Lyle Fitterer, Baird Asset Management - You Could Even Argue That They’re Better Credits Than The Federal Government | #341

Episode Summary

Executive Summary: The episode is a deep dive into municipal bonds: what they are, why tax-exempt income matters, how the market recovered from the pandemic sell-off, and how managers position portfolios amid taxes, inflation, infrastructure spending, and ESG concerns. Lyle Fitterer emphasizes credit analysis over blanket assumptions, warns against lower-quality and non-rated deals, and argues that munis remain attractive for income and relative value despite rich valuations.

Main Topics: Municipal bond market overview (Priority: 5/5): Fitterer explains munis as the financing vehicle for state and local projects such as schools, hospitals, roads, and infrastructure, highlighting the market’s tax-exempt income and broad issuer base. Credit risk, structures, and investor pitfalls (Priority: 5/5): He details why individual analysis matters, including premium-bond tax rules, the limits of general obligation strength, and dangers in non-rated or complex deals. Pandemic shock and market recovery (Priority: 5/5): The discussion walks through March 2020 dislocation, why munis sold off sharply, and how Federal support and fiscal resilience led to a strong rebound and improved credit outlooks. Inflows, valuation, and relative value (Priority: 4/5): Fitterer attributes heavy inflows to tax concerns and attractive valuations after the sell-off, noting strong demand for longer-duration and high-yield muni funds. Macro outlook: rates, inflation, and negative yield scenario (Priority: 4/5): He discusses inflation, the likely range for Treasury yields, and why the Fed is unlikely to tolerate negative U.S. rates, given implications for pensions and fixed-income investors. Portfolio construction and sector rotation (Priority: 4/5): He outlines a duration-neutral approach focused on security selection, sector rotation, credit-quality upgrades, and barbell positioning to capture curve roll-down. Areas to avoid and research tools (Priority: 3/5): He flags sectors like Puerto Rico, long-term care, speculative multifamily, land development, and project finance as higher risk, and recommends EMMA, Bloomberg, and news-monitoring tools for research.

Key Arguments: Munis remain compelling because they offer federally tax-exempt income and, in many cases, state tax benefits, making them attractive relative to low yields elsewhere. The muni market is far broader and more heterogeneous than many investors realize, with over a million CUSIPs and tens of thousands of issuers, so credit selection matters. Investors should not assume all general obligation bonds are safe; population decline, pension burdens, and fiscal stress can undermine even taxing-authority-backed credits. Premium-bond taxation rules can create unexpected after-tax outcomes if a bond falls below de minimis levels. The pandemic created a temporary but severe dislocation; however, federal transfers, delayed tax payments, and resilient household income stabilized state and local finances faster than expected. Large inflows into munis were driven by tax concerns, low global yields, and attractive post-selloff valuations, especially in longer-duration and high-yield segments. The market is not cheap today, but technical demand remains strong, and additional supply may come later from infrastructure financing and possibly higher tax burdens. If Treasury yields were to go negative, munis would initially cheapen versus Treasuries but could ultimately benefit from global demand for positive-yielding income. Portfolio value is best added through sector rotation, security selection, and curve positioning rather than large duration bets. Certain sectors require special caution because high leverage, weak project economics, or restructuring risk can overwhelm headline yields.

Data Points: Outstanding municipal debt: roughly $4 trillion - Size of the muni market compared with Treasury and corporate bond markets Outstanding Treasury debt: over $28 trillion - Used as a comparison to show munis are a much smaller market Outstanding corporate bond market: about $10-11 trillion - Comparison point for muni market size Number of outstanding municipal CUSIPs: over 1 million - Illustrates breadth and complexity of the muni opportunity set Number of municipal issuers: 85,000 plus/minus - Shows fragmented issuer base Recent muni fund inflows since May 2020: close to $130 billion - Demand surged after the pandemic sell-off and into 2021 Year-to-date muni fund inflows: over $60 billion - Shows continued investor demand in 2021 Assets in muni funds and ETFs: over 15% - Share of assets represented by fund and ETF products in the space High-yield muni performance year to date: close to 7.5% - Cited as one of the best-performing fixed-income segments globally 10-year Treasury yield: around 1.2% to 1.3% - Used to compare absolute yield attractiveness of munis 10-year Treasury peak discussed: about 1.75% - Describes the post-pandemic rise in rates before they fell back Potential 10-year Treasury forecast: towards 2% - Fitterer’s thematic view on where rates might move Illinois pension funding ratio: roughly 38% funded - Example of long-term fiscal stress in a major muni issuer Illinois state upgrade timing: first Moody’s upgrade since 1998 - Shows how unusual the recent improvement in credit perception was Chicago budget size: roughly $11-12 billion - Context for federal stimulus support as a percentage of local budgets Chicago stimulus received: roughly $1.9-2 billion - Illustrates magnitude of federal support Unspent state/local federal aid: $210 billion remains unspent - Explains why budgets may remain strong for 12-18 months Total state/local federal aid: about $500 billion - Half of the aid package remains unused, supporting future budgets High-grade muni spread compression: additional yield on lower-quality bonds has declined dramatically - Supports the case for moving up in credit quality Example pandemic purchase yield: 5% tax-exempt yield - Yield on 30-year Ascension Health bonds bought during the sell-off Example current yield on same bonds: about 1% - Shows dramatic price recovery after the pandemic dislocation Proposed infrastructure spending: $600 billion plus/minus - Potential future muni issuance linked to infrastructure needs Portfolio duration exposure change: decreased duration exposure - Response to rich muni valuations versus Treasuries Muni yield curve examples: 2-year ~0.10%, 5-year ~0.30%-0.35%, 10-year ~0.90% - Illustrates steep curve and roll-down opportunity

Pivotal Quotes: "the income that you generate is exempt from federal taxes" — Lyle Fitterer: Explaining the core investor appeal of municipal bonds "you really had to look at, you know, what are the individual credits that you're buying?" — Lyle Fitterer: On the post-crisis shift away from blindly relying on insured AAA muni wrappers "the hard thing to do is usually the thing you should be doing" — Lyle Fitterer: Describing how the best buying opportunities appeared during the 2020 pandemic sell-off

Implications: Munis still offer powerful tax-efficient income, but investors need to be selective: focus on credit quality, structure, and sector risk. With rates, taxes, and infrastructure spending in flux, active management and liquidity may matter more than ever.