out and try to take advantage of what we know is historically a very steep curve in the muni market.

Let's talk about our outlook, and I mentioned midterms. And quite frankly, from a muni market professional's perspective, we're thrilled. I mean, gridlock is fine. Gridlock is okay. You guys have all read the stories. You go back and look at gridlocked Congress, and during those time periods where there's a gridlocked Congress, markets do okay. And that's great. But our concern was really more myopically focused. And really it's on our living, on how we make our living, and that's on the muni market. So we, in my opinion, escaped the worst-case scenario by having gridlock. And the worst-case scenario from my perspective would have been an outright sweep by Republicans. And the reason I say that is because we've had tax cuts. So let's call tax cuts tax reform 1.0. Tax reform 1.0 blew a $1.7 trillion additional hole in the deficit. You may recall we had a little uneasiness in the bond markets during the summer as we started to focus on how this was getting paid for, and many people thought that the Treasury calendar would have to pick up and accelerate, and that supply might cause rates to rise. From a muni perspective, my fear was if we got that sweep, tax reform 2.0 which was making 1.0 permanent would have been front-page news. And if that was done, recall that President Trump was recently talking about adding an additional tax cut to the middle class of 10% for those earning between $40,000 and $80,000; let's call that tax reform 3.0.

Well, where's the money going to come from for all these tax cuts, right? And I think the "Trump bump" — I think if you look at the performance of the equity markets here over the last month or so, it looks like the Trump bump may be fading, and it's back to how are we paying for some of these initiatives? And my guess is that if we had that sweep and if they were going to make these tax changes permanent and add the additional tax reform 3.0, muni exemption either outright or some kind of cap would have been back in play. And recall during the fiscal cliff of 2012 — many people don't remember this, but in the 11th hour, there was a change. At 11:59, there was going to be a cap on munis. That was in there, and it got taken out at the last minute. The exemption is not sacred. Now, you've heard me say before there's been a lot of lobbying. A lot of people woke up after 2012, National League of Cities, many lobbies, muni-related lobbies have done masterful work educating congressmen about the importance of this marketplace. But it is not a sacred cow, okay? The exemption I would not take for granted. And so from our perspective, the midterm elections turned out just absolutely fine.

The next point from the midterm elections - and I want to give you our spin on this - is I mentioned supply being down 16% year-to-date. And it's probably going to wind up in and around there, 15%, 15% plus/minus. Looks like the calendar's trying to pick up here in the final weeks, but I don't know how much of the deals are actually going to get priced. Infrastructure, we've mentioned this before on many calls, this shadow calendar that exists, right, the American Society of Civil Engineers, their report, the horrid state that our current infrastructure is in. The latest number was over $2 trillion in need over the next couple of years to get our infrastructure state back up to an adequate rating. It's now rated poor and in need of immediate repair, a B-plus rating. So once we got the Democrats taking over the House, the comments started that the probability of a BAB-like deal happening, an infrastructure program happening, increased dramatically.

Now, I will say that I agree. If that occurs, the supply side of our market, the supply picture is going to change pretty dramatically. I think we could see an additional $50 billion to $100 billion in extra supply each year going forward if we got a significant program like that. I don't think that's going to happen. There's fundamental difference on how to structure this program and certainly where the money's going to come from. And again, we haven't paid for the tax cut quite frankly yet that was initiated by the Trump administration. So it's nice to think about. It's nice to talk about. And I think the reality about infrastructure is that if the onus of infrastructure finance is being put squarely back in the lap of state and local governments, and quite frankly the ability for certain state and local governments to take on that extra debt, is extremely varied depending on what entity you're talking about. Some have the capability to do it and many don't. So I think the infrastructure — there's certain projects out there we all know about that have been written about that have to start to get addressed, and I think you'll see a pickup in new money issuance. We saw it in 2018. We'll see it again in 2019.

But I'm not looking for any substantial program coming from this new Democratic-led House. The other thing I want to mention, 76.3 billion in bond ballot propositions. Many of you are in states where it's required that if a state or local government wants to raise a tax to fund a program or some kind of deal, create a deal, it must go and get passed by the constituents. I said only 65% of those ballot measures passed. And I said only 65% because the typical success rate is 80 or over 80%. So I think that's a legitimate protest in certain states. If you look at where some of these bills were defeated, they're high-tax states. And this is the SALT revolt that's going to go on. And we haven't focused on SALT yet. We'll get to that in a second. But I think that people are going to be surprised when they visit their accountants in the spring. And it's one of the questions I've been asked quite frequently on the road. "Hey, I live in a high-tax state. Do I buy just in-state bonds because of the advantage I get with the high —" I think this. While certainly buying munis isn't going to lower your tax status, right, I think that the prevalent attitude coming from accountants' offices for high net worth individuals will be, "I want to shelter as much of my income as I can."

And I think we've seen it in California already. In California, spreads have gone one way this year. They've tightened, and they have not lined out at all. In New York where we've had more supply, we've narrowed that down recently, but New York has not tightened like California has. But I think the preference for in-state bonds or funds will increase fairly dramatically next year. That's something we wrote about in a tax piece earlier in the year. And lastly, we'll move on here. Muni credit, against everything we're talking about, muni credit fundamentally is very, very strong, the strongest it's been since the great financial crisis. And if you flip the slide, I want to do just a quick run-through and explain to you why that's the case. This shows the revenue sources on the left side for states, on the right side for local government; and there's a distinct difference. On the left side, state, if you look at it, 50% of revenue comes from income tax, and income tax is earned income and it's also capital gains. And we've had solid equity markets, and I've told you people have taken gains, and we're seeing tax-loss harvesting.

The other component is sales tax; 41% is sales tax. So 90% is from two sources. On the local side, it's about property taxes. So on average, 81% of revenue comes from property taxes. Well, if we think about the bright spots in the economy since the depths of the recession, right, jobs have been more plentiful. The unemployment rate has been sinking. The number of people working has increased. That means more people employed; more people are spending money; revenues are up. All right. Third quarter, we just got the number for the second quarter revenues. The revenues at the state level were up almost 9%, 8.7%. We've had a significant period here where we've seen the rating agencies upgrading more credits than you have downgrading. Moody's for five consecutive quarters has had more upgrades than downgrades, not only in number but in par value. And for Fitch, it's four quarters in a row. And quite frankly, given the way there is a lag effect, the way the sources where revenues come from, these revenues aren't as tied to this business cycle as, say, the corporate bond market is.

So we expect this positive credit trend to continue into next year. We're not looking for any credit degradation over the next year. I will tell you this. We're keeping our eye on those states that will be impacted by SALT, right, and that's something we wrote about. States that get a lot of their income from property taxes that now they have individuals, many of which own multiple properties that can only cap out their write-off at $10,000. Just the other day, if you didn't read it, it's a great article about the real estate market in Dallas. Pretty eye-opening in what's going on in some of these high net worth areas. Housing has definitively made a turn. I've been watching the data all year really soften. And I don't know if you guys follow Toll Brothers, but Toll Brothers had a pretty somber call the other day in talking about some softening in key markets they hadn't seen in years. So housing has turned. I think the psychology again has shifted in the markets, and that's why we're getting this bond-market rally and this equity sell-off. Growth expectations are being lowered, but fundamental credit, muni fundamental credit, is strong. And even though we're talking about GOs, if these sectors are strong, this GO sector is strong, the trickle-down effect into other sectors — for instance, more people working, the more people drive.

And more people are in homes using electricity and flying and using the airports, right? It trickles over into the revenue bond sectors as well. So I can tell you that credit is fundamentally strong, and we don't see any hiccups on the horizon here in the near future. How much time do I have? Okay. Last thing I want to talk about is supply and some interesting crosscurrents occurring on the supply side, which I want to mention. Down about 16%. The culprit is advance refundings that we talked about earlier. Advance refundings, which are now prohibited, are down 43% year-over-year. They can't do them anymore. It has been the reason why supply is off as much as it is. So the question is what happens next year? A couple of interesting things occurred that are going to affect supply next year. First, again, if you can only currently refund bonds, that means bonds which are to be refunded next year have to be from 2009. So those are the Build America Bond years, 2009, 2010. During those Build America Bond years, we had fairly low tax-exempt financing. And we know that some of those deals, just based on pre-res I have in my portfolios that have 2019 and 2020 pre-refunded dates, they've already been advance refunded prior to the change in the legislation.

So the amount of refundable, currently refundable paper is going to be down. There is an offset to that. And that's the bad refunding. So we recently had a ruling by the IRS that says despite the fact that a tax-exempt deal can't be advance refunded by another tax-exempt deal, a taxable deal can. So there are currently about $42 billion worth of Build America Bonds that have calls, 2019 and 2020 calls that are going to be refunded. We think looking at the analysts, the range will be somewhere between $10 billion and $20 billion of additional refundings next year due to that category, taxable Build America Bonds being taken out by tax-exempt deals. So on the margin, that's going to add to supply. And lastly, we talked about the infrastructure thing. We are looking for a slight uptick in new money issuance next year. So if you put it all together — and again, I want to remind you, we aren't bankers. We don't underwrite deals. We don't have bankers that talk to issuers. So we basically will survey the top firms and their predictions and come up with what we believe is the best-case scenario. We're looking for an increase next year, I would say, in the 10% to 15% range. And that's considering that we're not going to get a Build America Bond program or some kind of significant infrastructure program. And that's not including any of the restructure deals that we might get out of Puerto Rico. We're excluding that.

So supply down 15% — let's call it 15% to 20% this year. We're going to see a boost somewhere in the 10% to 15% next year. Go to the next slide. We use this slide quite frequently, and it's actually worked out okay. We've been asked, "Empirically, can you tell us the best time to buy muni bonds?" And it's a very simple thing. So what we did, we go back, in this case, to 2001. Take a look at the returns. And no secret, the time to buy munis is when the technicals go against the market, when there's outflows, say, in March for pretax time. Supply typically picks up in June. We see it again in October. The technicals turn negative. Those have been historically good times to add to portfolios. November made it in here based on the Trump tantrum. That one month alone in November after he was elected got November in there. But I'll say this. In 2019, we'll continue to see volatility. I think the Fed, as far as interest rates go, the Fed hike in December is baked in the cards. I think the market is anticipating that. The market was looking for two hikes next year. The Fed was talking three. I think the jury's out. You've got to watch the data, which is what Bernanke used to tell the market, right?

And for some reason, the market doesn't want to follow the data because I think if you do that, you're going to keep yourself out of trouble. But the data's telling me that things are softening and that growth is softening. So I think to sum it up, we think that there's value in the market right now in municipal bonds. Technical conditions have driven to the market where we've traded cheap, particularly in the long end of the curve. We have preference in the 13- to 17-year part of the curve or long, 22-plus out long. And we're looking for solid credit fundamentals to continue into next year. We are looking for a positive return from the market. It looks like we're going to eke out a small return this year. I think you're going to get a coupon return. You're going to earn the coupon in the market plus/minus depending on when the Fed stops, if the Fed stops, and then the curve dynamics thereafter. But certainly, I think you're going to get an opportunity. I don't think we're going to see a straight line. There'll be the fits and starts.

But in my opinion, as far as this rate-hike cycle goes, we're obviously closer to the end of it than we are the beginning. And I think you've got to put that into your calculus when you think about positioning these portfolios. More taxable accounts. You've seen the taxable-equivalent yields. You're buying the fixed income instrument relative to its yield and its inherent credit quality, munis are the way to go. So I've taken up a lot of your time. I want to thank all you guys for paying attention. I wish you a healthy and happy and prosperous new year.

Thank you again to Greg for sharing this conversation with us this afternoon. Thank you again for your participation.

The views expressed represent the Manager's assessment of the market environment as of December 2018, 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.


Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Recipients should not construe the contents of this presentation as tax advice. Macquarie Investment Management is not in the business of providing tax services.

Document must be used in its entirety.

Diversification may not protect against market risk

The views expressed represent the Manager's assessment of the market environment as of the date indicated, 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. Information is as of the date indicated and subject to change. Charts shown though out are for comparison purposes only.

The information contained in this presentation is not intended to be legal or tax advice. If you need assistance preparing your tax return, please consult a tax advisor.

Investing involves risk, including the possible loss of principal. Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The investment may also be subject to prepayment risk, the risk that the principal of a fixed income security may be prepaid prior to maturity, potentially forcing reinvestment of that money at a lower interest rate. • High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds. • Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable. • Duration number will change as market conditions change. Therefore, duration should not be solely relied upon to indicate a municipal bond fund’s potential volatility.

A benchmark is a standard against which the performance of a security, mutual fund, or manager can be measured. It is usually an index of securities representing a particular market of a portion of it. Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

Taxable-equivalent yield is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. All third-party marks cited are the property of their respective owners.

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Index ㅇefinitions

The Bloomberg Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, non-investment-grade tax-exempt bond market.

The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.

The Bloomberg Barclays 3–15 Year Blend Municipal Bond Index measures the total return performance of investment grade, US tax-exempt bonds with maturities from 2 to 17 years.

The Bloomberg Barclays US Credit Index measures the total return performance of nonconvertible, investment grade domestic corporate bonds and SEC-registered foreign issues.

All bonds in the index have at least one year to maturity.

The Bloomberg Barclays US Corporate Investment Grade Index is composed of US dollar-denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least one year to maturity.

The Bloomberg Barclays US Aggregate Index is a broad composite that tracks the investment grade domestic bond market.

The Bloomberg Barclays US Corporate High-Yield Index is composed of US dollar-denominated, non-investment-grade corporate bonds for which the middle rating among Moody’s Investors Service, Inc., Fitch, Inc., and Standard & Poor’s is Ba1/BB+/BB+ or below.

The Bloomberg Barclays US Treasury Index measures the performance of US Treasury bonds and notes that have at least one year to maturity.

The Bloomberg Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency.

The Bloomberg Barclays US Credit Index measures the total return performance of nonconvertible, investment grade domestic corporate bonds and SEC-registered foreign issues with a maturity from 1 up to (but not including) 3 years.

The Bloomberg Barclays US Securitized Index is a composite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible), and fixed rate mortgage-backed securities. For Rising Rate Period 1 in Exhibit III, Securitized Debt is represented by Bloomberg Barclays Mortgage-Backed Securities Index, which is an unmanaged index of collateralized mortgage backed securities (ERISA-eligible) securities.

The ICE BofAML Fixed Rate Preferred Securities Index tracks the performance of fixed rate US dollar-denominated preferred securities issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch) and must have an investment grade rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings).

Credit ratings definitions:

Moody’s Investors Service, Inc.: Aaa - Highest quality, smallest degree of investment risk. Aa - High quality; together with Aaa - bonds, they compose the high-grade bond group. A - Upper-medium-grade obligations; many favorable investment attributes. Baa - Medium-grade obligations; neither highly protected nor poorly secured. Interest and principal appear adequate for the present, but certain protective elements may be lacking or may be unreliable over any great length of time. Ba - More uncertain with speculative elements. Protective of interest and principal payments not well safeguarded in good and bad times. B - Lack characteristics of desirable investment; potentially low assurance of timely interest and principal payments or maintenance of other contract terms over time. Caa - Poor standing, may be in default; elements of danger with respect to principal or interest payments. Ca - Speculative in high degree; could be in default or have other marked shortcomings. C - Lowest rated. Extremely poor prospects of ever attaining investment standing.

Standard & Poor’s: AAA - Highest rating; extremely strong capacity to pay principal and interest. AA - High quality; very strong capacity to pay principal and interest. A - Strong capacity to pay principal and interest; somewhat more susceptible to the adverse effects of changing circumstances and economic conditions. BBB - Adequate capacity to pay principal and interest; normally exhibit adequate protection parameters, but adverse economic conditions or changing circumstances more likely to lead to weakened capacity to pay principal and interest than for higher-rated bonds. BB, B, CCC, CC - Predominantly speculative with respect to the issuer’s capacity to meet required interest and principal payments. BB - lowest degree of speculation; CC - the highest degree of speculation. Quality and protective characteristics outweighed by large uncertainties or major risk exposure to adverse conditions. D - In default.