Welcome to Know More, Risk, and Better, a Credit Sites podcast. Across the global strategy team, we aim to make sense of the macro and the micro, highlighting opportunities and the risks facing the fixed income markets. As the macro makes headlines, we leverage our network of experts across fish solutions to better understand economic trends, rates, gyrations, geopolitical events, and how these factors impact corporates. At Credit Sites, we understand that credit investing comes down to picking winners to generate alpha and avoiding losers.
Our team over 100 analysts across the U.S., Europe, and Asia provide unmatched sector expertise and fundamental knowledge. In our weekly podcast, the strategy team offers a look at the conversations we have with our colleagues, including analysts, fellow strategists, economists, and leveraged finance market experts. If you want to know more so that you can risk better, you'll want to give this podcast a listen. Hello, everyone, and welcome back to the Credit Sites podcast.
This is Winnie Cesar, Global Head of Strategy at Credit Sites, and today we are trying something new. We are trying some video with our podcast, so if you are listening and you want to see my smiling face, then head on over to YouTube and check out the video. Today, joining me, I have Pat Luby. He is our Head of Municipal Strategy and Resident ETF Guru, and looking good today, live from Hearst Tower, the Credit Sites headquarters in New York.
Pat, thanks for joining us. Hey, Winnie, thanks. I'm excited to be here and glad to be a part of the first video version of the podcast. I know.
You are always on the forefront of trends, on the very cutting edge, so we, of course, had to have you for our first video podcast. And today, we're going to talk about a lot of stuff, lots of stuff going on in the muni market for certain, and I know that people are very focused on the world of ETFs as well. I've had a few reporters reach out to me today, actually, asking what the heck is going on with ETF flows lately in investment grade and high yield, so hopefully, Pat, we'll have some interesting insight there. So, Pat, where should we start first?
Should we talk about the Fed and payrolls? Yeah, let's start there, because that's foundational to what I'm expecting we're going to see over the next couple of months in the muni market, so I'd love to have you share your update on the Fed, because it's changed right here over the last week or so. It certainly has. I know.
We got a little bit cute last Friday. On the back of that July payrolls report, it came in pretty terrible. I mean, it was not a good report, and that's especially true when we consider the revisions to payrolls in May and June. Now, leading into that report, we had put out a Fed preview, laying out some of the criteria that would cause us to perhaps change our view on the Fed, and regular listeners will probably recall that we had been in the camp that the Fed would make like its 2023 and be on hold for much of this year, and we thought that if there were clearer signs of labor market erosion, things like, you know, sub-100K payrolls in multiple months, perhaps a jump toward 4.5% on the unemployment rate, which is what the Fed has in its June summary of economic projections, then the Fed would probably become more sensitive to that labor market dynamic, which was showing weakening, and the July report hit a few of these things.
We had the unemployment rate take up a little bit, and that was on a falling participation rate, and falling participation is generally not a super healthy sign in the market, and with the downward revisions for May and June data, we got three months of sub-100K job ads. In fact, we got to a very low level of job ads over the past few months, lower than any other period post-2010, but for COVID, which we all know is a little bit of extraordinary operating in the labor market overall. So we did go ahead and change our Fed rate call, and we are now expecting a perhaps jumbo rate cut in September, much like what we saw from the Fed last year in September 2024, and effectively what we did was pull forward some of the Fed market action that we had been anticipating for the first half of 2026. In our outlook that we put out in July, we highlighted the risk that the labor market could be a little bit complicated because of different policy changes, different sectors coming under some pressure while other sectors are still adding bodies, and we thought that that really increased the risk that the Fed could be behind the curve on the labor market, and we thought they might have to be easing a bit more aggressively than what the market was anticipating in the first half of 2026, and so we pulled that forward into the second half of 2025.
Now, what this doesn't change is some of our key market views, including a little bit of a risk-off tone. We still like duration over credit risk. We put that view out a couple of months ago on some changing technical factors in the rates market, and just the reality that the 10-year treasury around 4.5%, 30-year around 5%, looks like a pretty reasonable entry point overall. We also think that investment rate in the U.S.
from an all-in yield total return perspective also still looks pretty good, but credit risk is a much more challenging prospect right now. It's very difficult for us to justify spreads that are still very thin despite a little bit of volatility last week, and the reality that we think margins are still going to be a bit of a challenge for the coming quarters as we continue to see a wide range of impact from consumers weakening a bit, from tariff and trade policy complications, from the adoption and evolution of AI. There's just a lot of factors that corporates are dealing with right now. So, Pat, that was probably a lot to absorb at once, but, you know, you've heard this before.
Or with the prospect of that change in the Fed's posture, what does it mean for Muniland? Yeah, there's really two direct impacts that come to mind right off the bat, but one of them really is an investor behavior perspective. You know, we've talked about this before. There seems to be an unusually large amount of cash on the sidelines, investors who are underweight duration because they've been paid pretty well to stay in cash or extreme low duration.
And so if all of a sudden it looks like the very short rate or the floating rates are going to be heading lower, is there going to be a scramble for duration? I think that there's some probability of that. But, you know, what does it do to the muni yield curve? Of course, the short end is going to rally.
We look for the short end of the muni yield curve to get richer still. Demand has been very, very strong through especially 10 years, but even out to 15 years, demand has been strong. So the risk of seeing those yields go even lower and some folks kind of scrambling for duration, that part of the yield curve could get even stronger. When overlooked and not widely discussed, part of the muni market is the leverage closed end funds, which should be in the toolkit of especially wealth management of clients and individual investors because it's a good place to go for incremental yield.
They're extreme long duration, however. And so that duration comes from borrowing at the short term rates. And so the prospect of Fed's Fed cutting rates and doing a jumbo cut in September should have a pretty immediate effect on the cost of leverage. And if the cost of leverage for the closed end funds goes down, it ultimately will translate into some better dividends coming out of the closed end funds.
But the cautionary part of it is the long end of the yield curve. What's going to happen at the long end of the yield curve? And in munis in particular, prior at the beginning of the year, I was cautioning that the post-Labor Day period was going to be a more volatile time of the year just from the seasonal technicals. Summer redemption season is basically done now.
A huge amount of money was paid out on August 1st from maturing and called bond principal. The August 1st money is actually going to be more than will be paid out in all of September or October or November. So reinvestment demand is going to go down. New issue volume has been pretty significant and it's kind of outweighed the demand for long duration bonds.
So I said, you know, demand's been really strong through 15 years. You can see how efficiently that part of the yield curve is priced. When you get beyond 15 years, it gets cheaper and more attractive, but there's not as many natural buyers. Year-to-date issuance of muni supply has been on a tear.
We're on a pace to set a new record. We just updated our forecast for new issue volume for this year. We had been at 550 billion for the year. We're now expecting it to be 600 billion.
But as news circulates that the Fed is getting ready to cut rates, new issue volume could be even more than that as issuers come in to borrow more or to refinance more debt. One of the things we look at is net supply. What's the amount of new issue volume minus the amount that's getting paid back from maturing and called bonds? Last year, net supply was 135 billion.
This year, it could be 267 billion. That's 267 billion that's going to need to find incremental buyers to bring it into the market. So I'm looking for very strong demand at the front end of the curve as folks are trying to get some duration to lock in some income and probably exaggerated volatility at the long end of the curve as issuers continue to borrow and the market is going to be looking for some buyers for this long duration paper. Yeah, Pat, I mean, there's so much to unpack in all of that.
But what really stands out to me is this uptick in net supply in the muni markets. You know, a doubling of net supply seems pretty material. And it's also not consistent with what we've seen in the corporate credit markets where companies have still been really focused on refinancing. That's true of investment grade and high yield and even the broadly syndicated loan market, which tends to be a bit more aligned to A and dividend recaps and things like that.
We don't feel like issuers have been as excited about new money issuance. They're a little bit uncertain about what the world is going to look like in 5, 10, 30 years. How are you thinking about the drivers of net supply in the muni world? Well, that's actually one of the fundamental differences between the muni market and corporate market.
The muni market is a project finance market. Bonds are issued in munis. If an issuer needs to build a school, they need to resurface a highway, they need to expand an airport runway. So the munis are self-liquidating.
They're typically issued to pay for a specific project, not because an issuer likes the interest rate environment. They don't have a permanent balance sheet, you know, permanent capital balance sheet like a corporate issuer. So it's utilitarian. They're borrowing because they need to borrow.
Coming into this year, we were expecting that borrowing for new money financing would be up 11%. That's partly a function of inflation. If you needed to build a new parking garage at your airport, it's more expensive now than it was three years ago, maybe when you did your engineering and your blueprints. So the cost of steel, cement, labor, everything is up and it's gone up.
It's continued to go up. So projects are getting scaled back, but also financing is getting scaled up to cover the cost of those projects. But new money financing right now is running about 25% ahead of last year. Well, why is that?
I think it's a combination of the inflationary impact of more expensive physical products that go into projects, but also the changing finances of state and local governments given the current economic environment. I think state and local governments are more likely to want to bond out projects if they can, if they have revenues available to secure the projects rather than deferring and doing some, you know, paying out of general revenues or general funds or cash on hand for specific projects. I think they're bonding out more than they may have in the last couple of years. And they're also refinancing.
So where the market is right now, there's a lot of issuers who are paying off their taxable Build America bonds, which is really sad news for the investment grade investors who've been priced out of munis. So they're getting their taxable credit called away from their IG portfolios. It's hard to replace that mini credit risk. So it's a combination of the inflation, driving the new money, financing higher, and also the refinancing activity, paying off older, higher rate debt.
Yeah, that makes a lot of sense. And as someone who lives in Charlotte, North Carolina, where the airport has been under construction for what seems like forever. Permanently. Permanently.
You know, that's the perils of living somewhere where there is a lot of growth. I feel the airport comments very deeply. I'm looking forward to that runway whenever they finally get it built. And Pat, I think that some of your comments really lead me into my next question.
What about credit trends? A lot of clients I talk to in the corporate market, they point to good credit trends. Fundamentals have been seemingly benign. We haven't seen a push for intentional re-leveraging or a large-scale M&A for repaying dividends and share buybacks by issuing debt.
Uni market fundamentals are different, but what do credit trends look like? How are market fundamentals looking? What do you have on your radar screen? I'm sure we've all seen a lot of headlines around different federal government policy funding changes.
Are those impacting things? We'd love to hear your thoughts. Yeah. So the federal policy changes are definitely having an impact on some of the sectors, but traditional state and local government finance, you know, finances are in okay shape.
I like to look at sales tax collections really for two reasons. They're an important source of revenue for state governments, the sales tax collections that they pull in, but it's also a good indicator of what's the general prevailing economic wins look like in a particular area. And they're doing okay. Through the first six months of this year, California sales tax collections are up 2%.
Illinois is up 1%, kind of behind trend. Pennsylvania up 4%, Texas up 4%. Those are solid numbers. They're not up, you know, fast year-over-year inflation.
They're up, but sales tax collections obviously don't get inflated, nor does debt service. The cost of providing governmental services does get inflated. They obviously need more than just sales tax collections to grow at this rate, but as an overall indicator of economic strength, I think those numbers are okay. Illinois, a little bit of a concern there, but even California, all the headlines that come out of California are still an enormous economy.
Sales tax collections are up 2% in the first six months of this year versus 2024. I think that's a good sign. If we go to some of the sectors, airports are one of my favorite sectors because I think it's such an interesting sector. Airport revenue bonds are really a way for investors to get access to a local economy at yields that are going to be better than buying a GO in the local market.
The airports aren't going to do well unless the local economy is doing well, and airports have been on a building binge. Now, airport issuance has also been kind of on the light side, I think, because of the uncertainty attached to the individual alternative minimum tax, which has now been solidified by the OBDBA, the One Big Beautiful Bill Act, which made permanent the current status quo and who was going to be paying the A&T in 2026 meant that it was a challenging environment for airports to want to sell airport revenue bonds. So I think we're going to see a big surge of airport issuance in the second half of the year. I think we'll see a surge in issuance in A&T airport bonds in particular.
Power bonds have been a fairly reliable sector, but right now, year-to-date, there are, I think, downgrades outweigh the upgrades. That's a function of LA DWAP, which obviously has significant costs and exposure associated with the wildfire. We'll see how the market prices that DWAP's going to be in the market here in the next couple of weeks. I'll be anxious to see how that goes.
The headcount reductions coming out of the federal government are certainly going to have an impact since the end of the first quarter. Virginia bonds have outperformed the index, but not all of them. Richmond and Alexandria have underperformed, but Commonwealth Virginia bonds have outperformed. So it is inconsistent how those bonds are performing, but I've had investors tell me and the managers say, they've got lots of clients who want those bonds to get cheaper.
They want to see wider spreads and there'll be buyers at wider spreads. The good news for investors is most of those credits are really highly graded. So even if they get some stress, they go on credit watch, probably. Will there be some downgrades here and there?
Probably, but it's not going to be a serious stressful event. Now we turn to hospitals and colleges and universities to get a little bit more interesting. Both of them are subject, especially the academic hospitals, subject to the proposed changes and how the NIH, the National Institute of Health, allocates costs as a part of their grant money. And there's the potential because, I mean, these are, they write zero baseline budgets, right?
They're not, they don't have extra money in their budgets. And if there's a cut from NIH on money that's available to cover overhead, those are basically hard dollars that have to be found elsewhere or cut from the budget. So there's some potential challenges ahead depending upon how the NIH proposed changes goes through the court cases. We are watching when new issues come to the market.
We want to make sure that new issuers are fully disclosing what kind of grant money they've been receiving, how much of it is NIH grant funding, what kind of other grants they're receiving and how their overhead is allocated. It's an important disclosure issue that we're watching and we encourage clients to be watching as well. Colleges and universities, they're feeling it from multiple directions. You know, the NIH cuts, we looked at just the top schools or roughly the top 75 schools or so, but we estimated about $1.6 billion potential change in the cost allocation for these colleges and universities.
That's an enormous amount of money to have to replace in these budgets. $23 million average for these schools, the top 80 or so schools. Changes in international student enrollments, this is another political hot button issue. Among the top schools, again, the top 80 or so schools or so, about 15% of the students are international students.
One school that had more than 50% of the student body was international students. This is a big revenue issue because the international students typically pay full freight. U.S. students come in and mom and dad are expecting to see some sort of a discount, anything off of sticker price and the international students are paying full freight.
So they're in effect subsidizing the tuition for the U.S.-based students. change in international student enrollment has the potential to really change the finances of colleges and universities very important to watch that and of course the big beautiful bill act also increased the excise tax on endowments uh schools are already subject to an excise tax i think of 1.4 so there's going to be a scale depending upon the size of the endowment uh per student per student body so schools that have an endowment that's i think more than two million per student average will be subject to the max rate by our calculation we think that there are five schools looking at an incremental tax liability of over 100 million dollars per year i can't think of that that's yes we've got a huge endowment but september it's you know it's in all so it'll be a function of what they're actually getting an income off their endowments but even if it's half that that's still an enormous amount of cash that is going to have to be consumed by taxes instead of whatever else they would prefer to be spending their money on so there are some definite challenges coming towards market hospitals but colleges and universities especially uh are going to see some big changes wow i mean just walking through all of those changes i've had a hard time keeping up with what's happening in the credit markets the muni markets even more so just so many different pressure points and you know places that still look interesting and then places where the next couple of years are just going to be a whole new universe for so many i think that the colleges and universities are particularly interesting because there's there's no measure of what's the the upgrade downgrade ratio of headlines around the sector but there are very few positive headlines about the sector all the headlines are negative and that gets reflected in spreads and yields on the sector there are absolutely schools are going to be winners they're going to figure out how to navigate through all of this there's other schools are going to be challenged by it so i think that retail investors retail smas um there will be some sensitivity to the headlines a lot of portfolio managers just don't want to get involved in the headlines take harvard university i think there's been a lot of investors who have sold harvard but harvard is now cheaper spreads are wider there's been buyers of harvard yeah who are yeah they want to own harvard harvard's not going out of business are there going to be more headlines about harvard probably but for the investors who are paying attention there's going to be some good opportunities yes absolutely with volatility there is always opportunity and we just have to keep reminding our clients of that and try to stay on top of the drivers of volatility so we can make good calls so speaking of volatility etfs let's talk about those that you i feel like like as a child you just dreamed of being an etf guru you didn't even know that it was going to be something that existed but you know in your wildest dreams etf guru is top of your list well it's funny you know i've been in muni lane my whole career and i looked around and i wanted to learn more about etfs and you know 10 plus years ago i looked around and most of the etf people they didn't understand bonds they didn't understand fixed income they didn't understand fixed income portfolios and how etfs could play a role in portfolio and so i set out to learn more about it and ended up becoming the expert in the space it's super interesting right now you know munis are uh particularly interesting but you know i do follow all the fixed income etfs um you know a couple of things that have happened recently in muni etfs but apply elsewhere just you know last month we had two more muni etfs were launched alliance bernstein announced that they're going to convert two of their billion dollar plus open and muni mutual funds into etfs but that's that's a huge event there's been other sponsors who have also converted muni mutual funds and etfs but that's a big decision because it requires rewiring all of the all of the back office of those funds maybe not a single security changes hands but all the plumbing of who owns those shares how do they get how does the bookkeeping work out of the fees and everything that support the fund pay for the fund the overhead how does that work so everything's got to get rewired but we're going to have two large billion dollar muni etfs joining the 128 etfs that are already out there right now there's 500 muni mutual funds we've got 128 etfs how much room is there for more i don't know in some ways the market needs more large etfs i've had lots and lots of questions from folks about a tariff independence day and you know the market was extremely volatile that that week a lot of a number of etfs were losing assets and a lot of bonds were coming out of those etfs at the end of the day the authorized participants they're not like a dealer desk typically that wants bonds to feed their distribution channel the authorized participants they're not investors they're traders so if they are redeeming shares and taking a basket of bonds they generally are going to want them out of the out of their risk as quickly as possible so those bonds get fed out into the street it hits the prices pretty quickly and that's really what we saw uh in april i've been going to a longer philosophical discussion of is that good or bad but it just is and if you look at the muni market 128 etfs uh the two largest muni etfs mub and vteb they those two etfs represent two-thirds of the daily turnover of the muni etfs and those two etfs represent 50 percent of the aum of the muni etfs so i think you know 128 yeah yeah it really is and so if you think if the market is moving yes there's a benefit to investors to get in to get in and out of the shares quickly the secondary market is really efficient but when when the secondary market moves are sufficient that shares need to be created or worse redeemed and therefore feed bonds into the market having so much of the the market relying on two etfs uh is really heightened volatility and creates a kind of a potential for disruption and the disruption volatility would be a better word to use so i think the market as it matures the market needs to have more of these really large etfs that have large positions large numbers of qsips and large secondary market trading flows yeah that makes a ton of sense so the two mutual funds that are being converted to etfs do you think that that is a function of client demand or a function of mutual fund provider would they prefer to be operating an etf or is it that clients would be preferring to buy etfs rather than mutual funds i think it's the uh the sponsors recognizing where's the puck going where's the puck going to be in five years where's the main going to be in five years etfs are the the easy button of bond investing and as as markets get more complicated a lot of advisors a lot of investors like to have the easy button even if it's only for a part of the portfolio mutual funds are not going to go away but the the ecosystem that distributes mutual funds is is changing and in flux and there's a whole generational growth of investors who are in accumulation phase who aren't going to be a part of the mutual fund distribution channel it's easy for them to use etf so i think we're going to see more more growth in etfs but because i think there is limited amount of shelf space in the marketplace i think sponsors need to be thinking do i want to be in this business in five years and if so i need to stake out stake my claim and be in that part of the market yeah i think that that mentality is pervasive across a lot of lines of business right now as we all talk about ai and technology and innovation i know uh here at credit sites it is a hot topic how will we be delivering research how will people be consuming research over the next one three five twenty twenty five years we're about to celebrate our 25th anniversary at credit sites which is very exciting anything else on the etf topic that you wanted to highlight you do track so many of the flows not just in munis but also in corporates and you know looking at some equity flows as well which have been interesting any any big tidbits for us to share today um i think just the the most important thing i alluded to this earlier is i think it's really important for fixed income market professionals to be paying attention to the fixed income etfs you don't need to be involved in the space but i think the the the intelligence that you can get about what's going on with supply and demand is unique with the etfs and because they're exchange traded a couple of things that i watch of course asset flows which everybody watches but also the turnover what's the dollar value of shares traded and how are shares closing relative to their nav um our month our weekly reports we put in the us weekly includes the friday close uh premium versus discount on the etf so if you see that lqd is closing at a nice premium on friday you should expect that there's going to be some share creations and positive trading action on monday so you don't have to be active in lqd to find that information informative so and of course we're always here so you can always reach us on and ask an analyst or ib chat on bloomberg or whatever have an answer questions that is so helpful pat and i think that you're absolutely right so many people involved in the fixed income market they have kind of a high concept idea of etfs and look at navs on a regular basis but really dialing in the connection between what is happening within etfs and what that is going to mean for cash positions is absolutely crucial especially in periods of volatility and expectations like when the fed is starting to cut rates exactly and one of the things that we started adding to the weekly report is within ig etfs for example how much of the flows are going into or out of ultra short short intermediate and long-term strategies it's not just a top line number but the details are really interesting too yeah that positioning across the curve has been a really fascinating evolution for the past few years and i have a feeling that it's going to continue to evolve in the coming months for sure all right pat it is always such a delight talking to you i always learn a lot about the world of munis try to figure out where we may send our kids to college and university in the coming years and of course your expertise on etfs is just very much valued by the credit site strategy team and our clients as well well thanks when it's great to see everybody today on the podcast i know isn't it fun all right thank you all for listening for perhaps watching us on youtube if you ever have questions for me for pat for any of our guests on the credit sites podcast you can reach 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