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CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association.
Today, we are joined by Rob Amodeo, Head of Municipals at Western Asset. Western Asset is an affiliate of Franklin Templeton, where the firm has successfully managed US municipal assets since 1984. With nearly four decades of average experience, the Western Asset Municipals Team seeks to identify long-term fundamental value, inefficiencies, and opportunities in the US municipal market through top-down macro assessments, deep credit research, and relative value analysis.
The Western Asset Municipal team manages three municipal closed-end funds: Western Asset Managed Municipals Fund, ticker NYSE:MMU, Western Asset Intermediate Municipal Fund, ticker NYSE:SBI and Western Asset Municipal High Income Fund, ticker NYSE:MHF.
Rob, we’re happy to have you with us today.
Rob Amodeo:
Thank you for having me, and I look forward to our discussion about the opportunities in the municipal bond market today and, of course, how we approach them at Western Asset Management. So thank you.
CEFA:
Rob, the municipal bond market presents a broad and diverse range of opportunities for potential investment. In managing MMU, SBI, and MHF, can you discuss the investment team’s core strategy?
Rob Amodeo:
Sure. At Western Asset Management, we’re all about active management, and what that means is, we’re really looking to identify the best investment opportunities that the municipal bond market has to offer, and then we look to deliver those opportunities to our clients within an actively managed, well-diversified portfolio. So specifically to MMU, SBI, and MHF, which are the symbols of these closed-end portfolios. Each of them is unique, and yet some of them are very similar to one another. So first, the similarities, they’re all national portfolios, so we invest in every part of the United States and its territories, so every region, whether it’s down to the town level or municipal authority at the town level. Now the difference, though, is in terms of credit allocation as well as their duration or sensitivity to interest rates.
So MMU, which is… We call it a managed municipal portfolio. Again, it’s a closed-end fund. It’s a national fund, but its durations are longer than most of the other portfolios. So it’s considered to be a bit more sensitive to changes in interest rates, while SBI is intermediate. So we call out an intermediate portfolio, and all that means is that its duration or sensitivity to interest rate changes is slightly less than that of MMU. MHF, it’s a very unique product. It’s income-biased, and so therefore we anchor the portfolio within, say, the triple B part of the credit spectrum. Its duration is more similar to MMU than SBI as it’s a long-duration product, but the difference across or between these three portfolios, besides the facts that I just mentioned, is, MMU and SBI are leveraged portfolios, while MHF is an unlevered closed-end portfolio.
CEFA:
What is your process to evaluate this investment universe to develop a workable set of potential investments?
Rob Amodeo:
The process to distill down the vast universe of municipal bonds to a manageable set of potential investments is truly a formidable challenge. There are over 1 million CUSIPs in the marketplace. Here at Western, it’s a mix of seasoned professional investment team members and cutting-edge technology that truly helps us sift through the municipal bond market and helps us evaluate the risk in every bond. Of course, we’ll contrast our evaluations to the current market prices. The current market prices are really just where supply meets demand in the market, and we do that to identify, in our view, the best investment opportunities. In summary, I think it’s a unique synergy here at Western Asset Management, this powerful combination of cutting-edge technology and a team investment approach, that enables us to do a few things. One is to cast a wide net really across the entire market, but it also allows us to refine our focus and identify specific investments that resonate extremely well within our value-based portfolios.
CEFA:
How do you then make specific security selections and allocate those positions as you build your portfolio?
Rob Amodeo:
When it comes to security selection, I think the goal is always to strike an optimal balance between, say, navigating risk and maximizing potential returns. So specifically, we begin our security selection process by focusing primarily on three things. Of course, there’s a variety of factors to consider, but the primary things that we focus on are first the issue is credit strength, the sector outlook, and then, of course, the bond characteristics that are attached to the specific investment that we’re looking at. But first, the credit team here at Western Asset Management, we have obviously the global, the depth, and the breadth of the global resources. Here we have a team of credit analysts that are dedicated specifically to public finance, and of course, they’re backed up by the resources around the firm. So if we need to tap into other credit resources from around the globe, we have that opportunity as well.
With regard to our sector outlooks, certainly, with the veteran team that we have here at Western Asset Management, we understand the health and the risk within and across the different sectors, but also, we have a firm view as to where we are in the business, the interest rate, and the inflation cycle. We will call it the macro view, and our sector outlooks are consistent with our firm’s macroeconomic outlook. Then the last part is, you want to look at the respective risk characteristics attached to the respective bonds, and that is coupon, maturity, optionality, and cash flow. When you look at all of those factors combined, then we start looking at our allocations within our portfolio, they’re really guided by a well-defined risk budget.
But also more importantly than just a risk budget. We’re looking at the value of each security and the value that each security offers at the CUSIP level, and then, more importantly, or just as importantly, how well those securities are expected to work by themselves as well as together within the aggregator at the portfolio level. So I think it’s a multipronged approach, but it is really backed up by the breadth and depth of the global resources here at Western Asset Management.
CEFA:
Interest rates have increased dramatically over the past two years. How did your portfolios adjust over this period?
Rob Amodeo:
I think the past few years offered a dramatic amount of volatility, and obviously, we hope that that level of volatility is behind us. I think as an active manager, we look to take advantage of those bouts of volatility, especially during the past few years, I think. Thankfully, our active management style afforded us the opportunity to adjust our portfolio’s sensitivity to interest rate changes by both increasing and as well as decreasing our durations or our sensitivity to rate risk. We also adapted to the volatility by also repositioning our curve exposure. So here, being an active manager, we have the opportunity to buy a bulleted structure, which is just a concentration of small amounts of maturities. We could barbell the portfolios, which is owning a combination of short and long bonds or really a variety of curve exposures, and we did move our curve exposures around as well. Of course, focusing on credit quality to stay ahead of the market. So I think all of those factors combined really helped us successfully navigate the market volatility that we experienced during the past couple of years.
CEFA:
Rob, the Federal Reserve seems to be near the end of its rate-hiking cycle, inflation has slowed but remains elevated, and economic growth has been resilient. We also have significant geopolitical tensions that have added to volatility. Where do you see the fixed-income markets currently and what is your outlook for 2024?
Rob Amodeo:
Currently, fixed-income investments are offering the best values we’ve seen in a very long time. You’d have to go back almost a little bit more than a decade to see better values than we see today. I think also the other important part about being within a well-diversified portfolio and active management-type style, the other benefit of owning fixed-income portfolios that we deliver to our clients here at Western Asset Management is, the diversification benefits of fixed-income are resurfacing, and we haven’t seen that over the last couple of years. So I think a couple of factors. One is, the diversification benefits are improving, and the valuations in the marketplace are much improved over the last couple of years.
Looking ahead, our view from a firm’s perspective is the economic growth is expected to be solid. We’re not expecting extraordinary domestic economic growth, but we are expecting a resilient economy and inflation. Our view, in terms of inflation, we continue to believe that inflation will downshift. It’ll be an uneven path, a few steps forward, a couple steps backward, but with attractive fixed-income valuations that we’re seeing today, a decent economic outlook. We’re optimistic for 2024, and we believe that investors will be rewarded for owning fixed-income securities in ’24. Yet, as always, being an active manager, we’ll be ready to manage our way through any challenges that come at us.
CEFA:
Specifically for the municipal bond market, what are your expectations for new issuance of bonds with regard to scale of supply, quality, and diversification?
Rob Amodeo:
Expectations for new municipal bond issuance, I think there’s a scarcity value to municipal bonds today, and it’s real. There’s been really little, if any, borrowing needs among issuers, and there’s been a decrease opportunity in refinancing older, higher-cost debt and replacing it with new, lower-cost debt. Both of those factors have really dragged supply lower this year. Looking ahead, we’re expecting a modest increase in new municipal bond supply next year, 2024, but in our expectation, nothing that really should upset the market’s balance, so we think a nice, healthy balance between supply and demand. I think, more importantly, the scarcity value that we see in municipal bonds today is more likely to remain in place into the early part of next year. Of course, we’ll be taking a hard look by the end of the first quarter into the second quarter, but we think that the marketplace is in good shape to absorb any potential modest improvement or pickup in supply.
CEFA:
Are you finding municipal bond valuations to be broadly attractive or is this more security or segment-specific?
Rob Amodeo:
It’s a mix of both. I think some sectors broadly offer good value. Just a couple examples. One is transportation. The other water and sewer, just to name a couple. Though, other sectors require a more selective approach, like healthcare and higher education, to name a couple. So I think, in summary, there’s value to be found across various and a variety of sectors, and we don’t really see a fundamental justification for avoiding munis at all. But I think it’s also about picking the right securities, the right names within and across the different sectors, and I think that’s good advice for investors broadly. It’s always essential for municipal bond investors to maintain, in our view, a sharp focus to isolate specific securities that offer compelling value, and that’s how you’re going to differentiate yourself in this type of marketplace.
CEFA:
How do municipal bond valuations compare to taxable fixed income securities?
Rob Amodeo:
I always like to say, and perhaps it’s too general of a statement, but I’ll go ahead and say it. If you pay taxes, it’s always a good time to own municipal bonds, and municipal bonds generally look more favorable than their taxable counterparts if you’re paying taxes. Now, absent that broad and very general statement, I think municipal bonds often provide better after-tax yields than their taxable counterparts, and really make them quite appealing for those investors who pay income taxes. I think in today’s marketplace, when you look at municipal bonds with maturities say shorter than 10 years, specifically where the valuations are, I think they’re more fully valued versus those with maturities, say, 10 years and longer, which we think are offering better value when you compare them to their taxable counterparts. Other than that, municipal bonds are offering compelling valuations just more broadly.
CEFA:
Where are you seeing the best opportunities in the municipal bond space?
Rob Amodeo:
So we’re encouraged by the solid fundamental backdrop in the municipal bond marketplace, and it’s our view that municipal credit spreads should remain stable against this backdrop of a steady economy and a downshifting of inflation. So what we’re eyeing are really allocations toward a healthy dose or a healthy allocation toward single A and triple B-rated bonds, and we also have interest in larger, more liquid, below-investment-grade issuers. So below-investment grade looks attractive to us as well. From a structure perspective, I think one thing that investors in municipal bond market don’t talk enough about is what we call the coupon stack.
You hear that very often from mortgage-backed investors, but particularly the yield spreads between a 3%, a 4%, or a 5% coupon in the municipal bond market for the same issuer can be significant. What we’ve been doing is we’ve been adding to lower coupons because of a couple of things. One, we expect them to outperform. We expect them to outperform because there’s a yield premium where you could earn more income, and also, they afford the investor a potential for improved price action as they come with a better convexity, a lower dollar price, and better convexity. So we’re expecting lower coupon debt to perform better in a lower rate environment, and of course, as we just mentioned, we see better value in the longer end of the curve versus shorter maturities as well.
CEFA:
What are the most significant risks in the current environment?
Rob Amodeo:
The immediate risks that we see to valuations are more likely to come from less favorable market technicals, meaning an imbalance between supply and demand. So we’re watching very closely the cash flows into and out of open-end mutual funds and ETFs on the buy side. On the sell side, obviously, we’re watching very closely the new issue pipeline, and we already talked about that. We expect a modest improvement or pick-up in supply, but nothing to the degree that will destabilize the market. I think other potential risks that we’re watching for certainly include shifts in investor sentiment that could lead to elevated market volatility, and certainly, we’ve experienced plenty of that over the last couple of years. Another factor we’re looking at is potential for regional budget shocks. Although we think that’s a low probability in today’s market environment but budget shocks are always risks that you want to be aware of or potentially be aware of.
Of course, cybersecurity threats. I think the increased use of technology to deliver public services and really to retool and modernize our infrastructure, increased use of technology, and such is leading us down the road toward more potential for cybersecurity threats and, of course, tax changes that could impact tax-exempt valuations. Those are the factors that we’re watching. Again, I think all of those combined are probably low probability events, and I think the greatest probability is more likely a pickup in the imbalance in the market technicals, supply versus demand, but I certainly have a watchful eye for a pickup in any credit rating downgrades from unexpected budget shocks. Again, we think that’s a remote concern today, though.
CEFA:
How are your portfolios currently positioned?
Rob Amodeo:
Our portfolios are positioned to strike a balance between navigating risk that we just talked about while also optimizing returns. I think, specifically, our portfolios from a rate risk perspective or durations, our durations are as long today as they’ve been in 10 years, so we really think that the investor will benefit by having long rate risk, long durations in their portfolio. Also, as we talked about the credit profiles in the marketplace, we think also investors will benefit by being long credit risk, as we say, or being focused on the part of the credit spectrum where we see single A, triple B, and below-investment grade where we see more yield and more potential for total return. So we’re long risks in our portfolios. Now, of course, some parts of our portfolio with long duration, and some of that long duration can be viewed as somewhat of a hedge to offset potential for spread widening, which we think is a low probability event. But for the most part, we’re positioned in a risk-on position in our portfolios, long rate risk and long credit risk.
CEFA:
Rob, municipal bond closed-end funds have been trading at very wide discounts to NAV compared to historical averages. MMU, SBI, and MHF invest in different segments of the municipal space. How do you see an allocation to actively managed municipal bond strategies, best positioned in an income-oriented investor’s portfolio?
Rob Amodeo:
Yeah, I think, in a very direct response, active municipal bond strategies should be a key component of any well-rounded portfolio, especially for those investors who are subjected to income taxes. There’s little, if any, way to shield income from taxes other than municipal securities. The benefits of active management in the fixed income marketplace are known throughout, and here at Western Asset Management, we take great pride in delivering outstanding or superior performance within and across the variety of portfolios that we offer our clients. So I think it should be a key component in any portfolio.
CEFA:
Rob, thank you so much for taking the time to share your thoughts with us today.
Rob Amodeo:
The pleasure was mine. Thank you.
CEFA:
We want to thank you for tuning into another CEF Insights podcast.
