Lyle Fitterer: The State of the Municipal Bond Market Today

Episode Summary

Executive Summary: Morningstar’s Long View interviewed Baird muni manager Lyle Fitterer on how active managers analyze a fragmented municipal-bond market, use technology and AI, interpret muni/Treasury ratios, and position around valuations, structure, geography, and sector risks. He argued munis remain an inefficient, tax-advantaged market where active credit work and diversification can add value.

Main Topics: How Baird analyzes a fragmented muni market (Priority: 5/5): Fitterer explained Baird’s eight-person team uses a credit-scoring system, daily news scraping, and role flexibility to narrow 5,000+ obligors into a manageable research universe, with each analyst covering about 50 watch-list credits. AI and technology in credit research (Priority: 4/5): He said Baird is increasingly using AI to summarize offering statements, roadshows, and covenants, while keeping human judgment central and leveraging broader fixed-income teammates for adjacent credit work. Muni/Treasury ratios and valuation (Priority: 5/5): Fitterer described muni/Treasury ratios as a tax-adjusted valuation tool, discussed historical ranges by maturity, and said ratios and absolute yields still make parts of the curve attractive, especially the 2-year and 15-20-year sectors. Active management vs. indexing (Priority: 4/5): He argued munis are especially well suited to active management because of inefficiencies, though intermediate-term index funds can track well; longer-duration passive products may miss income due to benchmark differences. General obligation vs. revenue bonds (Priority: 5/5): He unpacked the structural differences, noting GOs rely on taxing authority while revenue bonds depend on specific cash flows, covenants, and sometimes stronger bankruptcy protection; portfolio mix shifts with relative value. Sector, issuer, and geographic risk (Priority: 5/5): He highlighted areas to avoid or scrutinize—Chicago/Illinois-related credits, unenhanced multifamily, project finance, tobacco, and some healthcare/higher-ed names—while emphasizing that even weak sectors contain selective opportunities. Climate risk, diversification, and individual bonds (Priority: 4/5): Fitterer said climate events are hard to predict, so diversification and quality matter most, especially for separately managed accounts with large position sizes; pooled funds can reduce issuer-specific and environmental risk.

Key Arguments: Municipal bonds are a large but highly inefficient market, which creates room for active managers to add alpha through credit selection and relative value work. Technology allows a small team to cover a vast universe by triaging credits into strong/core/watch buckets and monitoring news feeds for local developments. AI is useful for summarizing documents and comparing deals quickly, but it is an additional tool rather than a replacement for credit professionals. Muni/Treasury ratios help investors assess tax-adjusted value and can inform duration or curve positioning, especially when long-end ratios become unusually rich or cheap. Current valuations remain attractive on an absolute and tax-adjusted basis even after some cheapening/richening swings, with value shifting across maturities. Active muni management can outperform index funds over time because passive products may give up income or use narrower benchmarks than the broad market. Revenue bonds can offer stronger structural protection than GOs in some bankruptcies, but the best choice depends on issuer quality, sector, and valuation. Investors should be cautious with very high-yielding munis because unusually high yields often signal hidden risk or weak structure. Municipal tax exemption is politically challenged at times, but Fitterer views broad repeal as unlikely because it underpins essential public financing. Climate and other ESG-related risks are best managed through broad diversification, high credit quality, and smaller position sizes rather than trying to forecast disasters. Individual munis can make sense for tax and maturity matching, but pooled vehicles provide better diversification, liquidity, and access to lower-quality credits without concentration risk. Muni portfolios can act as a sleep-at-night asset class with lower long-term volatility, though short-term volatility can rise due to ETF flows, technicals, or policy shocks.

Data Points: Baird muni team size: 8 people - Used to explain how the team covers the municipal market through technology and shared analyst responsibilities. Obligors owned across portfolios: over 5,000 - The total credit universe fed into Baird’s internal scoring system. Watch-category credits: about 400 - Credits that require the most research attention after scoring. Credits per analyst in watch category: roughly 50 - Illustrates workload distribution across the eight-person team. Top marginal tax rate referenced: 37% federal + 3.7% net investment income tax = 40.8% - Used to show why muni yields can be compelling on a tax-adjusted basis. Current 10-year AAA muni/Treasury ratio: around 65% to 67% - Referenced as the current level for a 10-year AAA muni relative to Treasuries. Typical ratio ranges by maturity: 2-year: 60%-65%; 5-year: similar; 10-year: 70%-75%; 30-year: ~90% - Historical/typical ratio bands used for valuation context. Long-end ratio in spring/summer: close to 100% of Treasuries - Explained why the long end looked especially attractive earlier in the year. 30-year ratio later in the year: sub-90% after being in the low 80s - Showed valuation normalization after summer volatility. Typical high-quality muni yield example: 15-20 year muni at about 4% absolute yield - Used to frame long-term attractiveness of current muni yields. Tax-adjusted yield example for top bracket: about 6.25% - Illustrated how a 4% muni yield translates for a top marginal taxpayer. Vanguard intermediate muni index fund 5-year return: 1.35% average annual - Compared with the index and Baird’s active intermediate strategy. Vanguard index benchmark 5-year return: 1.19% average annual - Referenced to show passive tracking performance. Baird core intermediate muni fund 5-year return: 1.63% average annual - Used to demonstrate added value from active management. Outperformance target: 25 to 50 basis points after fees - Baird’s stated goal for active municipal bond management. Small-investor trading cost improvement: from 1-2 points to roughly 0.25-0.5 points in many cases - Discussed as electronic trading improved muni execution. Liquidity shock example: 100 basis point spread widening on LA water bonds - Used to show why large positions in individual bonds can create meaningful drawdowns. Position-size example: 5% position in an 8-year-duration bond could mean about 8 points of portfolio underperformance if spreads widen 100 bps - Illustrates concentration risk in separately managed accounts. Historical muni default comparison: 10-year cumulative default rate on BBB munis is lower than AAA corporates - Used to support the view that munis are a high-quality asset class. Portfolio position size at Baird funds: generally under 1%, often 0.5% or less - Explains how diversification mitigates issuer/event risk.

Pivotal Quotes: "We like to think of it as a smaller pool, but with a lot more fish in it." — Lyle Fitterer: Describing why the municipal market is large, inefficient, and attractive for active managers. "If you see a muni and it's yielding, you know, 7% or 7.5% or 8% or 10 plus, there's a reason behind it. So just be careful and do your due diligence." — Lyle Fitterer: Warning listeners that unusually high muni yields usually reflect significant credit or structural risk. "It's a sleep-at-night part of the portfolio." — Lyle Fitterer: Explaining the role of high-quality, diversified municipal bonds in reducing portfolio volatility.

Implications: Listeners should think of munis as a tax-advantaged, credit-driven market where active management, diversification, and valuation discipline matter more than headline yield. For investors, the best opportunities may be in select curve segments and higher-quality credits, not the highest coupons.