Munis and infrastructure Munis and infrastructure http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\webcasts\road-construction-small.jpg February 2 2022 January 28 2022

Munis and infrastructure

Portfolio managers Ann Ferentino and Patrick Strollo discuss policy and the impact on municipal bonds with guest Dan Clifton of Strategas.

 

Published January 28 2022
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Podcast Transcript
00:00
Steve Chiavarone: Hello, and welcome to the Hear & Now podcast from Federated Hermes. I'm Steven Chiavarone, equity strategist and head of Multi-asset Solutions. I'll be moderating today's episode. And I'm joined by Federated Hermes' portfolio managers Ann Ferentino and Patrick Strollo. We're very excited today to welcome today's guest Dan Clifton. Dan is a partner and head of policy research for Strategas Securities in Washington, DC, where he evaluates the financial market implications of policy and political developments. Dan has also been ranked as a top Washington policy analyst in each of the past 11 years. And he's someone with whom I've had the pleasure of working for most of my career. Dan, welcome to the podcast.
00:46
Dan Clifton: It's great to be with you today, thank you for having me.
00:49
Steve Chiavarone: Today's episode is going to come in two parts. We'll discuss the Infrastructure Investment and Jobs Act, the Build Back Better bill, or the outlook for that bill, and the upcoming midterm elections, and then the outlook for how those factors may impact the municipal bond sector. So with that, let's jump right in Dan. We had a bipartisan infrastructure bill passed last year, the Infrastructure Investment and Jobs Act; what's in it, how significant is it for muni issuers, and how should we be thinking about it?
01:20
Dan Clifton: That's right. So there's a long-running joke here in Washington about it being infrastructure week every week. Congress has been trying to get a more comprehensive infrastructure bill done over I would say the past eight or 10 year, and this year or in 2021 Congress was able to achieve that. People will say to me Dan what's the difference between this bill and previous highway construction bills that we've done before? And I would break that down into two categories. First is size. We generally do a highway bill that's about 500 billion over five years for all the different types of traditional infrastructure we do in Washington. This legislation doubles that by having a trillion dollars over five years. And so annually we do about 50 billion of highway spending from the federal government we basically give that money to the states. Now we're going to be doing 100 billion. So a doubling in that core infrastructure area.
02:24
Then there's another part of this, which is called the non-core areas, where we've now broadened out what that definition of infrastructure is going to be. So you're talking about 75 billion for electric grid spending. So if you want to have electric vehicles and a lot of the renewable energy, you're going to need a grid that can do that. You also have money in there for broadband, 55 billion for broadband, something that we learned during the pandemic is a crucial part of our nation's infrastructure.
02:54
And as we'll talk about, we get into areas like EV charging stations, we get into areas like electric buses. So it's a little bit more comprehensive than the previous bills we've done, in addition to the more money. And I'll just give you this one example. This legislation includes 55 billion for water, that's about half of what we spend on highway. That ratio of 2 of highway spending for 1 of water is very different than other types of pieces of legislation we've done on infrastructure. You usually have a 4 for highway for every 1 of water, and we've basically cut that in half. So not only more money for highways, but a lot more money for water in light of the issues that were surrounded by Flint, Michigan, and being able to upgrade these water systems.
03:47
So money for highways, money for water, money for airports, money for the electric grid, money for broadband; there are a lot of different winners in this bill. In addition to what we've done on the coronavirus aid. When you put it all together, you're looking at over a trillion dollars for Muni issuers over the last two years itself from all these different programs.
04:13
Steve Chiavarone: Yeah. Let's dig into that a little bit because we've seen a bunch of numbers thrown out on this, is it a 500 billion package? Is it a 1.2 trillion package? It really has to do with what's reauthorization versus new spending. So is it a trillion dollars in new spending or is it some smaller number? How do we think about that?
04:33
Dan Clifton: Yeah, it's definitely a smaller number. Think about my first comment we do about 500 billion every five years, so we had to reauthorize that spending because it had expired. And so Congress reauthorized that existing 500 billion over five years, and then they said, Let's go and do a doubling of that amount. And so that's why you'll see two different numbers; one is about 1.1 trillion, the other one is about 500 billion. For us, because we're evaluating the economic and investment implication of this, what we define it as is a 500 billion bill, because that's where the incremental additional new spending is coming into effect. That's what's going to affect GDP, that's what's going to affect the earnings of different companies, and that's what's going to affect Muni issuance.
05:21
Steve Chiavarone: Great. And you mentioned spending for the electric grid, ESG; at Federated Hermes we've integrated that into our investment strategies, it's a focus for us. What are some of the other ESG green issues here that are addressed directly by the infrastructure bill that our listeners should be thinking about?
05:42
 
06:40
And then as you mentioned, there's a very big, significant investment in the grid, 75 billion. And then there's funding in there for carbon capture. There's a nuclear tax credit. You're starting to see a lot of momentum for something called hydrogen. There also 21 billion for environmental remediation, and several billion dollars in weatherization grants. So there's different ways to get to that ESG component to it, as well as looking at how some of these provisions are going to be implemented, but for the first time, you're actually starting to see a renewable energy component and a more energy efficiency component being built into an infrastructure bill.
07:24
Steve Chiavarone: Certainly a lot of money going to the Muni issuers based on this bill. I want to switch gears for a second and think on a prospective basis. So there was a lot of optimism around the Muni sector last year around the potential for Build Back Better. And in particular there were a number of provisions that the Muni market was excited about: higher taxes, meaning more of a tax advantage from the municipal space, tax exempt advance refunding, potential changes to SALT, Build America Bonds. Where are we on that? I mean, we all know about the kind of break up between senators Manchin and Biden, but what is the outlook for Build Back Better, and can parts of it be raised from the ashes, if you will?
08:11
Dan Clifton: Yeah, first let me start off by saying that Build Back Better, which passed the House of Representatives in the month of November, a very comprehensive bill, many of the provisions that you mentioned were included in there, that bill will not pass into law, will not pass the United States Senate. That bill is over. And so the question is what is going to be the alternative if there is going to be an alternative? What we're doing at Strategas is identifying where there is lots of agreement on different provisions. So if you think about what Senator Manchin is saying, and by the way, in a 50-50 Senate, you need Senator Manchin's vote, he's saying there's broad agreement on the renewable energy tax credits that are included in that; that is tax credits for wind, and solar, and energy storage, as well as nuclear, hydrogen, biofuels. You name it, it's getting a tax subsidy in there.
09:10
And so it's about 325 billion of tax credits. It's about 235 billion of additional spending. And let's just assume for the worst case scenario here, is that the Build Back Better or some refined version of that doesn't pass in the law, Congress can still take those renewable energy provisions and pass them. There's also about 90% agreement on healthcare, in particular more ACA expansion of healthcare. And so if you put the renewable energy and healthcare provisions together, it gets you to about 900 billion over 10 years. Some of that is going to have to be paid for.
09:46
There is a pretty broad agreement that there should be a minimum corporate tax rate increase, that US multinationals should pay more, and that there should be a surtax on the wealthiest 22,000 Americans. So my sense is if there is going to be a bill, there will probably be a higher tax increase on the wealthiest Americans through this surtax; and we can get into the details of what that is. There's also about 90% agreement on healthcare, in particular more ACA expansion of healthcare. And so if you put the renewable energy and healthcare provisions together, it gets you to about 900 billion over 10 years. Some of that is going to have to be paid for.
10:11
But think about the way that bill was written. The bill was written with a retroactive state and local tax deduction increase in the cap. And each day that goes on in 2022 without passing something, it makes it very difficult for that SALT to be retroactive to 2021. I will say this, no piece of legislation is going to pass without some sort of state and local tax deduction relief. Most of the moderate Democrats in tough reelections need that to pass into law, and they're going to demand it. So I do think you'll get something on that.
10:47
I also see broad support for Build America Bonds part two, as well as advance refunding, but those provisions may not get decided until we get past the election as an end-of-the-year tax bill that will probably need to be passed to prevent expiring tax provisions from being put into law. So my sense is there's still a little bit in here for munis. munis are basically going to be benefiting from what I think is a better fiscal outlook at the state and local level. That's probably going to drive it. Tax revenues are at record highs and are only going to go higher as we get into 2022. And the balance sheets have been pretty clean because the federal government has paid their bills.
11:28
So that's going to give them a little bit of flexibility to increase spending in addition to the Build Back Better provisions, and that's why I think you could see some more issuance there than the consensus expects at this point.
11:39
Steve Chiavarone: Dan, thanks. And I'm going to come back to you in a second about those upcoming elections and the impact there. But I want to switch gears a little bit, I'll probably start with you Ann, but I'd like to get your comments here as well Patrick. We've heard a story about a lot of funding coming into the muni space from the infrastructure bill, it looks like while Build Back Better is certainly not likely to pass in its preexisting form, we could get provisions that could be helpful. Why are you as constructive as you are on the muni bond space as we head out into 2022, given all that's happened on the policy front?
12:18
Ann Ferentino: I would say with last year, for most of last year, when we thought about fiscal policy and an infrastructure bill, everyone assumed that taxes were going to increase for higher income earners and for corporations, and that simulated the significant demand from munis, we had record demand. And I want to make the point that we don't need taxes to move higher for munis to be attractive for buyers because they still offer the same benefits that they've always offered; and that's high tax-advantaged income, you keep more of your income after taxes; average higher credit quality than comparably-rated corporate bonds; they provide diversification, combining munis and stock lowers your risk; and strong total return profile for many years has benefited munis.
13:07
So I think we're going to continue to have strong demand for munis based on those factors, regardless of what happens to taxes and fiscal policy. And then also we are constructive on munis, we don't need additional fiscal policy because if you look at the impact from the outsized unprecedented amount of US fiscal policy that has already become into law since March of 2020, including the 1.2 trillion infrastructure bill that Dan just talked about, this is going to continue to positively support US public finance and the municipal bond market in 2022.
13:48
Early in 2021 there were concerns that the ongoing pandemic would create waves for the finances of muni issuers and lead to downgrades. And that was reflected in valuations, but that did not happen. Instead credit fundamentals, they recovered from the pandemic quickly and almost uniformly across sectors. And that was aided meaningfully by the federal support. In fact, our market, through the coronavirus aid relief packages that were passed, received 1.1 trillion directly to our market. And now on top of that, we have this infrastructure bill.
14:27
And so we expect that the robust economic outlook for 2022 should lock in these gains, and that muni credit quality, which is characterized by low default, more upgrades than downgrades, strong revenue growth because of the strong economy, and recovering pension funds, that should remain in 2022. But I will say that this continues to be reflective though in tight quality and sector spreads throughout the market.
14:58
Steve Chiavarone: Patrick, you focus a little bit more on the shorter end part of the curve in muni space, but you are also quite constructive, can you spend a minute talking about why?
15:08
Patrick Strollo: Yeah, absolutely. I'd like to echo a lot of Ann's comments that we are very constructive on the muni space, especially in the front of the curve. We think that we can attract a lot of value out of the single-A and triple-B rated space because balance sheets are so healthy, like Dan had spoken about previously. It's been said a couple of times, but it's unprecedented the amount of support that munis have gotten over the last two years, and it really needs to be reiterated that balance sheets are incredibly healthy going into 2022.
15:39
Additionally from an inflation standpoint, and to Dan's point on the stalling of the Build Back Better plan, we're constructive on the inflation outlook because of the lack of additional federal stimulus will not contribute to current inflationary pressures. With the Fed's current tightening agenda, we should see the rate of it change for inflation decreasing into the second half of the year. And the inflation time series data should prove to be supportive of risk asset credit, as the data can help the Fed achieve its inflation agenda without forcing the economy into recession. If inflation ultimately cools, as we expect, we should see an elongated economic expansion, which should be supportive of credit markets, not only on the short end, but also on the long end as well.
16:16
Steve Chiavarone: So Dan I want to turn back to you here you and your team I thin, have done some of the best work in modeling out midterm elections, and what the relevant factors are. We certainly saw a shockwave through the political system with the gubernatorial elections in both Virginia and then in addition in New Jersey, which were kind of shockers. And it raised the question, is there a red wave coming? So let me ask the question this way. One, does your work suggest that a red wave is possible? What does that mean for policy in the medium term? But maybe more immediately, what might the Democrats do between now and the midterms in terms of policy, either on the tax, the spending, the ESG, the green policy side, to try to position themselves to weather this wave if it is in fact coming?
17:07
Dan Clifton: Yeah, first let me say that nearly every president has suffered midterm election losses. There are only two presidents over the last 100 years to actually gain seats for their party, that was FDR during the Great Depression, and George W. Bush following 9/11. So generally you need a big event to preserve your majorities. The average number of seats a first-term president loses is 28 seats in the next midterm election, the Republicans only need five to take over the House.
17:36
And so it's probably likely the Republicans are going to take over the House. And if I can give you one data point that you can watch from now until the midterm election, because that's a long time away and a lot can change, is the President's approval rating. There's a very strong correlation between the President's approval rating and the number of lost seats in the House. Right now, the President's 42% approval rating is suggesting a loss of about 40 seats in the House. You mentioned the Virginia and New Jersey governor's elections, they're very good leading indicators of what happens in a midterm one year later. In both of those instances, those states moved about 12 or 13 points to the Republicans. If you move 12 or 13 points to the Republicans in the midterm election, you come out to around 40 House seats. Again, my sense is the Republicans are probably going to win about 30 House seats.
18:24
And then the Senate, which is a little bit harder to handicap because candidate quality matters, and we still have to go through the primaries. Again, I look to the President's approval rating, and once the President's approval rating falls below 48% he starts to lose seats. And the President's at 42 right now, and that suggests that the Republicans, all else being equal, would win three or four seats in the Senate and have control. So that's a wave. The Democrats understand the wave is coming, just like they understood this 12 years ago in President Obama's first term. And a lot of people will say, Oh, well, you're not going to pass the Affordable Care Act. No, because the threat of losing was so big they figured out, We have to pass something, and we're going to lose anyway, so we might as well pass it, maybe voters will reward us, but if not, at least we got policy in place.
19:13
And that's why I think when you look at Build Back Better, it may not look like what passed the House, but the Democrats are definitely going to be looking for some win on renewable energy and healthcare, possibly something small in the child tax credit, before the election, because failure just doesn't seem to be an option. The problem is they are dependent on where Senator Manchin is, and as long as inflation remains elevated it's going to be very difficult for him to move off that position.
19:43
So I would think about a movement in February, March, where the Democrats are really pushing Build Back Better or some version of Build Back Better. And you're probably not going to see it until May, June, but you'll see some sort of slimmed down version of this pass into law. You're also likely going to see a semiconductor bill, which tries to incentivize semiconductor companies to locate here in the United States. You'll see that in Texas and Virginia, some other states, maybe Arizona, so that could affect municipal bond issuance given the jobs that could be created from that.
20:15
And those are the types of things that I think you'll see over the course of the year. I think in terms of large fiscal policy at the federal level, that's over. This is a fiscal policy tightening year because we are normalizing coming out of an unprecedented level of stimulus over the last two years.
20:34
Steve Chiavarone: All right. So let's put this all together. Patrick, I'm going to start with you on the short end, Ann we're going to finish with you giving you the final word on the long end of the curve. Lots going on, lots potentially to happen in the year ahead. How are you positioned in your asset class? Tell us your outlook, what you like, what you don't like, and how you'd recommend our listeners think about the muni space?
20:59
Patrick Strollo: On the short end of the muni curve we remain very optimistic on municipal credit. Muni credit is still benefiting from unprecedented federal transfers and strong receipts due to economic expansion and strong property markets. Net revenue pledges, coupled with the yield advantage of single-A and triple-B rated securities is where we anticipate to add the most value for our fund shareholders in the coming year.
21:18
By virtue of being on the front end of the curve, we are insulated from rate shocks to an extent, while simultaneously making our calls against our benchmarks to react to quantitative tightening and future rate increases that we anticipate. We also see taxable equivalent yields that are competitive with treasuries and corporates in the current environment. There are three security types that work very well in rising rate environments, floating rate notes, floating rate tender option bonds, and variable rate demand notes.
21:41
Steve Chiavarone: Final word to you Ann.
21:43
Ann Ferentino: Okay, I would just like to start by saying that when we entered 2022, this is following a year where all this federal support that the muni market got, the record demand that it had in flows, the strong recovery in revenues because of the strong economy, well this led to significant out performance relative to most taxable fixed income asset classes. Last year, the muni bond index was up 1.77%. This compares to the Bloomberg US Treasury Index, which posted a loss of 2.32%. And the S&P Muni High Yield Index was the best performing fixed income sector, which was up on the 7%, at 6.82.
22:23
So we think though that it's possible that munis could actually provide relative out performance again in 2022. And in fact, it's probably worth mentioning that munis have a history of outperforming during periods when the Fed is hiking rates. And this is because the tax reinterest that munis pay becomes more attractive at higher yields. And so we think this out performance is possible, but we do not think that it'll be anywhere near the same extreme. And we do not think it's going to come without volatility.
23:00
As I mentioned before, we enter 2022 with low yields and tight credit spreads across all sectors. And given elevated inflation, we expect that treasury yields are going to continue higher as the Fed shifts their policy direction, and we actually think this sets us up for a year of volatility, but also for a year where we can find opportunities. As we talked about, we are constructive on credit fundamentals from munis. However, at this point, lower rated and high yield muni spreads, they've compressed to past pre-pandemic hype and historical averages. So we're basically waiting at this point to add lower credit quality to our portfolios. And we plan to move to overweight, taking advantage of this rate volatility, which we expect will drive weakness in the demand from munis, and then valuations will become more attractive because of technical factors, not because of credit fundamental factors.
24:10
And on a sector basis, we like transportation. It's a sector that should continue to benefit as demand returns. And we also like sectors that should benefit from higher inflation. Believe it or not, there are sectors within the muni markets that do better on higher inflation. One of those being, or we expect to be, since we haven't seen inflation like this in quite some time, but we expect that toll roads will outperform because they covenant in their bond documents that they will increase toll rates indexed to CPI.
24:46
We also like dedicated tax bonds because we are seeing tax revenues increase because of inflation. So we like the fact that taxes that support repayment of the bonds are higher and inflation is making them that way. So Federated offers municipal bond funds across the yield curve. You just heard Patrick talk about the short end of the curve, but in conclusion, I'm just going to say that we don't expect that 2022 is going to be like 2021, which in the muni market, given all the positive factors that we saw, was relatively calm, and really where being long and overweight credit, that was the win.
25:31
We don't think it's going to be like this this year. As I mentioned, we think it's going to be much more volatile, but we do think munis can offer opportunity, but that's going to come from active management, the active management of duration. And we do expect rates to rise so I should say we are short duration right now. Federated's call is 90% of bench, but we're going to actively manage that duration, our bond structures, our credit quality, our sector allocations, and our selection. And our muni team at Federated Hermes is excited about delivering on these opportunities.
26:08
Steve Chiavarone: Ann and Patrick, thank you so much for taking the time to participate in our discussion today. Dan, thank you for your continued partnership over the years. We've had I think, many interesting political discussions and asset class discussions today with many decisions coming down the pike and developments over the next year and I look forward to seeing how they'll pan out regarding today's conversation. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Hear & Now episode, plus our other series, Amplified and Fundamentals for global perspectives on the issues, challenges, and trends shaping the investment landscape. I also encourage you to subscribe to Insights, email updates from the Federated Hermes website, and follow us on LinkedIn and Twitter. Thank you for listening.
26:56
Disclosure: Views are as of January 14, 2022 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Past performance is no guarantee of future results. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. Municipal bond income may be subject to the federal alternative minimum tax and state and local taxes.
27:22
ESG investments may be viewed as sustainable responsible or socially conscious among other names. ESG factors may be utilized and evaluated differently by different investment managers and may mean different things to different people. Investing based in part on ESG factors carries the risk that under certain market conditions the investment strategy may underperform strategies that do not utilize such factors. The application of responsible investment criteria may affect exposure to certain sectors or types of investments and may impact relative investment performance depending on whether sectors or investments are in or out of favor in the market. An investments ESG performance or an investment managers assessment of such performance may change over time. The successful application of ESG factors is dependent on an investment managers skill in properly identifying and analyzing material ESG issues and the suitability of ESG investments may change over time.
28:12
Diversification does not assure a profit nor protect against loss. The yield curve is a graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities. Credit ratings do not protect against market risk.
28:27
Bloomberg Municipal Bond Index: Is a market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least 7 million and be issued as part of a transaction of at least 75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990 and must be at least one year from their maturity date. Bloomberg US Treasury Bond Index: Is part of Bloomberg global family of government bonds indices. The index measures the performance of the U.S. Treasury bond market, using market capitalization weighting and a standard rule based inclusion methodology. S&P Municipal Bond High-Yield Index: Consists of bonds in the S&P Municipal Bond Index that are not rated or are rated below investment grade.
29:14
Indexes are unmanaged and investments cannot be made in an index. Federated Investment Management Company.
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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.  In addition, fixed income investors should be aware of other risks such as credit risk, inflation risk, call risk and liquidity risk.

Municipal bond income may be subject to the federal alternative minimum tax (AMT) and state and local taxes.

ESG investments may be viewed as “sustainable,” “responsible” or “socially conscious,” among other names. ESG factors may be utilized and evaluated differently by different investment managers and may mean different things to different people. Investing based in part on ESG factors carries the risk that, under certain market conditions, the investment strategy may underperform strategies that do not utilize such factors. The application of responsible investment criteria may affect exposure to certain sectors or types of investments and may impact relative investment performance depending on whether such sectors or investments are in or out of favor in the market. An investment’s ESG performance or an investment manager’s assessment of such performance may change over time. The successful application of ESG factors is dependent on an investment manager’s skill in properly identifying and analyzing material ESG issues, and the suitability of ESG investments may change over time. 

Diversification does not assure a profit nor protect against loss.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Credit ratings do not provide assurance against default or other loss of money and can change.

Bloomberg Municipal Bond Index: A market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issues as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg US Treasury Bond Index is part of Bloomberg Capital global family of government bonds indices. The index measures the performance of the U.S. Treasury bond market, using market capitalization weighting and a standard rule based inclusion methodology. Indexes are unmanaged and investments cannot be made in an index.

The S&P Municipal Bond High-Yield Index consists of bonds in the S&P Municipal Bond Index that are not rated or are rated below investment grade.

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