First Trust ROI Podcast
On the ROI podcast, we discuss some of the most important questions facing investment professionals today, ranging from macroeconomic views, to perspectives on the equity and fixed income markets, to insights on practice management. We aim to cut through the noise, examine the data, and provide fresh insights to investment professionals as they help their clients find better ways to invest…seeking to generate attractive returns on their investments.
First Trust ROI Podcast
Ep 57 | Bill Housey & John Wilhelm | Overlooked Opportunities in Tax-free Bonds | ROI Podcast
In the wake of underperforming municipal bonds this year, portfolio managers Bill Housey and John Wilhelm of First Trust highlight why they believe fresh opportunities for tax-free investors have emerged.
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Hi, welcome to this episode of the First Trust ROI Podcast. I'm Ryan Isakinen, ETF strategist at First Trust. Today I'm joined by Bill Housey, Managing Director of Fixed Income at First Trust, and John Wilhelm, Senior Portfolio Manager of the First Trust municipal securities team. Today we're going to talk about bonds. We're going to discuss the impact of Fed rate cuts. We're going to talk about the yield curve. We're going to talk about government shutdowns. And we're going to discuss why the municipal bond market has underperformed this year and what they what that might mean going forward. Thanks for joining us. So as I was preparing for this podcast, I got to thinking what would be more fun than talking to a bond portfolio manager.
Bill:It's not much.
Ryan:It's talking to two bond portfolio managers. Twice the fun. So twice the fun. I'm glad you guys uh glad you guys made it. Um so I was I was thinking about um the Fed, as I often do as I'm driving around just contemplating interest rate policy, as I'm sure you guys do. And um I guess what I was wondering is do you have a sense of where the Fed stops cutting rates? They've already begun the rate cutting cycle. Where do you think we end? And and I guess when?
Bill:Well, I guess I can start with that. I mean, the framework that we typically use to approach that, and it the market refers to this as what's the ultimate terminal rate. For us, it really hinges back to those inflation expectations, because in a normal market, there should be an appropriate real yield. Like what's the amount above inflation that the Federal funds rate should be? And I think a big part of why the Trump administration has argued that rates should be lower is that inflation isn't 9 percent anymore, it isn't 8 percent, it's not 7 percent, right? It's been stickier in the mid-twes, let's call it, bouncing around, around that number. But what's the appropriate Federal funds rate above that? And we've had a Federal funds rate that's been, call it 200 basis points above inflation, and that's restrictive by most accounts. Most people would say that's restrictive. Now, some people would say, but look at the stock market, and we can debate whether high stock prices are indicative of whether it's restrictive, or we can look at delinquencies on credit cards and how it squeezes various parts of the economy. So there's a lot you could debate around that. But for us, that is what it would typically come back to. And so when we look forward and we say, where do we think inflation will be, let's just say by the end of next year, right? By the end of 2026, where do we think inflation will be? And I think in those discussions I have had with Bob Stein, our Deputy Chief Economist, Brian Westbury, our Chief Economist, the expectations are for inflation to work its way back down towards that 2 percent. So normally we would say the bond market today is pricing in around a 3 percent terminal Fed funds rate. So the Fed cuts rates from where they are today, 4 to 4 and a quarter, down to that 3 percent level between now and the end of next year, and holds them there. That is what is priced into the curve. And we would say that's probably a pretty reasonable middle-of-the-fair way bet based on the data we have today. Obviously, a recession would cause something different. A higher inflation would cause a different path, but what for what we know today, a hundred-basis point real rate over our expected inflation seems like a reasonable set of circumstances.
Ryan:So, John, uh what do you think that does to the yield curve and what as the Fed has begun to cut rates in this cycle so far? I mean, how how has that impacted the yield curve thus far?
John:Well, we've seen uh the short end of the Treasury curve decline quite a bit as the rate cycle or the Fed cutting cycle began, and we've seen that as well in the municipal bond, let's say one to five year part of the curve. And where we've seen uh more stickiness, I think partially because of inflation, but also you could add in things like the U.S.'s structural budget deficit, is when you get to 10 years to maturity and beyond in the U.S. Treasury curve and as well the municipal bond curve. And I I think there we're also we're gonna be looking at employment, we'll be looking at what we would expect as well as the decline inflation over the next 12 months, but we'll also have to look at the size and magnitude of the structural budget deficit in the U.S. Is it gonna stay at 6.5% or 6%, or what's the trajectory of it and how does that affect uh borrowing by the U.S. government?
Ryan:Yeah. So the fundamentals of the U.S. Treasury market, that the the uh ability of the U.S. government to to pay for its its debts. I mean, no one really calls that into question, right? We we all kind of think that that's gonna happen. Is that that's a fair statement, right? Um but it's fair. But eventually the market starts to charge us more for uh in interest, despite the fact that the Fed is lowering rates at the front end. Is that what your expectation is that the if if we don't address some of the budget deficits, that you could see rates drift higher at the longer end?
Bill:The way I would tend to think about that might be a little different. It would just simply be that when we look at what's in in the market today, we we have a view on what the deficit is. Now I can tell you coming into this year, no one had a view that the administration would generate $350 billion of added revenue from tariffs. Right? That wasn't in the equation. And so there are other dimensions to this that that one has to consider, the unknowns, if you will, but it has more to do with the unknowns in the sense that there's a price today for what is known. And if we were to show up to work tomorrow and the budget deficit were to ramp up from here, well, that's that's that would be a new variable, and that would have to be priced. But when we think about today, it's not like the budget deficit today is a surprise. So the way we think about it, it's in the price. The deficit today is in the price, right? Because it's it's already known. It's the unknowns that aren't in the price. So if you have a materially larger deficit, well, then you would have to reset rates higher to accommodate larger supply, treasury supply. And if you have a smaller deficit, right, when in and increased revenues coming in and increased growth in the U.S. economy because of, let's say, pro-growth um you know pro-growth policies that haven't been sort of priced into SIBO scoring and things like that, obviously that's not in the equation. So there's a number of variables, so we want to be careful with the sort of always this happens or never that happens. But in reality, I think it has more to do what's in the price today, what's known versus what's unknown, and how that will drive the equation going forward.
Ryan:John, I was also wondering about labor market dynamics and and how that plays into what the Fed is doing in conducting policy. Um have you been surprised at how resilient the labor market has been? Because it's I think most people, if you would have asked them a couple years ago, you know, where uh the unemployment rate would be today, given all the variables that we've seen, I don't think anyone would have guessed that the unemployment rate would still be this low. So um what do you think about that?
John:Yeah, I think when you saw job growth, uh the initial numbers, especially last year, they looked robust. Uh various reasons were put forth for that, everywhere from the amount of immigrants looking for jobs, uh stimulus payments, uh another potential source. Uh however, when you get to look at this year, there's a couple of items. One, when you look at the payroll numbers over the last four months, you know, much more muted growth. Whether you look at the ADP figures or the payroll numbers that now we're not seeing because of the government shutdown. So I think that has really led to the Fed having a much more balanced approach than they had in January of this year, where they seem much more concerned about the inflation outlook and the potential impact on tariffs, to where they sit today, where they seem much more concerned about now what uh the job growth numbers will be in the upcoming months. And also the revisions that they do when they adjust previous statistics that they put out have showed significantly uh weaker and fewer jobs. And I think those revisions plus the actual uh previous four months data really paint a different picture of very muted job growth.
Ryan:You mentioned the government shutdown, and you know, there's always a risk when you're recording a podcast that by the time it airs, maybe the shutdown will be over. But assuming it's not over, I guess I wanted to talk a little bit about that because it seems like at least the equity markets have kind of shrugged it off and said this isn't a big deal. Uh maybe it's because it happens pretty much every year lately. So do you have any thoughts on uh the impact of the government shutting down for a period of time, what impact that has on the economy or or markets?
John:Yeah, historically we've looked at the data from a municipal bond perspective. And when you look back at the duration of government shutdowns, the five most recent, let's say, they've been short in nature and have had limited impacts uh long term. Uh what gave us a little bit more pause from a municipal bond fixed income perspective was the potential of more federal uh job losses. That was one point that was discussed, perhaps just as a negotiating tactic. But to the extent that that was realized, especially if it was those federal job losses were in certain uh specific areas, whether it's Washington, D.C. or parts of Maryland or Virginia, for instance, that could have a longer-term impact on municipal bond credit quality where those workers are located.
Bill:Yeah, and I mean I think you know, as you look back and empirically and think about what the impacts have been to the market, I mean it's very rarely there's a de minimis impact to the economy from a GDP perspective when you've had government shutdowns. And just like anything else, the longer a shutdown lasts, the more uncertainty will build. And you could see that spill over. But empirically, what we've generally seen is that interest rates have typically come down in government shutdowns, a little bit of a flight to quality, right? A little bit of a flight to safety under those circumstances. But I think the market is pretty comfortable with government shutdowns by now. And so again, just like you know, most things, the longer they last, the more uncertainty builds around them. So it really will come down to how long it lasts before we get the the appropriate signatures to to sign the bill.
John:Yeah. When you look at the last five government shutdowns, Muni returns were positive and four out of the five. The only one where they were negative was during the taper tantrum. So you could really say there were other factors overwhelming the nature of the government shutdown.
Ryan:So do you guys have a sense as to where we are in the economic cycle? Because you know, the Fed is cutting. We have a relatively low unemployment rate. We've got I mean, at least the last couple prints have been fairly strong in terms of GDP. So it doesn't it doesn't necessarily seem like we're in a you know about to tip into a recession. And you know, our chief economist Brian Westbury um has some other thoughts on that and maybe a higher probability of a recession. But um where do you guys think we are in the economic cycle today?
Bill:Well, I think just looking back, the reality of where we're at in the cycle is always unknown, right? It's it's never easier in hindsight to know. Always easier in hindsight to know, and nobody really knows. But what I would say is, we really haven't had a true recession since 2008 and 2009. We had a government-induced shutdown, obviously with COVID. It was very short-lived. And the inflation that followed, the stimulus that was injected in caused the yield curve to invert. Clearly, you know, even I thought that would lead to that ultimate recession at the time, but it was dwarfed by the stimulus that came in. I mean, we put it we put a trillion dollars into people's checking accounts and you know, trillions more into the economy with a T, right? These were massive, massive numbers. And they had a really big impact. And today, where's that coming from? Well, clearly that's coming from AI spend. That capital spend is enormous, and it goes beyond a data center build in the sense of buying semiconductors, GPUs, the things that are needed. It goes all the way down to the HVAC, the cooling, the the you know, the contractors that are that are constructing. There's a tremendous amount of ripple effects through the economy. And these things are very supportive right now. But with that being said, it doesn't have to be a hard recession eventually, but it would be very normal after such a big uh capital spend to eventually get to that point. So is it 2025? Probably not. It's almost over, right? Um it's uh it's hard to know exactly how that plays through, but we have seen, you know, they say history rhymes. It rhymes. It rhymes with 01 and 2002 and the capital spending that took place, obviously, through the dot-com build. Um, in reality is we haven't even had a 5 to 10 percent pullback in stocks since the April low. So that's something we should be mindful of as well. It would be very normal to have a 5 to 10 percent pullback, which would then spill through to credit markets and the things that we're focused on after a 35-plus percent recovery from the April low, you know, that we haven't had yet. So, you know, it's more likely than not we get a correction before we get a recession. I don't think there is anything today that says that imminent recession is coming. We're looking for the canaries in the coal mine all the time. Bankruptcy is making some headlines recently, things like that that we want to pay very close attention to to see are they idiosyncratic or are they more pervasive throughout the economy?
Ryan:So, Bill, you spend a lot of time with uh financial advisors and your your travels. What are the questions that you're not getting today that you should be getting? It's a really good question.
Bill:I I think that it's maybe a question, but asked differently. So a lot of advisors today have they're being shown a lot of new and innovative products, right? The world has changed dramatically in the last 10 years. For everything from levered products, um, you know, we used to just think about leverage in the market as margin. Now you've got to look at levered ETFs and all these different ways that investors get levered into the market. Um, and there's a lot of questions, especially after 2022, about whether advisors think that bonds even belong in their book anymore, right? Because they have got all these other alternatives and substitutes. And you know, I look back over the last few years, so let's think about this three years, and I actually counted. In the last three years, there were still nine rate hikes that came through the numbers, right? We've obviously had some cuts as well in there, but there were nine rate hikes that still came through. There were 21 in total hikes from the tr from you know, zero in the Fed started raising. But when you start to look at the cumulative returns in the bond market over the last three years, I think advisors, the most advisors that I'm talking to are surprised by the numbers. You know, high yield up 36 percent, bank loans up 32 percent, Munis tax adjusted 26 percent over the last three years, investment grade corporates 23 percent, MBS 16 percent, the ag core bonds up 15 percent, even treasuries are up 11 percent in the last three years. So, you know, when you think about numbers like that and the importance of the bond market, especially when you think about where valuations are in the stock market today, Dave McGarrell, our CIO, talks about this all the time. Valuation multiples are high, forward returns statistically, empirically, um, they're not as great when you enter the at these levels. And you start to overlay the bond market durability that that we've got today, because rates have set reset higher, and whether it's taxable or tax-free, I think it's really compelling, and I think it's going to continue to be compelling, and I and I think it needs to be understood more about how durable these returns have actually proven to be, with that rare exception of what we saw in 2022, which was just the resetting back to normal, right? That's already taken place. And I think that is going to be something that should be really much more topical.
Ryan:So do you think that advisors maybe have avoided rebalancing back into their bond portfolios, given the strength of the equity performance?
Bill:Yeah, I mean, when we talk about what we have seen in terms of just just talk about cash balances, you know, I see the numbers, we all see the numbers, they're kind of staggering over $7 trillion in cash balances. Um I ask most advisors, many will tell me that they have larger cash balances, maybe in aggregate they're about the same, but some have certainly more. Um, if you have money market exposure, your income is already down over 20 percent just from the cuts that have already taken place. It's already fallen by 20 percent. So when we think about income and how to position and the duration that we add to portfolios, it's to build income durability. And so if you haven't thought about it as an advisor or uh as an investor, if you haven't considered why that's important, it's because on a path of lower federal funds, right, money market rates are likely to continue to fall, and that income durability is going to be really important to kind of supporting your portfolio over time. And so we think that that's a a really significant consideration that has to be made.
Ryan:Okay, John, what questions are you not getting from financial advisors?
John:In the in regards to municipal bonds, really the question has been why have Munis so underperformed other fixed income asset classes for a good portion of the year, really until September and performance uh really turned around. And I think when you look at it uh with the benefit of hindsight, I think Munis were particularly impacted by the one big beautiful bill act and some of the fears that were out in the marketplace about how our $4.2 trillion asset class might be affected. So, first you had the possibility of the diminishment in the tax exemption. So, would the full coupon payment that you receive on a municipal bond be tax free? And then the conversation would turn would certain kinds of municipal credits not be able to issue bonds on a tax exempt basis in higher education or universities were talked about, um, hospitals, private what we call private activity bonds. And as we know, up with the passage of the act, none of these potential fears came to fruition. There was no uh substantial change uh in the value of the exemption. There was no change really, and then there were certain nuances or changes in tax laws where new municipal entities could issue. But what I think the effect was was it brought forward new issues supply by higher education institutions, by healthcare institutions that were concerned about whether they might lose access to the tax-free market. And I think this bulge in new issues supply has really been one of the reasons why the municipal market has underperformed year to date, but also creates the opportunity when you look out that over the next 12 months.
Ryan:So, what you're saying is that borrowers, municipal borrowers, instead of maybe borrowing in October or November, they weren't really sure that the same provisions in the tax code would would still be enforced. And so instead they wanted to borrow earlier in the year, and as a result, there was more supply of those bonds that hit the market, and that had a lot of supply, and that had, you know, supply and demand cause prices to drop.
John:Is that yeah, it's that fundamental. If you went through the end of September, new issue supply was up 12% to $435 billion. That was compared to 2024, which was a near record year of supply. If you compared that to the five-year historical average, it's a lot higher percentage than that. So, what our expectation is is we'll have a fairly robust October for new issue supply, but the bulge bracket underwriters are expecting it to uh new issue supply to be diminished in November, December. So, really, there's been this belief of buying the dip this month. If you, to the extent you get some lower prices, higher yields, wider spreads, you should buy into it because there will be less new issue supply as we get into the last two months of the year.
Bill:It really did seem to set up sort of a perfect storm. We were talking about the supply-demand dynamic and the points John made. I think through July we measured it, and there was it was 55 percent higher, $100 billion more supply than the last five years. I mean, that's a big number for the market to absorb, all you know, largely driven because of this fear of losing the tax exemption. But there were other factors, and one of those was also tied up in the one big beautiful bill on the credit side. And that's something that John and I spent a lot of time working on last year because Bob Stein was talking all around the country about how he believed that Donald Trump would win the election and how Republicans would sweep. And one of the big policy points that he felt like the administration would go after was Medicaid funding. And Medicaid funds a lot of hospitals, right? Hospitals depend on those payments as they treat patients. And so last summer, before the election, we had brought together our analysts across from health care, from high yield, you know, senior loans, investment grade corporates, municipal bonds, John, myself, and working through where our Medicaid exposure was to preemptively clean the book to ensure that we were prepared to play through that. And that was another variable because we did see a bit of baby with the bathwater in a lot of pockets of the credit markets, from munis through corporate credit, where there was so much uncertainty about what bit what one big beautiful bill would do, and that has an impact on pricing. And let's not forget what the administration was doing or has been doing with universities also funded the municipal bond market. So it really was a perfect storm and has been uh throughout the course of the year that has kind of led to some of this volatility and candidly the opportunity that we see.
John:Yeah, and it that's a great point. And what we saw in September actually was hospitals outperformed versus other revenue bond sectors in our market. And I think now uh it's been that collective analysis by the market of, well, who will be successful hospitals? It's obviously a very important sector, healthcare in general. So we did the same thing after you know a lot of conversations with our research team and talking with Bill's team about, well, what do you prune? You know, what have you reduced? And it's the safety net hospitals that have high Medicaid exposure, a lot of self-pay exposure, focus on those stronger credits that are number one or number two market positions in their geographic footprint, growing populations, better payer mixes, higher commercial payers, for instance, stronger balance sheets. And now I would expect those providers, those that show great ability to survive and thrive in a reduced Medicaid reimbursement market, will see better returns and credit spread compression for them.
Ryan:Okay, so you've got an environment where prices drop as a result of the dynamics you talked about, yields go up, they get more attractive, demand has that come back? Have investors, what have fund flows looked like for Munis? Has that been an area where you've seen some strengthening demand?
John:It's actually been a surprise, but a positive surprise because when you looked at how much the municipal yield curve steepened beyond 10 years for a good portion of the year, historically you would think, well, we're going to be in an outflow cycle because as a retail-driven asset clash, you'll get more selling of fund shares and mutual funds or exchange traded funds or other types of products. But we've really seen the contrary. So just this past week, for instance, we had 1.1 billion of inflows into the municipal market. Year to date, we've had 31 billion of inflows into mutual funds and ETFs. That doesn't take into account separately managed accounts for SMAs. Uh and we've seen 21 of that 31 billion come into municipal ETFs as municipal uh exchange traded funds take greater market share. And to kind of fill out the picture, within that 31 billion of positive fund flows, 8.6 billion have come into high yield. So I think what what that shows is that with this rise in yields, especially in 10 years and beyond, uh you see taxable equivalent yields for those clients in the highest tax bracket that are very attractive. That's sound equity, like that's something that Bill and I have talked a bunch about. And that uh investors are responding to that. A unique opportunity where municipal bonds have cheapened for, I would say, reasons that now we can see what reality is. There were fears that didn't come to become realized, and now you have the opportunity, and there's been more buying of mutual funds, exchange traded funds, and SMAs.
Bill:And usually what you see in the market is, you know, you get these periods in the market, supply-demand technicals, as we just talked about, and eventually the smoke clears, the dust settles, the focus shifts back to valuations, fundamentals, and that's where it tends to mop itself up. So the, you know, I it's one of those opportunities where we think that as it's plays through into next year, I think we're gonna all look back and say, boy, that was a really good opportunity because it's not likely to persist based on the way that perfect storm that kind of developed this year, that's not really likely to exhibit itself. And when you think about, especially where the Muni opportunity is is m has been most attractive, as John pointed out on the long end of the curve. So think about that from tens out to 30s in particular, right? A lot of some some activities taking place in the U.S. Treasury curve as well, where you know, if you think about foreign yields relative to U.S. Treasuries, you know, this is one of the things that's often overlooked. A lot of the headlines and narratives are typically tied to the Treasury curve saying things like deficit spending is a big driver of that, um, fears around auctions and the like. But if we looked around the world, we'd see that you know Japanese government bond yields are up over 80 basis points this year, um, places like Germany and France up you know 60 plus basis points this year on 30s, um, the U.K. uh. So this dynamic, this relative value dynamic that's taken place has caused some upward pressure in my mind, at least on the outskirts of the curve. And then you factor in what's happened in Munis with this supply-demand technical and it's created tech uh taxable equivalent yields, you know, that would most of us, if you look at, I think we were looking at double A taxable equivalence, we're at double A taxable equivalence right now, would you say, and that back end of the curve, sort of tens to thirties.
John:It's still very commonplace with A and triple B rated bonds in 15 to 20 years to get you know well over four percent yields. And it once you're at a 4.12 percent, that's a 7% taxable equivalent yield. So to me, if you're buying good structure and call protection and you can lock that in for a number of years, as you're suggesting with an A or A rated bond, you know, I think I asked you earlier about the uh the yield curve and and uh you and I were talking last week about the roll down, the the importance of the roll down in in uh contributing to your returns.
Ryan:For those that don't know what that means, give me some some bond nerd talk.
John:Yeah, so to go into a little bit more detail, I hesitate, but uh my bond geekdom for sure. But when you look in the 10 to 12 year part of the municipal yield curve, and you you look at that bond a year from now, it'll be 11 years to maturity and two years, 10 years to maturity. So the yield curve uh has a slope that's upward sloping, so you get more yield in general for the longer out you go. Right now, if you look from 10 to 12 years to maturity, there are 46 basis points of roll down. So about 15 basis points a year. And the you know, the without do if I do finger math, that's potentially a point and a half percent of performance just from roll down from that 15 basis points plus your coupon income. The coupon income for a 12-year bond that's A-rated is 3.56% or thereabouts, right? 3.5%. So to me, to lock that in where in the steepest low part of the curve where you're gonna roll down about 15 basis points a year for three years with a good, pretty good starting yield, that's a place to allocate some income. And then as Bill said, further out the curve, if you look out 16 to 18 years to maturity, you don't get as much roll down. It's not 46, but it's still 33 basis points. So still about 11 basis points a year or a percent. If you're buying a bond with a long embedded call structure, you really don't want to go into bond structures. But then your starting yield for an A-rated bond is 4.26% in that for that 18-year bond. So that's to me the opportunity. You get this really attractive nominal yield, highest tax bracket client, that 4.26 is well over 7%. And you've embedded, if the slope of the yield curve rolls down at the today's rate, you've built in performance. And if rates go up, you're playing good defense, because at least you'll offset some of that increase in rates by the bond rolling down the yield curve.
Ryan:Um it strikes me that a lot of what you're talking about positioning on the yield curve, selecting credits, you don't really get that in an index fund. You guys are both active managers. So, you know, it when you when you're managing a fund, are these things that you're looking for opportunities to add value?
Bill:Well, absolutely. And it and this is one of the things that we've always talked about why in terms of why we believe active wins over time, especially in fixed income, it's because the indices are literally just constructed based on where the debt issuance is. And so it doesn't consider where the better opportunity on the curve might be. The indices don't consider how much credit risk you're taking and when you want to take that credit risk, for example. Um it's simply based on that debt issuance. So from our perspective, you risk management is really the nature of fixed income. And so, you know, you start to think about, hey, I want to own bonds for the income, I want to carry, clip that coupon, and I want to sleep at night. Most bond investors think like that, right? They want to capture income, avoid loss. And there's just no risk management takes place in a passive index. It's simply representative of where the debt is issued, the more debt that's issued, whether it's the ag, where 44 percent of the ag today is treasuries because the government is funding large deficits. That wasn't always the case. That's probably 20 percent higher than it was 15 years ago. That doesn't mean you should have more treasuries just because the government has borrowed more, or in the municipal bond or corporate credit market, you know, a large issuer borrowing a lot of bonds. And we can go down a list of credits that that we have avoided that have borrowed a lot of money, both on the taxable and tax-free side, because they have borrowed a lot of money, we've avoided them. And they become large weights because they've borrowed a lot of money, so in a passive index. And those are really critical distinctions, we think, with respect to active in fixed income versus passive. And it's particularly different when you think about it relative to equities, where your large capitalizations might tell you something about the fundamental health of the business. You might want to own more of a big company on the equity side because its market cap may tell you something about the fundamentals. In the bond market, it's there isn't a market cap, it's a debt cap wherever the largest debt issuance is. And these are very different.
John:Yeah, and I would say uh during certain periods of time through the economic cycles, the amount of debt you can issue is not merit-based. Sometimes you get into very speculative investment opportunities that find an open, uh, well-received market by purchasers. And I think of that especially in the high-yield context, whether you're in the municipal market or the corporate high-yield market. And Bill and I have talked quite a bit about a name that's in both of our markets, uh, the Bright Line East Railroad. And this is a project that was uh in Florida to finance railroads from the Miami area out to Orlando and eventually Tampa. Well, there's been a lot of debt issued, and they have been increasing ridership, but what they're seeing is that they're not raising ridership at a revenue per passenger that now covers debt. And to me, that's just an example of a capital market that was very receptive to uh letting borrowers sell them bonds, that then you build it, and then the build and they will come part of this. Is will you have enough ridership? Will you have enough revenues per writer to cover all that debt that's now in the public market?
Ryan:So let me play devil's advocate because I've heard this from some uh passive bond fund um managers where they suggest that yes, it's debt capitalization weighted, but those that's a good thing because those big debt issuers um have their more liquid holdings. How would you respond to that? That those you know, the yes, they have got a lot of debt, but but it's liquid.
Bill:It's to me, this has always been one of the most common misconceptions in the bond market. In the most extreme sense, some of the largest issuers that have come to the market to borrow on the credit side have filed for bankruptcy. And so quality, we would argue, drives liquidity. In 2008 and 2009, during the financial crisis, if I needed to sell a bond to meet a redemption in a fund, for example, during hemorrhaging of fund flows and the volatility that ensued the market, there was always a bid for a bond where it was a quality bond, because I can open a 10 Q, I can open a 10K, I'll bid the bond because I know what it's worth. If it's a distressed situation because it was big and they borrowed too much, good company, bad balance sheet, or whatever the circumstances were, bad company, too much debt, that doesn't mean you're going to get a bid for it. So where's the liquidity? Where's liquidity in that situation? Because distressed buyers aren't lining up in that environment to take out distressed debt. So the reality in those circumstances is quality drives liquidity, and that's when you want it most. It's what's the quality of the holding, and that's what provides durable liquidity. And what we spend all of our time doing is thinking about what is the quality of this company, what is the quality of this bond to prove that it will be liquid when we need it to be.
John:I love your term durable liquidity. Yeah. Because initially you may gain some liquidity benefit from very large bond issues in the municipal market. There may be more participants that may be supporting the market, but ultimately it's cash flow in your ability to cover your interest and principal payments and how much leverage you have and what your balance sheet liquidity looks like. And that's really what's important. So to us, it's really that upfront review of looking at the prospects of the business and trying to do sensitivity analysis of what is their ultimate leverage and ability to cover debt service look like.
Ryan:So everyone's talking about AI these days. Um you guys are portfolio managers. You know, we hear that AI is going to displace all the white-collar workers eventually. Is AI impacting the way that you do your jobs? And are you using it or is there a use case for you to use it today?
Bill:We're using it quite a bit right now, and we've been developing tools to use it more robustly. I think it has been a phenomenal innovation for what we do on a daily basis. It has absolutely empowered our team to process a far greater volume of data expeditiously. The ability to source the information through the tools that we've developed, developed have been spectacular. It's really going to be sort of fascinating in our careers to see where this takes us, um, and especially our ability to, as I point to, like custom develop some of these tools that have been really robust in what we're doing. Now, it's going to impact us in two ways, right? The tools we use, but also the businesses we invest in. So we want to be really thoughtful about the risk of AI to a company that we're investing in. So how does AI displace what they do, or how can it? Because what we've seen is that a simple narrative of it could displace what they do is cause price volatility in certain credits. So we want to be really, really thoughtful about where that risk is and how we size that risk. Um, you can have really solid fundamentals, good performance, but if somebody's afraid of AI risk, you have selling pressure in that company. So we've got to be thinking through that. Um it's gonna have a uh a really big impact in a number of ways, in both in terms of how we're investing and the thought, um the risks that we have to mitigate when we look at various companies, but also um as a really powerful tool. And the development we're doing there, I think, has has been extraordinary.
John:Yeah, I think for us uh early days as an additional municipal bond research tool, it's come in very handy. You've read through the bond documents, you've um looked at things like feasibility studies, you've done your article searches. Well, what have you missed? What other things can you look at? And I think artificial intelligence is a way of then being another set of eyes for someone that's taking the lead on a new municipal bond issue to see, okay, well, what else? It gets into well, you got to be crafty and ask the right questions to be able to really dig and and have this broader view of data out there. That's to me like the power of it is you you can't get really wider in terms of finding data and presenting it to a research analyst or a portfolio manager and hopefully making the best decisions. I think where we're we're a little bit earlier, DIDs, on the municipal side is how do we incorporate that more in the portfolio management side to make sure we're seeing the broadest array of, for instance, secondary market offerings as quick as possible so that we can make decisions with research about what we want to buy, sell, and hold.
Ryan:You know, one of the things that's always fascinated me about the municipal bond market is just sort of the mismatch between the way the credit rating agencies evaluate muni bonds versus corporate bonds in terms of you know the the uh default rates for relatively similar credit ratings. Can you talk about that uh a bit? Because I I I've listened to you talk about it before and really kind of enjoyed the comparison.
John:Well, I think the municipal bond versus corporate, you can look at feasibility or studies by rating agencies that go over the past 50 years or so, and you can look for a given credit rating, let's say an A-rated MUNI versus an A-rated corporate bond. And Munis have had a lower historical default rate when you look at 10-year compound annual growth rates and higher recovery rates if there is a default. I think there's potentially various reasons for that, including the degree of essentiality in basic municipal finance. You know, it's it's hard to make an electric utility or water and sewer system or a leading healthcare provider not be able to cover debt service. And I'm sure that there are lots of parts of the investment grade corporate market in my example that have a high degree of essentiality, but maybe not as fulsome, not maybe not across all the different industry sectors. So I think that's uh an important component of why high net worth investors that maybe are looking at municipal bonds as a as a source of ballast, so it's not going to generate the returns of other parts of the portfolio like a high-yield corporate fund. But what it can do is provide stability, knowing that you have things like lower incidence of default and high degree of essentiality.
Bill:And I think, you know, when we when I look at ratings, it's a little bit different because a lot of people look at a rating and see a letter. I look at a rating and I see a number. Because ratings, as John was putting to, are really about empirical research. If you look at a rating, it tells you uh there's a numerical number associated with these ratings that give you an element of what a cumulative probability of default is for a given issuer with that rating. So for example, a mid-single B has got something like a 27% cumulative probability of default in the next five years. So understanding what those ratings really mean from the probability or statistical probability empirically of a pro of a default is is really important. So it isn't linear, right? There isn't a linear relationship between a double A and a single A and all the way down the rating scale. It's logarithmic. Your probability of default statistics change dramatically when you're moving up in quality, and you know, they move all the way to a hundred percent probability of default as you get into the lowest ratings. So ultimately D4 default. But understanding that, I think, is really, really important.
John:I think to the I totally agree. And one of the areas that we've tried to do differently than what you would see if you were looking at the rating agencies is our research team has to come up with a numerical score for credit quality momentum. So we use a numerical score, we don't call it stable, for instance, or declining or positive. Those are the normal terms for the rating agencies, but we make them put a number on it. So which shows the strength of credit quality improvement or declining, and that helps us in our surveillance meetings decide which credits are we going to focus on for buying additional power amounts of those with the strongest credit rating momentum and those that have the weakest. Well, those are bonds that you're more likely to engage in a sell discipline and decide, well, is this something that we want to continue to hold or do we want to pair back? And the last thing I'll I'll say about this is the rating agencies can do a good job on the initial review of a municipal borrower. But what we found is oftentimes their ability to do surveillance on an existing bond that they have provided a rating on isn't always timely. And that's one of the areas that we really try and differentiate as a research team, too, is make sure that not only have you done the credit work, but you've done the follow-up work to see if that particular borrower is doing what they said they were going to be able to do.
Ryan:All right. John, since it's your first time joining us on the podcast, I'm going to ask you the uh the final question because I've I've already gotten some book recommendations from Mr. Housey over the years. I've I've read about uh Shackleton and uh his his adventures. Uh but one of the things that I tend to ask guests of the ROI podcast is what's your reading lately, or if there's anything you've read recently that you would recommend us checking out. It doesn't have to be uh a book about bonds as as scintillating as I'm sure that would be. Um is there anything that you would recommend that we add to the book list?
John:Well, I've got uh three adult uh daughters, and my wife and I traveled actually to wine country in California the last couple of years, and at one of the places we visited, they recommended a book called Wine Folly Magnum Edition. And this book I have found will not only tell you a lot about wine and grapes, but also geographic regions across the world, as well as then how you might pair specific types of wine with different types of food. So for someone that's wanted to learn more about this important topic, I'm not surprised at all that John's following.
Ryan:I don't think we've gotten um that sort of book recommendation yet, but um I I really like it. I'm gonna check it out. Thank you for that. Well, guys, I appreciate you uh spending some time with me on the podcast today. Um, like I said, it's always fun having two bond portfolio managers join me. So thanks. We'll have to do this again very soon. Um, and thanks to all of you as well for joining us on this episode of the First Trust ROI podcast. We'll see you next time.
