Taxes and Munis in Today’s Volatile Environment
TEXT ON SCREEN: PIMCO
TEXT ON SCREEN: PIMCO EDUCATION –TITLE – Taxes and Munis in Today’s Volatile Environment with John Nersesian and guest David Hammer (8 minutes)
Text on screen: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.
TEXT ON SCREEN: John Nersesian, Head of Advisor Education
John Nersesian: Hi everybody. I'm John Nersesian, head of advisor education at PIMCO. And I'm joined by my colleague, David Hammer. Dave is the head of municipal bond portfolio management at PIMCO. Dave, welcome to our conversation.
David Hammer: Hey John. Thanks for having me.
John Nersesian: It's my pleasure. So Dave, let's start the conversation by talking about equity market volatility that we've seen recently. And of course the topic on everybody's mind, the prospect of higher interest rates. Can you help our audience understand what that means to the municipal bond market, both individually and from a portfolio management perspective?
TEXT ON SCREEN: David Hammer, Head of Municipal Bond Portfolio Management
David Hammer: Yeah. Sure John. You know, investors are contemplating a Fed hiking cycle. And that really increases the probability of volatility. So I think it's important to note for tax exempt munis,
TEXT ON SCREEN: TITLE - Municipals have historically performed well during Fed rate hike cycles, SUBTITLE - Fed Funds Target Rate
IMAGES: A line chart shows the fed funds target rate from 2004 through 2022; it highlights three rate hike periods: 1 from May 2004 - November 2008, 2 from November 2016 – May 2020, and 3 from 2022 into present time.
it's these types of environments that they tend to thrive from an asset allocation perspective.
And first and foremost it's performance in a rising rate environment. Looking back to previous Fed hiking cycles, munis have both outperformed taxable fixed income as rates have risen, but also delivered relatively decent cumulative returns over those time periods.
TEXT ON SCREEN: TITLE - Municipals have historically performed well during Fed rate hike cycles, SUBTITLE - Fed Funds Target Rate
IMAGES: The table shows the returns of U.S. Treasuries, investment grade munis, taxable-equivalent investment grade munis, high yield munis, taxable-equivalent high yield munis, during periods 1 and 2, demonstrating that munis have historically performed well during fed rate hike cycles.
So going back to 2004 to 2006, or 2015 to 2018 more recently, investment grade munis absolute returns over those time periods, about 7 to 9 percent. High yield munis have done a bit better, 18 to 22 percent. And of course that's all without adjusting for taxes. So those taxable equivalent returns are even a bit better.
TEXT ON SCREEN: TITLE - Municipals can offer diversification benefits versus a variety of asset classes
IMAGES: A bar chart shows the correlation between a number of indexes that represent variety of asset classes and the S&P 500 and the Bloomberg U.S. Aggregate Bond Index as of December 2022. The chart shows that municipal bonds tend to have a lower correlation to the Bloomberg Aggregate than Treasuries, and a lower correlation to equities than investment grade and high yield taxable credit.
And in terms of diversification, it's important to note that historically munis have had lower correlations to these riskier parts of the market like equities and high yield corporate credit. And that applies both to IG munis if you're comparing them to the Barclays Ag, or high yield municipal bonds if you're comparing them to the S&P 500, or high yield corporate credit spreads.
John Nersesian: That's great, Dave. Thanks for the comments on that. Let's talk about another aspect of the municipal bond opportunity today. I was reading an article recently where you were quoted, and you referred to the idea that state and local coffers are more flush with cash than they have been in recent history. What exactly does that mean in terms of credit quality for the municipal space?
David Hammer: Yeah. This moment in time is peak credit quality for the muni market. And there are a number of factors that have influenced it. Number one is that despite the severe economic contraction in 2020, state and local tax collections were only down about 1 to 2 percent. High income earners kept their jobs. There were record levels of monetary and fiscal policy support.
Once we add in 2021 COVID relief, it actually swung state and local government balance sheets from deficits to surpluses.
TEXT ON SCREEN: TITLE - State and local government revenue streams remain resilient. SUBTITLE – Rolling 12 month state and local government tax revenues.
IMAGES: A line chart shows tax revenues (mm) from Q1 1994 to Q2 2022, rising from $600,000 in 1994 to about $2,000,000 in 2022.
And throughout 2021, state and local governments were experiencing record revenue collections. The state of New Jersey announced in 2021 that they hit all-time new highs in revenue collections.
And then at the local level, many muni bonds were backed by property taxes. And house price appreciation it accelerated during this crisis. Very different than the financial crisis of a decade ago in which house prices were a drag on local economies. In this case they're actually supporting local economies. And investors and rating agencies alike are taking notice here.
So this is a phenomenon that we expect will turn into a multiyear favorable credit environment. Much of the COVID relief, it hasn't been spent yet. State and local governments have until 2024 to allocate it, till 2026 to spend it. They're also improving credit quality by paying down pensions. And as we head towards mid or perhaps late cycle at some point, this improves the overall credit quality of an already safe asset class that has historically low default rates versus IG corporate bonds or high yield corporate bonds.
John Nersesian: Dave, let's talk a little bit about tax reform. If we were having this conversation in 2021, tax reform was the topic du jour. Everybody was convinced that ordinary rates were going up, that capital gain rates were going up, that there was going to be some sort of meaningful tax legislation.
Of course that hasn't come to pass. And therefore the number of opportunities for individual investors to save on their taxes is still very limited.
Text on screen: TITLE – Individual income tax deductions, SUBTITLE: Itemized deductions BULLETS – Medical expenses, SUB-BULLET: Medical expenses subject to 7.5% AGI floor, BULLETS: Mortgage interest, SUB-BULLETS: Mortgage interest capped based on size of the loan, BULLETS: Charitable gifts, SUB-BULLETS: Charitable gifts limited based on type, recipient of gift, BULLETS: SALT taxes*, SUB-BULLET: SALT capped at $10,000
We've got medical expenses, if they exceed 7.5 percent of AGI. Mortgage interest of course is still deductible. Charitable giving is still deductible. And then of course the all important state and local taxes, which are currently capped at $10,000.
Dave, let's talk a little bit about how munis fit into that context of a limited state and local tax deduction.
David Hammer: Yeah. You hit the nail on the head, John. There are limited places to go for tax efficient investing today. The other thing that's become limited is the supply of tax exempt bonds. The most recent bills around infrastructure, they failed to bring back tax exempt advanced refundings, which allows muni issuers to refinance a tax exempt bond with a new tax exempt bond. As a result, muni issuers are actually turning to the taxable market. That's taking tax exempt supply away and converting it to taxable form. So there's simply not enough supply of muni bonds to satisfy this demand in many cases.
TEXT ON SCREEN: TITLE - Case Study: Puerto Rico.
IMAGES: This line chart displays the price of Puerto Rico bonds, and PIMCO’s buying and selling of them. It spans a 7-year period, from March 2012 to March 2019. The two bonds measured are Puerto Rico benchmarks, the “GO 5% of 2041” and the “COFINA 5.5% of 2028.” The chart shows the price of the bonds beginning around $100 (GO 5%) and $115 (COFINA), respectively. It points out that PIMCO sold its last COFINA position at $105.45, around April 2013. After, the prices began a steady decline, through to the period of September 2017, when the prices were around $50 (GO) and $23 (COFINA), respectively. In September 2017, Hurricane Maria hit Puerto Rico, and Washington DC made negative comments, causing the price to crater further, to around $20 (GO) and $17 (COFINA), respectively. Shortly after the cratering, PIMCO began to buy GO and COFINA, around the price of $22 (GO) and $15 (COFINA). By March 2019, the end of the period measured by the chart, prices had risen to around $50 for both GO and COFINA.
One place that we see opportunity in value for tax aware investors, it's the Commonwealth of Puerto Rico. The island has been going through a multiyear restructuring process. And we see value here for a few reasons.
Number one is that debt has become more sustainable. The Commonwealth has reduced their debt burden by about 60 percent by imposing haircuts on legacy bondholders. The new bonds also offer better security protections for bondholders than they did pre-bankruptcy. So it's a higher quality asset coming out of the restructuring.
And then last but not least is the high levels of tax free yield. These bonds are not rated. They're trading with a wider spread or a higher tax free yield. That means 4 to 5 percent tax free yields as these bond transition back into the muni market. That's equal to somewhere in the 7 to 8 percent taxable equivalent range. For those investors in California and New York, it actually gets close to double digit returns. So it's an area we see a lot of value this year. And we've increased our allocations here at PIMCO across our municipal vehicles.
John Nersesian: And clearly with that state and local tax deduction capped at $10,000, paper like Puerto Rico becomes really attractive for those residents of those states. Dave, thanks so much for your comments today. Very helpful. I want to thank our audience for joining us. And I want to encourage all of you to learn more about our capabilities in the municipal bond space by visiting us at pimco.com or by contacting your local PIMCO account manager.
TEXT ON SCREEN: To learn more visit Advisor Education at pimco.com or speak with your Account Manager
TEXT ON SCREEN: TITLE – PIMCO
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