ERIK AARTS:
Hello, and welcome to Touchstone’s Fixed Income update. My name is Erik Aarts, and I’m the Senior Fixed Income Strategist for Touchstone Funds, and I’m joined today by Jeff Timlin, Managing Partner, Portfolio Manager, and member of the Investment Committee at Sage Advisory here in Austin, Texas. Jeff is the Portfolio Manager for the Touchstone Core Municipal Bond Fund, ticker TOHYX, and Sage Advisory is the subadvisor, one of our subadvisors at Touchstone managing this strategy. The topic today is challenges in the municipal marketplace and the opportunities that have arisen, given the reset this year. Hi, Jeff.
JEFF TIMLIN:
Erik, how’s it going? Thank you for having me.
ERIK AARTS:
You’re welcome, great to engage on this conversation, and let’s kick it off with a question. Jeff, investors have been selling munis this year, as you well know, we’ve seen this across the fixed income marketplace, but there’s been negative total returns coming out of the asset class as a result of this selling. How has this impacted yields in the municipal marketplace? Can you comment on that?
JEFF TIMLIN:
Absolutely. Yeah, it’s been a very tumultuous year, obviously, not just for municipal investors but investors across all asset classes, but specifically as it pertains to munis, we’ve had a pretty significant sell-off in the market. As you can see on this presentation, this slide, on the bottom, you can see the adjustments that we’ve had in yields. We can see in kind of the lighter blue at the bottom, where we ended the year in terms of yields across various parts of the yield curve, and let’s just take the 10-year for instance. We ended the year at 1.03, so that's 103 basis points or 1.03%. You can see there’s been a major adjustment in terms of how yields have moved for the first three quarters of the year, and that's 2.27% or to the tune of 2.25% returns or yield, and we’ve ended the quarter at a yield on the 10-year at 3.3%. Now, what does that mean for investors? Yes, it’s been painful for those who’ve been in there, but it’s a great opportunity for those investors looking to maybe redeploy some money or have been waiting on the sidelines in cash or are looking to reallocate out of some riskier asset classes into fixed income, and why is that? We haven't seen these types of yields or income levels in the past 10 years, and what do I mean by that? With yields in the 10-year area for AAA municipal bonds at 3.3%, you’re getting approximately $33,000 on a hypothetical $1 million portfolio of AAA rated 10-year bonds, or a basket of 10-year bonds, and that is actually the highest it’s been, again, in the past 10 years, so you’re finally being paid to own fixed income and getting what you need from fixed income. We’ve been starved for income for so long, and now investors are finally receiving a decent compensation for owning fixed income municipal assets, and you can see that on the line chart in the dark blue. In the light gray, that's just showing, for somebody in that 35% tax bracket, that it would require over $50,000 in taxable income to equate to that $33,000 approximately in income you’d receive from investing in municipal bonds, if you were at that 35% tax bracket, so we think from an income perspective, which is why most people invest in fixed income and particularly municipal bonds, that this is the most attractive period of time we’ve seen in quite some time.
ERIK AARTS:
Yeah, what a difference a year makes, for sure, and around Touchstone, we’ve been saying that the Fed has put income back into fixed income.
JEFF TIMLIN:
Very much so.
ERIK AARTS:
That’s the tagline, at least recently, but tight monetary policy by the Fed, of course, in reaction to high inflation has been one of the reasons that interest rates have been on the rise, and the result is likely some slowdown in the economy. Of course, that has folks nervous about what that might mean for state and local municipalities going forward, and so the question to you, Jeff, is will state and local municipalities be negatively impacted from a credit perspective by what’s happening in terms of interest rates?
JEFF TIMLIN:
Well, the simple answer is yes. Obviously, all ships rise and fall with the economic tide, and municipalities will, obviously, be affected by the slowdown in the overall economy.
The nice thing, though, or what municipalities benefit from, relative to most other asset classes, is that it does take some time for those revenue slowdowns to hit their balance sheets and their income statement. As you can see in the top bar chart, going back to the previous recession of 2007, we began the recession in the fourth quarter of 2007, and you can see in the dark blue that state revenues – the light blue is actually local revenues – you can see that state revenues took four quarters before they started to go into negative territory in terms of revenue, year-over-year revenue growth, or decline, in this manner, and you can see it actually took two years before local revenues started to decline, so you can see that there is a delay effect in the municipal arena, and that they have time or the foresight to adjust their balance sheets to that, from an expenditure standpoint. We didn't put expenses in here, but we saw that municipalities have a lot of flexibility and a lot of time to determine how they need to readjust their financials so that they can weather the economic storm, and if you remember, during that time, there really weren’t any significant credit issues in the municipal arena during the Great Recession or slightly after. If anything, there was some slight downgrades, but again, you’re dealing with an investment grade asset class where the majority of credits are rated AA to AAA, so a one-notch downgrade is not very detrimental to the overall credit quality. Then secondly, it's also a relative game, like where do municipalities sit today, and what have they done to prepare for such economic slowdowns, which again come as part of a normal economic cycle? If you look at the bottom graph, you can see that that's the State Rainy Day Fund or the reserves that they have put aside to weather any economic storm, that they can draw upon during recessionary or economic slowdowns, when revenues don't meet expectations, and you can see during the previous two recessions. During the tech boom 2000, it peaked out around 5% and then got close to zero. Same thing happened or a similar pattern happened during the Great Recession, which was driven primarily by a housing collapse, it peaked in 2008 at around 5% and then they drew down to close to 2% or just below 2%. Well, this time you can see what’s been going on. We’ve had one of the longest economic recoveries in our history, and municipalities have been very fiscally disciplined in terms of putting money away during that time to prepare for an eventual or a potential economic slowdown or recessionary environment, so we can see that revenues, or I should say Rainy Day Funds, are north of 10% and continue to decline at this period of time, so if we do enter an economic slowdown or a recessionary environment, municipalities not only can adjust their expenditures well in advance of the slowdowns that they will eventually see, but they also have prepared quite well in terms of their reserve funds and Rainy Day Funds that they can utilize to offset any of those challenges, so from our standpoint, municipal credits have never been stronger and represent a fantastic credit defensive play if you anticipate an economic slowdown or recessionary environment.
ERIK AARTS:
Got it, yeah, thanks for sharing that. Look, I think a lot of people in the bond market have been focused on the yield curve, right, the term structure of interest rates, and looking at the inversion, or the flattening, and now inversion that we’ve seen, particularly in the Treasury market. I know today, the conversation is about how the 2/10 Treasury curve inversion has deepened recently, and what that obviously means going forward. How should municipal investors think about that big increase in short-term interest rates and what that means for the potential of municipal market returns going forward?
JEFF TIMLIN:
Sure, let’s talk about the Treasury market real quickly, because you brought it up. The 2s/10s curve, before I just walked in here, was inverted at 70 basis points, so what does that mean? That means the 2-year yield is higher than the 10-year yield by 70 basis points, so you’re getting paid more or you’re getting more yield by investing in a 2-year bond over a 10-year bond. We won’t get into the dynamics now, that could be for another slide or another presentation, but suffice it to say that an inverted yield curve is representative or is indicative of a potential recession. It has a pretty good track record of predicting recessions anywhere from 12 to 18 months in the future. On the other hand, in terms of the municipal market, municipal curve inversions are very rare, and again, we won’t get into the reasons why for that, but if you have any questions, you can always reach out to your sales person and we can address that, but when they do happen in municipal yield curves, it’s the time to take note, and why do I say that? The last time we had a curve inversion
until recently, which occurred in the month of August into September of this year, the last time that happened of any significance, was back during the Great Recession, which I previously talked about, and I use that time period because, again, it was a very challenging time for those investors when we did enter in economic recession, so we want to prepare for that well in advance. So you can see the municipal yield curve entered a curve inversion on the 1s/3s curve, so the 1-year and the 3-year curves, so the 1-year yield was higher than the 3-year yield back in the 2007-2008 period, and then we entered a recessionary period somewhere between 6 to 12 months after that. Well, why is that important? Well, when we look at where the market’s headed – and again, this is a relative value game or a relative value trade – we look at how did municipalities perform during that period of time, so if you look on the right-hand side of the bar chart, the municipal broad market index had a 4.08% return during that recessionary period, from November 2007 to June 2009, and you can see the S&P, which we know, if you’re familiar with that period, had one of the worst sell-offs in history and was negative almost 38%. Now, the differential between that was 42%, in terms of the magnitude of the differential between the positive return on munis and the negative return on S&P. Now, we all know that past returns are not indicative of future returns, however, what we’re saying is that in general, we feel that the municipal market, because of the income that people receive and that we just previously talked about, because of the defensive positioning that we talked about, will perform better in an economic slowdown over a recessionary environment that we’re probably going to head into over the next 12 to 18 months, so from a relative value perspective, the market is probably going to enter a risk-off environment, which municipal bonds perform very well in, relative to what’s going to occur in the risk-on type of markets, those being equities and higher volatility type of investments.
ERIK AARTS:
Yeah, that makes sense, kind of the higher quality parts of the fixed income marketplace leading us out of this economic slowdown that we might be entering into here shortly. I know, and this chart is indicative of it, that Sage Advisory has done a lot of work, you know, historical research on the implications of major sell-offs in the municipal marketplace. Can you share the results of that research? What does it look like in terms of, you know, maybe there being a potential silver lining here in terms of the recent drawdown and what that might mean for returns going forward?
JEFF TIMLIN:
Yes, thank you for mentioning that. Yes, we’ve done a lot of work in terms of looking back historically and making sure that we’re positioning our portfolios correctly. In fixed income, there’s not a lot of upside, but there’s a tremendous amount of downside, so for us, we feel it’s imperative that we do our research and try to optimize the risk/reward of the portfolio, to make sure that we’re maximizing that particular dynamic, particularly during certain market events that can be disruptive, and the one that we’re speaking about in this particular slide is the outflow cycles, so during periods of either actual economic challenges or declines or headline risk, and what do I mean by that? As you can see on the left-hand side, we give several dates, between the start date and end date of outflow periods during the municipal market, and that means where money is flowing out of the municipal market through the fund complexes and through various avenues, where people are basically getting rid of their municipal allocations and money is coming out of the market. But in 2010, talking about headline risk, in 2010-2011, that November ’10 to ’11 was a period where there was some headline risk in the market that caused people to be concerned for really no reason, aside from an article that was put out into the market at that period of time, but suffice to say, what are we getting at here? We’re talking about periods that people are kind of panicking, everybody’s running for the door at the same time and exiting the market, so it’s kind of this panic trade that we’re seeing, and we can see that on the left-hand side, peak trough returns. When everybody’s heading for the door, there’s kind of panic selling, and then it’s basically hit any bid that's out there, and you can see those periods have been quite challenging and the negative returns have been quite high. You look back at the September 2008 to October 2008 one-month period, one-to-two-month period, -11.22%, right, and then the most recent one, obviously, what we’re dealing with now, and this was as of the end of the third quarter, down 12.13%, and it’s been the longest outflow period that we’ve had in the history of the municipal market, but what does that tell us? If we kind of look at those periods and then extrapolate or go six months forward,
we see that the returns have mostly reversed themselves. You can see back 2008, the -11.22% return, well, if you gave it six months and you just kind of held steady, it was 13.24%, right, and the same can be said of each of those other periods, where they’ve kind of offset each other, and you can see that in the graphical representation on the right-hand side of the bar chart. So you can see all these significant sell-offs and these painful sell-offs, we’re not trying to diminish the pain or the anxiety one may feel when they’re seeing these negative returns on their portfolios, but it’s not really at the end of the day a credit event, it’s a market event that takes place, but it sends or it lends itself to a period that is most likely going to set itself up for a significant outperformance in the near future. We can’t exactly say when that will, but just to kind of give you, you know, this presentation was put together at the end of the third quarter, we’re in November now, and we have already seen a significant turnout in the municipal market, to the tune of 3.5% on the broad market, so we’re seeing that type of event taking place, but even with that move, we still have a lot more to go, because if we’re looking at a reversal from these levels and we’re seeing a -12.13% negative return, a turnaround would be somewhere north of in the 10% range, and again, we can’t guarantee that, but again, if history does repeat itself – and we know that it doesn't always repeat itself, but it does align – that we will get a positive return environment going forward, particularly if we enter an economic slowdown where money is flowing back into risk-off assets or high credit quality portfolios, which municipals represent, and out of the riskier asset classes, so we feel that with the peak here that we’ve see in rates and the little bit of a pivot that we’ve seen in what’s going on from a monetary policy, that municipals are set up, fixed income in general is set up well for a nice 2023 in terms of return environment, and then for those investors who are in the top tax bracket and can take advantage of the tax-free income component of the municipal bond market, we feel that this is a great time to reallocate to municipal bonds.
ERIK AARTS:
Jeff, thanks very much. It sounds like it might be a good time to consider reallocating towards high quality municipal bonds. I think we’ll probably leave it there for this fixed income update. Thank you very much for joining us today and taking us through the dynamics of the municipal marketplace today. Again, Jeff Timlin joined us today. He is Portfolio Manager on the Touchstone Core Municipal Bond Fund, which is an actively managed, high quality, intermediate maturity offering from Touchstone. The ticker is TOHYX, that's the advisory share class. The SEC yield on the fund has risen recently to 3.5%, making this an interesting time to consider adding municipal income to your portfolio. If you would like to learn more about this strategy, please contact your Touchstone representative or visit our website at www.touchstonefunds.com. Jeff, thanks again for joining us today, really appreciate it.
JEFF TIMLIN:
Thank you, Eric. Thank you, everybody. Happy holidays.
The Fund invests in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. The Fund invests in investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. The Fund invests in U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. The Fund is subject to prepayment risk which is when a debt security may be paid off and proceeds invested earlier than anticipated. The Fund invests in municipal securities which may be affected by uncertainties in the municipal market related to legislation or litigation involving the taxation of municipal securities or the rights of municipal security holders in the event of bankruptcy and may not be able to meet their obligations. The Advisor engages a sub-advisor to make investment decisions for the Fund’s portfolio; it may be unable to identify and retain a sub-advisor who achieves superior investment returns relative to other similar sub-advisors. Events in the U.S. and global financial markets, including actions taken to stimulate or stabilize economic growth may at times result in unusually high market volatility, which could negatively impact Fund performance and cause it to experience illiquidity, shareholder redemptions, or other potentially adverse effects. Banks and financial services companies could suffer losses if interest rates rise or economic conditions deteriorate. The sub-advisor considers ESG factors that it deems relevant or additive along with other material factors. The ESG criteria may cause the Fund to forgo opportunities to buy certain securities and/or gain exposure to certain industries, sectors, regions and countries. The Fund may be required to sell a security when it could be disadvantageous to do so.
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