State of the Municipal Bond Market
Current Landscape and Themes for 2021
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State of the Municipal Bond Market
Gus Grefthen: OK, so thank you so much for joining us today for our presentation on the state of the municipal bond market, current landscape, and themes for 2021. Today, Elizabeth and I will be covering the impacts of state tax revenue changes, demographic shifts across the United States, climate risks to the municipal markets, the rise of green municipal issues. And then we'll finish off with a general municipal bond market update at the end of our presentation. So as I mentioned, today's presenters are myself as a moderator. My name is Gus Grefthen. I'm a wholesaler here at Saturna, as well as my colleague Elizabeth Alm. Elizabeth came to Saturna back in 2018 with 11 years of experience as a municipal bond fund analyst at Wells Fargo. She's currently managing our Idaho Tax-Exempt Fund and is the deputy portfolio manager to the Saturna Sustainable Bond Fund. In addition, she's brought really an invaluable amount of thought leadership regarding how Saturna collects and views sustainability data on both the fixed income and also the equity side. So, thank you so much for everyone joining the presentation today. Before we jump into the first topic, as always, it's important to consider an investment’s objectives, risks, charges, and expenses carefully before investing. So please do visit our website to obtain a prospectus and any other additional information you may want. And with that, we can jump in to sort of our first topic for today, which will be state tax revenue changes. So here, when we're looking at the map of the percent change in state revenues between 2019 and 2020, one thing that initially pops off here is we can see that only 10 states have had a positive revenue change in 2019 and 2020. So, it should be noted this is the first fiscal year with Covid. There are a lot of expectations in the markets that things are going to go poorly. So clearly, there were stark differences how states were hit geographically. So maybe, Elizabeth, welcome and thank you. And can you first talk a little bit about how the recovery played out among different states and anything else you think that would be important to highlight here on this map of the United States?
Elizabeth Alm: Thank you very much, Gus, and thanks for the introduction. This first map I wanted to share is we're really looking at state tax revenue changes between fiscal year 2019 and fiscal year 2020. So, this encompasses the initial Covid shock to the economy. And when we do a municipal credit analysis, a good indication where credit strength is going on a statewide level is to look at revenue. So, this includes state tax collections, including property sales tax and other forms of taxation. Overall, in 2020, tax collections declined 5.5% nationally. And a lot of this came down to individual income tax collections. They dropped around 20% year over year. But a lot of this could be attributed to timing effects of moving tax deadlines. You also had corporate income taxes were really impacted during this time. They declined around 17.5% as businesses went into the red. But fortunately for states, they actually account for less than 5% of state tax revenues. But their state taxes did suffer as the activities they tax, like driving, tourism, and entertainment were highly impacted by the pandemic. But on the positive side, local sales and property taxes have remained really resilient thus far. However, munis that impose local income taxes could experience distress as employees work remotely from outside their borders. And while state tax collections declined around 5.5% nationwide, as you mentioned, those losses were not evenly distributed. But a number of factors contributed to the variation between revenue loss. First is the intensity that the virus has spread in a given state, the strictness or duration of the business closure orders, industry mix and the state stability of the state's tax code. So, states that rely more heavily on broad based consumption taxes fared better with those with a heavy reliance on high-rate income taxes or whose fortunes are tied to the performance of extractive industries. And overall, only 10 states during this period had higher tax receipts in 2020 versus 2019. And Idaho actually led the way with an 8.2% increase. On the opposite side, Alaska saw the greatest decline with over 32% of revenue decrease. This was driven by a slump in energy severance taxes. The state doesn't have a general sales or personal income tax, but other states that saw some big declines, you had North Dakota. In California, Oregon, and states that are either really heavily dependent on energy or tourism.
Gus Grefthen: Here in the next slide, we're comparing the how the state revenues compared during the first three quarters of the fiscal year from 2020 to 2021. So, yeah, we're kind of taking a look at the following year where many states were greatly negative. They've now seen a massive turnaround. California, for example. So, the mini market has seen this great turnaround since the poor expectations and states seem to be doing quite well. Are there any potential landmines investors should be aware of? And, you know, what are you looking at when you're viewing this new year post Covid?
Elizabeth Alm: Absolutely. This really shows a more recent picture. So, we're comparing the overall revenue from the first three quarters of fiscal year ‘20 versus ‘21 to gauge how states have recovered. But you had really big gains in the fourth quarter of 2020 where state tax collections had pretty much recovered to just around 2% below their pre pandemic levels. And overall, just generally tax revenue has been on track to bounce back a lot faster than it did after the Great Recession. And this is really in big contrast to the expectations of state leaders in the pandemic versus the US. Remember in March 2020, right when we entered the national lockdown, we were expecting projections of $125 billion of tax losses. So, what's really behind this better-than-expected outcome is a confluence of factors. First of all, the downturn hit high income workers the least. So, they were able to continue working remotely and they generated income tax revenue for their states. And also, many states were able to better collect sales taxes from online companies as consumers shifted their buying power. We were all getting a lot of boxes from Amazon. But finally, you also had massive financial aid from the federal government, mitigated the economic effects of the downturn while also providing direct assistance to state and local budgets and also just moving on to employment to talk about the recovery. They also surprised to the upside in several places. For example, two states are actually above their pre pandemic employment levels. Utah employment is up 130% since February of 2020, while Idaho employment is up 120%. Idaho is actually ending its fiscal year with a billion-dollar surplus. But as of July, around 45 states have recovered over 50% of their jobs lost at the peak of the pandemic. So, this is really good. But there are some who are lagging behind. For example, Hawaii, New Mexico, Wyoming, Louisiana, and Alaska remain below 50% of jobs are covered, despite some improvement in recent months. Really, Alaska, Wyoming, and Kentucky remain notable job growth laggards. And some of this differential, when we're talking about potential pitfalls to look for is due to where the jobs are being lost. Since January of 2020, jobs for workers who earn less than $27,000 dollars a year are down 22% still. So, workers in sectors like hospitality, service sectors, etc. But on the other end of the spectrum, employment is up 3% for mid-wage workers and up 10% for the highest paid workers. So, this is really something that we look at and try to keep track of.
Gus Grefthen: Awesome. Well, I think with that, I think we can transition over to maybe some of the demographic shifts of analysis that you that you provided here. So, when we look at this trend in demographic shifts, to me, this state is a little unassuming. I wouldn't have thought that Idaho was the second highest percentage change and demographic shifts in the United States. What are some important takeaways from these trends that you find valuable as a municipal fund manager?
Elizabeth Alm: Yeah, when we're looking at state credit strength, demographics are a really important component. So, population trends are tied to states' economic fortunes and government finances. So, where people usually means more workers and consumers adding to economic activities as they take jobs, they buy goods and services, which then generates more tax revenue. And a growing economy can then attract even more workers and their families. But the reverse is usually true for states with shrinking or slow growing populations. This map shows the percentage population growth from the recent census data that just came out. So, we're looking from the periods of 2010 to 2020 and over the past decade, it's notable since population grew at its slowest rate since the Great Depression on a national level, although only three states, Illinois, Mississippi, and West Virginia lost residents. The slowdown is especially pronounced in the Northeast and Midwest, where the South and West were home to the fastest growing states. Since population trends are tied to state economies, governance, and finances, it's really useful for us to understand these things. So, the official count released this year in the census showed growth was slower in the 2010s than the 2000s in 38 states, with eight states experiencing their most sluggish decade of growth ever. But these regional patterns, they really do follow historical trends. Nine of the 15 states have the slowest population growth are in the Northeast and Midwest, while 13 of the 15 states with the fastest population growth are in the South and West. But for a half a century, people have really been gravitating toward Sunbelt states because of employment opportunities, lower cost of living and warmer climates. But as you mentioned, Gus, the really big winners here were kind of surprising, Utah and Idaho. These are the same states which had the most job growth. Utah had a huge growth at 18.4%. Idaho at 17.3%. And Idaho is interesting because a majority of Idaho's growth, about 60% of it is driven by people moving into the states, are actually in migration. And one in five of those came from California. A lot of these people are retirees. So housing prices and people seeking some of the most pristine wilderness in the continental US. By contrast, the biggest growth driver in Utah is in new births and migration was also strong since the state added tech jobs and the landscape of snowy mountains and five national parks has also promised a pretty good work life balance as is the same in Idaho.
Gus Grefthen: Yeah, absolutely. Absolutely. I think that's a good time to shift. You know, I was initially I was thinking that the data might be skewed a little here due to Covid and people moving away from the large metro areas. But this is just pre-Covid. So, I think it's a good time to kind of transition into some of those demographic shifts that we saw due to COVID-19. So, what sort of things can we expect to influence demographic shifts in the future? And maybe you just want to talk a bit about what we saw from COVID-19 into these different areas.
Elizabeth Alm: Absolutely. So Covid really accelerated some of the patterns that we were already seeing, but just made them happen faster. So, move-outs from high cost coastal markets accelerated as Covid unfolded. We all know that the appeal of being in a dense, high-cost urban metro, where we're all crammed together during a pandemic was not that appealing. But Sunbelt metros and those in the interior parts of the country, they gained new residents or had fewer people leave relative to 2019. But generally, metros as a whole saw an increase in move-outs nationally. Urban centers had 15% more move-outs in 2020 versus 2019. But what is surprising during... how Covid impacted movement of people... is that it did provide relief from some lower cost post-industrial cities like St. Louis and Detroit, where the rate of move-outs slowed. We think that it's because the industrial base of many of these cities is tied to goods and production and distribution, making them very much less amenable to remote work, forcing many residents to stay put. This contrasts with cities like San Francisco or more high-tech industry place can work remotely and live in places like Sacramento, which is less expensive and grew a lot during 2020. But most of these move-outs were short to moderate distances. So, it won't impact credit on a state level, but will impact it on a local level. You had a big cohort of the urban outflux outflow is affluent young adults who are well-educated, childless, and can work remotely. We do expect as we gain a sense of normalcy, a lot of these trends may be likely to subside, but they do follow general trends that were already present before the pandemic hit. But when looking at states as a whole. Idaho was actually still the number one place to move in 2020. United Van Lines conducts a national moving study. And the number of people moving from California to Idaho last year was actually up 27.5%.
Gus Grefthen: All right. I think, kind of kind of moving on, what sort of things are we expecting to influence the demographic shifts in the future? How can we, you know, think about how this affects municipal the finance world? And so that kind of transitions into our next slide here, where it's talking about the impacts of how climate impacts are a bit uneven as they're distributed across the United States. So here this map was pulled from the Journal of Science. And it's really interesting. You know, we're looking at how climate impacts regions around the US differently. Perhaps you can talk a bit about the increase in severity and frequency of major weather events and what indications this is going to provide investors when they're thinking about municipal finance.
Elizabeth Alm: Absolutely. Just as demographic trends and revenue strength is important, evaluating impact from climate change is also a really important part of our credit analysis and investment process as a whole. This map shows expected economic impact throughout the United States for climate change, and it's under a moderate emissions scenario over the next 70 years or so. So, this is saying that we're going to do something about climate change, but it's not going to be out of control and nor are we going to do a really good job. But what is notable is that if you look at... this is combining sectors. So, this is a labor force, this is agricultural productivity, et cetera. But you really do see a net transfer of value from southern, central, mid-Atlantic regions towards the Pacific Northwest, Great Lakes region and New England. In some counties, especially those in the southeast, median losses could exceed more than 20 percent of GDP, while gains in places like Maine and even in Idaho, the economic center Idaho, sometimes exceed 10 percent of expected gain in GDP due to climate change. Losses are largest in regions that are already poor on average. So, we do expect that climate change would exacerbate preexisting inequality in the United States. But in terms of weather events, that's another big reason why the southeast of the country is expected to have such a big GDP hit, just for example. 2020 set a new annual record of 22 separate billion-dollar weather events in the US. So, this shattered the previous record of 16 events and was the sixth consecutive year in which 10 or more billion-dollar climate disaster events have impacted the US. And just looking at 2021 so far, I mean, this includes Hurricane Ida. We've all seen the terrible images from New York and the flooding of the streets and the subway. But when you think about that from an infrastructure and economic damage point of view, all of that is going to impact the municipality. Or even the Texas freeze, where you had a lot of damage to refineries or manufacturing plants in Texas in the power grid. That alone cost the economy $15 billion. So, 2020 was a cost issue on record. We expect this to continue a general upward trend. In the US it cost the economy $450 billion in economic losses. But when viewed from a municipal credit perspective and what we're looking at for local governments, losses from such extreme events can have big fiscal ramifications for many years, even without climate change, the U.S. needs to make significant investments in building new infrastructure and maintaining existing infrastructure. So, climate change and big weather events add additional barriers of cost, time, uncertainty, and risk to these investments. As you see, large parts of Idaho are green, and we're already seeing this as people are moving to the state, but that also indicates increased agricultural productivity as the fertile land is expected to shift north. And so, they're well positioned from a fiscal demographic and climate perspective relative to other places in the southeast, which could have declines in agricultural yield up to 80 percent.
Gus Grefthen: Wow. Yeah, that certainly makes you wonder how the demographic trends we saw before those will keep pace and how they're going to be impacted by the kind of severity and frequency of potential climate impacts we're seeing from this map. But so, one of the things I wanted to touch on before we move on from this slide is we've been seeing more and more green municipal issues becoming available, albeit it's still a relatively small segment in the bond market as a whole. I was wondering, Elizabeth, do you expect to see more of these become available? And what are you looking out for when you're evaluating them?
Elizabeth Alm: You know, as these climate issues are gaining more visibility, dedicated use of proceeds, bonds like green and sustainable projects in the money market is definitely rising. So, green bonds currently make up a very small segment of the $3.8 trillion dollar muni bond market, but new issuance is increasing rapidly. So, you had $230 billion last year issuance in green bonds, up from only $2 billion in 2012. But with labels such as “green” or “sustainable,” these are relatively new to the bond market, and green is defined differently between issuers. So, for green bonds, generally take a thorough evaluation before purchase to gauge the merit of the underlying projects and also the credit of the issuer. But muni bonds have long funded projects such as clean water, power, sewage systems that have clear environmental benefits with or without the green label.
Gus Grefthen: Perfect. Well, I think that's a good a good time to transition away from sort of the bigger themes we were talking about there over onto more of sort of the financial and numbers side of things. So, you know, here on our first slide, we are looking at the municipal bond fund you manage alongside several indices noting returns as of July 31, 2021. Can you speak about how these stacked up to one another and perhaps surmise as to why they ended up where they did?
Elizabeth Alm: Absolutely. Muni bonds performed well in 2021, especially through July, relative to being in US corporate investment grade, long bonds, or U.S. Treasuries. And during the first half of the year, muni bonds really shrugged off the rise in long term US interest rates and did much better than their taxable counterparts. As you can see, they're right in the middle of the chart, the year-to-date number. The Idaho Tax-Exempt Fund and the general muni bond index both had positive returns versus the US long or US Treasuries or even the pretty much zero percent return US corporate investment grade bonds. This was due in part to expectations for higher taxes in 2022 due to all the stimulus that we've been seeing that kept demand high. Also, muni supply was pretty constrained during the summer, but should be noted that due to all of this recent outperformance, valuations in a lot of these bonds and sectors remain very high, very rich. You know, in terms of trading in the market, the past few months have been pretty slow in terms of volume, August being the lightest month of the last three years and July not far behind. There is generally a lull of issuance during the summer. But an important market condition here has been just net supply challenges for tax-exempt holders. So, tax-exempt maturities in calls are about $200 billion. You had about $86 billion float into the bond market, mutual funds and ETF inflows year to date. And together, those exceed the year-to-date tax-exempt issuance. And going forward to the rest of the year, we do think that munis will fare relatively well as investors have enough cash to easily absorb the pipeline if fund flows remain supportive and rates are in check. Even this week, the market absorbed billions of new issuance and the market has barely moved so far in September. However, we could see some rising rates through the last part of 2021 one with supply and primary deals needed to get priced heading to year-end. Taxes and rates are very expensive at their current yields. So, if we see a lot of supply and a lot of deals come to market, they may have to be cheapened a bit to pique investor interest. But generally, we think the market is stable and strong, especially from a credit point of view.
Gus Grefthen: Perfect. Well, we'll move on to the next slide here. And so, we'll be talking a little bit about the correlation of muni bond funds as it relates to other indices. So, in the previous slide, we examined the overall returns of these indices alongside of our fund. And here we have an opportunity to view how each of these correlate to one another. So, when looking at the numbers here, there seems to be a high level of no correlation between the S&P 500 and muni bonds, which should be expected. However, that also seems to be true when you're comparing the munis to other bond fund indices as well, which I found to be slightly unexpected. What is this indicating munis offer to investors? And what else do you think are some of the major takeaways that you see from this correlation matrix?
Elizabeth Alm: Thank you. Munis definitely benefit from a lack of correlation to other asset classes. And so, this means that they would provide diversification benefits in a portfolio. So, this chart shows correlation of various indices, along with our fund from the beginning of twenty 2021through July of this year, really focusing on those bottom two rows, which indicate the muni asset classes, the Idaho Fund and muni bond index have very low correlation with the S&P 500, 0.13% and 0.15% five respectively. But when we compare them to US Treasuries, they also have a much lower correlation to US treasuries versus, let's say, US corporate investment grade. So, for those who are concerned that equities or corporate debt have reached high valuations or well above fair value models, tax-free bonds can provide exposure to a risk bucket that's largely uncorrelated. And this is true from a longer-term perspective as well. If you look at the same data over a 2-year period, muni bonds still have low correlations with the S&P 500 and very low correlations to US treasuries as well. So, they provide an excellent way to invest in safe bonds that diversify against both equities and treasuries. Additionally, they're generally less risky, as a whole, from their corporate counterparts. For example, there were only 113 muni bond defaults out of 13,000 issuers over a 40-year period, up to 2019.
Gus Grefthen: Wonderful. Thank you for sharing that. Let’s kind of move on here to kind of take a little bit longer term view of performance across a variety of fixed income indices, municipal bonds of really seemingly done well relative to particularly long bonds and treasuries. You know, when we're kind of looking in between the 1, 5, and 10-year numbers, is there anything else you may want to note to the takeaway here, if you'd like to share that investors may find useful?
Elizabeth Alm: Yeah, absolutely. So, from a 1-year year perspective, they've definitely done well versus treasuries and US long bonds. But really, more importantly, if you look at a 10-year time horizon, the Idaho fund, but also the general muni bond index have done well relative to treasuries. And in addition, they offer a tax advantage in some cases. So even looking at a longer-term point of view, it can offer an attractive yield.
Gus Grefthen: Perfect. And I think you bring up a good point about sort of the tax-exempt status that that muni funds offer in particular. So here, you know, we wanted to finish up to remind and speak a little bit about the tax equivalent yield formula and when tax-exempt funds such as the Idaho Fund that we manage can be appropriate for investors. So as many of you know, this formula helps determine whether the yield on a tax-free investment is higher than the average tax yield of a nonexempt investment. So as illustrated, the higher tax bracket the investor is placed in, the greater the potential advantage a tax-free investment provides compared to their taxable counterpart. So, you know, conversely, investors in a lower tax bracket may find better yields in taxable alternatives. Is there anything else you wanted to kind of add here to before we finish up, Elizabeth?
Elizabeth Alm: Yeah, absolutely. So, interest income from a lot of municipal bonds is often exempt from federal income tax. And if the bond is issued in the state where you live, interest can also be exempt from state income taxes. So, if you're in a high tax bracket, then tax-free bonds could provide a higher after-tax yield than those provided by similar taxable investments. And interesting and important to note, the recent proposal from the House includes tax increases on long term capital gains, but also raising the marginal income tax for individuals in the highest bracket from 37% to 39.6% in addition to adding a 3% surtax on people making over $5 million. Now, the House plan is still just a proposal, and it can change, but those hikes and that potential for higher taxes really could impact the high earners who typically buy muni bonds. And although at first glance, a lot of these tax-exempt assets may offer less interest or yield in a corporate bond of a similar credit risk, they can offer a competitive return if you look on the tax equivalent basis. And that just leads me to the conclusion and to mention that a single state fund that's exempt from federal and state taxes could be a good fit in an overall asset allocation. Munis provide great diversification, benefits of low correlation to other asset classes. And in the case of Idaho, we're really proud to offer a fund in a state that's so well positioned in many important trends that will impact credit and economic strength. Revenue growth has been strong, along with stellar job growth and several demographics. Even from a climate perspective, the important economic centers in the state are expecting an increase in GDP over the next seven years with all the new people moving to Idaho. We expect the number of people who could benefit from investing in that fund to grow.
Gus Grefthen: Thank you so much for the research and time and sharing your thoughts on the various trends we covered today. And unless there's any other kind of parting notes you want to share, Elizabeth, I think we can kind of conclude our presentation for the afternoon. And if anyone has any questions, you can follow up with me specifically. I’d be more than happy to answer any questions. So, thank you very much everyone and have a wonderful day.
Elizabeth Alm: Thank you very much.
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