The Long View: Lyle Fitterer - The State of the Municipal Bond Market Today

Summary of The Long View Podcast with Lyall Fitterer on Municipal Bonds

Key Concepts:

• Municipal Bonds (Munis): Debt securities issued by state and local governments, typically tax-exempt at the federal level and sometimes at the state and local levels.
• MTOTT Ratio (Municipal to Treasury Ratio): A comparison of municipal bond yields to Treasury bond yields, used to assess the relative value of munis.
• Credit Scoring System: A proprietary system used by Baird Advisors to categorize municipal bonds based on credit risk (Strong, Core, Watch).
• Alpha: Excess return generated by an active investment strategy compared to a benchmark.
• General Obligation (GO) Bonds: Municipal bonds backed by the full faith and taxing power of the issuer.
• Revenue Bonds: Municipal bonds backed by the revenue generated from a specific project or source (e.g., water and sewer fees).
• ESG (Environmental, Social, and Governance): Factors used to evaluate an investment based on its sustainability and ethical impact.

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I. Introduction & Market Overview

The podcast features Lyall Fitterer, Senior Portfolio Manager at Baird Advisors, discussing the municipal bond market. He highlights the market’s size (smaller than the taxable bond market but still substantial – over a million bonds) and its characteristics: fragmentation, opacity, and inefficiency, which present opportunities for active management to generate alpha. Fitterer emphasizes Baird’s team of eight dedicated professionals leveraging technology to navigate this complex landscape. He has 36 years of experience managing bond portfolios, previously at Wells Fargo Asset Management. He holds a degree in accounting from the University of North Dakota and the Chartered Financial Analyst (CFA) designation.

II. Baird’s Due Diligence Process & Technology

Baird employs a credit scoring system categorizing over 5,000 obligors into “Strong,” “Core,” and “Watch” categories. This system analyzes historical default rates, credit enhancements (e.g., state backing, insurance), state pension issues, and other factors. The “Watch” category, comprising roughly 400 obligors, receives the most intensive research and offers the greatest potential for alpha generation due to higher yields.

The team utilizes technology in several ways:

• Credit Scoring System: Automated categorization of obligors based on credit risk.
• News Scraping: A vendor-provided system monitors news sources for information on issuers, providing early insights.
• AI Integration: Utilizing Artificial Intelligence to summarize offering statements, bond covenants, and compare deals quickly.
• Efficiency Tools: Technology is used for bid list analysis, option-adjusted spread calculations, and trade allocation.

Each team member functions as both an analyst, portfolio manager, and trader, fostering a comprehensive approach. The team reviews all credits at least annually.

III. The Municipal to Treasury (MTOTT) Ratio

Fitterer explains the MTOTT ratio as a comparison of municipal bond yields to Treasury yields for similar maturities. Currently (as of the recording), a 10-year AAA-rated muni yields around 65-67% of a 10-year Treasury. This ratio is used to determine the tax-adjusted attractiveness of munis based on an investor’s marginal tax rate (currently 37% federal plus 3.7% net investment income tax, totaling 40.7%). The ratio helps investors assess whether the tax benefits outweigh the lower yield compared to taxable bonds. Historically, the ratio fluctuates, with lower ratios (e.g., 50% of Treasuries) indicating less attractive valuations. Long-term averages are considered more reliable than short-term timing. The ratio also informs Baird’s curve positioning and strategic fund duration decisions.

IV. Valuations & Market Dynamics (2023)

Early 2023 saw significant volatility in the muni market, with ratios approaching 100% of Treasuries, particularly on the long end. Baird identified this as an attractive entry point. Since August, ratios have come down, with the 30-year ratio now below 90%. The 2-year part of the curve has cheapened, while the 5- and 10-year segments are less attractive. Baird believes absolute rates are attractive, with a 15-20 year muni yielding around 4%, translating to 6.75% for a top marginal taxpayer. The increased volatility is partially attributed to the growing influence of ETFs and the ability to short the muni market.

V. Indexing vs. Active Management in Munis

Fitterer argues that the inefficiencies of the muni market make it particularly suitable for active management. While Vanguard’s muni index fund has shown competitive performance, Baird’s core intermediate muni bond fund has historically outperformed, delivering roughly 20-30 basis points of additional average annual return. He notes that index funds may exclude certain sectors (e.g., housing bonds), potentially sacrificing some income. He emphasizes the importance of understanding the underlying index of an ETF.

VI. General Obligation (GO) vs. Revenue Bonds

• GO Bonds: Backed by the full faith and taxing authority of the issuer. Historically favored, but concerns exist regarding declining populations and pension obligations.
• Revenue Bonds: Backed by specific revenue streams (e.g., water and sewer fees). Offer a more predictable claim in bankruptcy, as demonstrated by the Detroit water and sewer bonds.

Baird’s approach is flexible, adjusting exposure based on relative value and issuer-specific analysis.

VII. Geographic & Credit Risks

Fitterer identifies Chicago and Illinois as credits requiring caution due to pension issues and economic challenges. However, he also notes opportunities within the state due to negative sentiment. He advises avoiding unenhanced multifamily housing and project finance bonds due to higher risk. He highlights the importance of diversification and focusing on high-quality issuers.

VIII. Climate Risk & ESG Considerations

Baird addresses climate risk through broad diversification and a focus on credit quality. While predicting specific disasters is difficult, they avoid concentrated exposure to vulnerable regions. They emphasize that high-quality credits are less susceptible to the impact of climate-related events.

IX. Individual Munis vs. Bond Funds

While individual munis can be attractive for tax benefits and maturity matching, Fitterer cautions against building portfolios with limited diversification. He recommends combining individual bonds with pooled vehicles (mutual funds or ETFs) to achieve broader exposure and liquidity. He points out the potential for significant losses if a small portfolio is heavily concentrated in a single issuer facing unforeseen challenges.

X. Trading Costs & Market Volatility

Trading costs for individual munis have decreased with the advent of electronic platforms, but remain a consideration. He reiterates the importance of diversification to mitigate the impact of potential losses.

XI. Muni Bonds as a Shock Absorber

While traditionally considered a safe haven, municipal bonds haven’t always provided downside protection during equity market selloffs, particularly in 2022. Fitterer explains that the MTOTT ratio provides a degree of volatility reduction, and that Baird’s focus on quality and diversification aims to provide better downside protection.

Conclusion:

Lyall Fitterer provides a detailed overview of the municipal bond market, emphasizing the importance of active management, thorough due diligence, and a nuanced understanding of credit and market dynamics. Baird’s approach centers on leveraging technology, a dedicated team, and a disciplined investment process to generate alpha while managing risk. He stresses the value of diversification, quality, and a long-term perspective in navigating this complex asset class.