Capital Markets Coaching Clinic: Municipal Bond Overview and Outlook

Capital Markets Coaching Clinic: Municipal Bond Overview and Outlook

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Erika 00:10
Our event today is part of the Delaware Investment evolving advisor practice management program. The Evolving Advisor is focused on developing forward thinking wealth managers. Whether that's keeping you ahead of the curve when it comes to technology and social media trends or if that's helping you with learning about the markets from our team of experts or simply making your day more efficient. We strive to be your partner in growing your business and serving your clients. This little housekeeping before we begin here in order to better serve you with this content in the future we'd love your feedback via our survey tool. We have that widget below in your screen. Also feel free to access our presentation materials today via the resources widget below our slide window. Finally, please stay tuned at the end of our presentation for information regarding your CE credit. Now we'll get started. Our presenters today are two of that team of experts that I mentioned earlier. To get us started please welcome Zoë Bradley.

Zoë Bradley 01:19
Thank you Erika and thank you to those of you listening in. This is Zoë Bradley and I'll be your moderator for today's session. I welcome you to the Delaware Investments Municipal Market Overview and Outlook. It has certainly been an interesting year and unexpected results. Today we will focus on the drivers of the market performance so far this year and provide a brief look into what lies ahead for the Municipal Market in 2015. Our guest speaker today is Senior Vice President and Senior Portfolio Manager Greg Gizzi and Greg has over thirty years industry experience and has been with Delaware Investments since January 2008. And we are very excited to have Greg with us today.

Greg Gizzi 02:03
Thanks Zoë

Zoë Bradley 02:06
So we are going to go ahead and get started and as I mentioned it really has been an interesting year for municipal bonds. The landscape has definitely changed relative to 2013. Can you provide us with a year upon year performance comparison.

Greg Gizzi 02:19
Sure, I think in a nut shell what we have seen in 2014 is a reciprocal of what we experienced in 13 and I think the best way to set up and review 2014 is to go back to 2013 and talk about what happened in 2013 specifically for the municipal market. Recall in the Spring of 2013 we went through what is fondly referred to now as the Taper Tantrum. When post F1C meeting press conference resulted in some miscommunication between industry and at the time what Ben Bernanke was supposed to be getting across with respect to the tapering of the quantitative easing, which resulted in a rates scare. In addition to the rates scare for the municipal side we subsequently had two credit events which led to mass exodus from tax exempt bonds funds. And those two events were the Detroit bankruptcy filling in July of 2013 and subsequently followed by a series of downgrades by Puerto Rican debt as that situation continued to deteriorate and as a result we experienced over 70 billion dollars in outflows from tax exempt bonds in 2013. Heading into this year in 2014 the overwhelming consensus was for higher rates, and us at Delaware here as well expected to see higher rates by this time, where we sit here today we thought it would be higher. And what really transpired, you guys know as well as I do, we had a number of factors combine to cause the opposite effect. But the important thing for the muni market is that we are extremely correlated to the U.S. treasury rates and with a rally in treasury rates we saw that ensue in muni's as well. But the key for 2014 I believe, coming out of the first quarter where we saw weaker economic growth we have had our series of geo-political events most recently in the last couple of weeks we have seen oil causing mixed signals for the economy and certainly recalibration of global economic growth, or at least questions of recalibration of economic growth that lead us to believe that certainly the market is set up for, perhaps, a lower for longer scenario as we enter 2015. But for 2014 as investors got comfortable that we were not going to see significantly higher rates for 2015 we began to see a reversal in fund flows early in the year and as a result investors began to get comfortable in reaching out the maturity spectrum and down the credit curve and really the municipal high yield sector was the real juggernaut for 2014. Approximately 43% of flows that we have seen in the tax exempt bond funds are coming from that high yield space. And so if you turn to slide 4 it's just a quick depiction, we're looking at different Barclays indices in the fixed income arena, you can see that second bar which shows an 8.50 return for the Barclays municipal aggregate index, which is theoretically the bench mark for all. Most muni portfolio managers it says eight and a half but we've had a rally here this December and we are up over 9% in 2014 for the Agg. 9.05 to be exact as of this morning. That is only surpassed by high yield which is up 14.18% here today. And again the driving factors, investors getting comfortable with the economic back drop and subsequently the treasury rally causing munis to respond as well. If you turn to slide 5 that's just showing you the individual maturity segments within the Barclays index and you can see the light shade of green representing 2013 on the bottom showing the longer you are on the curve the worse you performed and the exact reciprocal on top 2014 curve worked for investors. So the longer on the curve you went certainly the higher the return. Slide 6 shows the same index, the Barclays municipal Agg. index but broken out between credit segmentation, and I want to note that we are including the high yield segment there but obviously the high yield index is not part of the Barclays Agg. But what it demonstrates again, in 2013 the lighter shade of green, the lower you are in the credit spectrum the worse the performance for investors. The reciprocal here in 14 as we see certainly BBB's outperforming AAA's. In fact as of this morning BBB's were returning 13.33% versus AAA's at 6.41%. So in essence curve in credit worked here in 2014.

Zoë Bradley 07:02
Great, thanks for that summary on performance. I have also heard you when speaking with clients talking about positive technical and how they are influencing performance.

Greg Gizzi 07:12
Sure, so without question one thing we talk about to investors all the time is the positive supply demand technical that has driven muni performance in past markets and certainly this year as well. And from that technical, the supply demand technical, and from the demand side we have already noted that we have had a reversal in fund flows. So mutual fund flows, tax exempt mutual fund flows went from negative 70 billion dollars last year to positive 20 billion dollars as of the most recent reading. What also contributed to the demand side of the equation is certainly the amount of cash that has been returned to investors through refinancing or refunding. And I guess the best analogy to use for you guys out there, if any of you purchased a home when you get a mortgage on a home you certainly wouldn't relinquish the right to re-finance that mortgage if rates fell to your advantage. And certainly the way municipal issuers like to issue debt in our market typically we see long terms issuance but issuers will keep a call feature, keep their optionality for the event that rates fall in their favor and they refinance debt and lower their debt expense. And certainly that's what we've seen here and with most term structures having a 10 year call if you look back to 2003, 4 and 5 those were very good issuance years for the municipal market. So last year, certainly this year, and again the expectation for 2015 is to see a fair amount of refinancing activity. So in addition to the new cash that has come into the market, Zoë, as far as the 20 billion dollars in in-flows, we also know, and many of you who buy individual bonds know, the frustration of getting your bond called. But we know that a lot of investors have lost bonds to refinancing and as a result we've been in what we call a negative net supply situation. Simply stated the amount of available bonds to invest in is less than the amount of available cash.

Zoë Bradley 09:22
You touched on high yield performance, and also now on high yield flows. When I think of a high yield portfolio I think of a portfolio filled with below investment grade debt, or in other terms junk bonds. Which we find in the taxable side of the market are muni funds structured similarly?

Greg Gizzi 09:43
This is an important distinction that I think investors in the municipal space, particularly the high yield space, should understand. There are some stark contrasts between our high yield market and the taxable high yield market, or traditional high yield market. And the first and probably the most significant aspect from my prospective is the opportunity set that tax exempt municipal high yield managers have at their disposal. If we look at the size of the two markets, the taxable high yield market is 1.2 trillion in size. 1.2 trillion. The municipal market is approximately 370 billion, the municipal high yield market below investment grade 370 billion. So the opportunity set is less than a third the size for municipal managers that manage high yield funds on the tax exempt side. In addition it has been exacerbated by the fact that Puerto Rico for a long time had been in the Barclays aggregate index when most of Puerto Rico debt had investment grade ratings and what we saw I mentioned 2013 into 14 with subsequent downgrades below investment grade, we saw a migration of all this debt go from the municipal Barclays index into the high yield index. So as a result what used to be a stronger or a higher credit rating in the tax exempt high yield index is now the same as the taxable index. They are both B1'ed. But it used to be there was a contrast in rating. Essentially what this means, and I think the important part for investors to understand, is that there is a limited opportunity set for high yield managers. And what results from this fact, if you turn to slide 9, what you're going to find is the average high yield fund in the municipal space has approximately half of its investments in investment grade paper. Some people refer to municipal high yield as high yield light. And given this opportunity set that is what investors are going to be faced with buying high yield paper as a manager. You are going to have to invest a lot more paper in investment grade paper.

Zoë Bradley 12:08
So essentially Greg what you are saying is that a municipal high yield bond carries a much larger component of an investment grade or higher quality debt than the taxable brethren.

Greg Gizzi 12:20
Precisely because of the limited opportunity set you are going to have a lot more investment grade paper in a tax exempt high yield fund than you'll find in an average lipper high yield taxable fund. In fact the lipper high yield taxable fund I believe is close to 95% in below investment grade paper with a small opportunistic bucket and a cash management bucket. So what managers are faced with is really one or two options. In order to be truly a lower below investment graded fund you have to either use derivatives or in some cases take concentrated bets in specific sectors, say for instance tobacco bonds, NSA tobacco bonds. And in some cases funds will do both. Certainly we at Delaware have the ability to use derivatives but we consider ourselves a traditional cash buyer in the market.

Zoë Bradley 13:17
Great, Greg I don't think we can talk about high yield credit without discussing the fall incidents. Are they still much what we would see on the taxable side.

Greg Gizzi 13:26
That's a really good question and another one for investors to understand, who invest in the space. If you turn to slide 10 this is an interesting chart by Moodies and I will point out certain things. This is the ten year average cumulative issuer weighted default rate. And what is interesting is if you look at the occurrence, this is from 1970 to 2013, let's go to the lowest investment grade category BBB's. The ten year average issuer weighted default rate is .32%. That's versus the BBB taxable level at 4.61%. And certainly the same kind of contrast exists below investment grade paper. But just think about below investment grade incidents at .32% it's lower than the corporate AAA rating for that time period. For the same level of issuer weighted default rates. The obvious question that we get asked by investors this is only on muni rated paper can you say the same thing about the entire municipal place? I think you can. I think basically if you extrapolate using two studies, Kroll Bond Rating Agency did a study where they looked at incidents of defaults, municipal defaults, for all rated paper going from the period of 2008 to 2012 and the incidents of default during that time period was .29%. If you extrapolate that finding with the annual corporate default rate study tracked by SNP for 2012, that had the same time period 2008 to 2012, and the occurrence there was 1.77%. So again that's including all rated paper not just Moodies rated paper. So you can see even in their two studies the municipal occurrence, the occurrence of default, is significantly lower in the municipal product.

Zoë Bradley 15:30
So Greg in essence what you are saying is the investor is looking for higher total returns, choosing to invest in a high yield muni bonds then would be a much less risky proposition than investing in a taxable high yield fund.

Greg Gizzi 15:43
Certainly the numbers suggest that Zoë. And for those of you who do bond portfolios, laddering or buy individual securities you guys know that it only takes one investment to significantly harm a portfolio. This is where I would really encourage high net worth investors to use mutual funds and their credit expertise in order to gain the diversification that you need. You know certainly there is without question a need for certain skill set for analyzing these credits. And I think certainly in the sense of that aspect diversification bond funds offer a distinct advantage over buying individual bonds.

Zoë Bradley 16:28
So let's talk a little bit about rates. As we close out the year and the market focus continues to be on the Federal Reserve and the timing index trajectory rates. Would you anticipate a period of outflow similar to what we saw during the Taper Tantrum.

Greg Gizzi 16:45
Sure, let's go back to the Taper Tantrum and what expired there, and this is something that you should all be aware of. When we go through these bouts of inefficiency I'll call them, when the herd is heading for the exits and we start to see significant outflows from tax exempt bond funds a very similar pattern emerges whereby typically managers will sell what they can at first which is typically high rated security, typically down the curve... down maturity spectrum I should say. But then if we get an incident like we had in 2013 where there is an extended period of outflows what tends to happen is the lower quality paper tends to catch up and certainly if we look at flows in high yield funds last year we saw about 15%... the average lipper high yield fund lost about 15% of flows through the course of 2013. While all other funds, tax exempt funds, only lost about 7%. And I think that the combination of not only the rate scare but in conjunction with the two credit events where we had Detroit and Puerto Rico permeate the news every day certainly added to peoples concern about high risk municipal bonds.

Zoë Bradley 18:10
Great well that certainly summarizes what would typically occur during a rates scare but in your opinion what would be the reaction in high yields space when the Fed does actually begin raising rates.

Greg Gizzi 18:22
So predicated on a rate hike which we believe will ensue some time in 2015, I think the trajectory of rates will be the key. And what I mean by trajectory of rates if there is an orderly rate rise it's well communicated to the street, we certainly feel that high yield has the potential to put in a positive return in 15. There is really three distinct reasons which you will find on slide 11, that typically that is the case when we rates rise. And the first one is if you think about it intuitively when you are buying high yield paper you are getting higher income from high yield securities. You are getting paid more for the risk. Secondly, particularly now when we are near historical lows in rates, high yield bonds which are offering high incomes typically have high coupons priced back to a shorter call, which in that case when rates do rise the basis point value of their 01 is smaller. So versus say a AA par bond in ten years that is going to track the scale when rates start to rise the impact of rising rates is diminished by the fact that you've got a much smaller basis point value in your 01 with higher coupons being priced to a call. So certainly the idea of crossing over or being concerned about negative convexes will take a long time, a significant rate rise, for that to happen given the current rate structure. And lastly is an intuitive one, if you think about why if we are in an environment where the Fed is raising rates and why they are raising rates presumably it is because the economy is improving and when economy improves certainly the revenue picture improves for the state and local governments. Certainly company profits are higher and typically balance sheets are cleaner. So in historical prospective we see that credit spreads tend to tighten when we embark on situations where we are seeing rates rise. And our feeling is that in 2015, assuming that there is a commencement of rate hikes, we think that those three factors, you know, the structure of bonds higher income and credit spreads being tight but not near all term tight all those factors will combine and certainly help to off-set price degradation that we see from higher rates.

Zoë Bradley 20:54
Okay, Greg I know when you talked earlier about the changes this year relative to last year but let's talk about the market in much broader themes. Certainly a lot of change in the market since the great financial crises but more specifically what changes have you seen in the municipal bond market.

Greg Gizzi 21:12
On the surface the market looks the same quite frankly, if you look at some of the market matrix and, what I refer to as... let's start by observing the size of the market. So if you use Federal Reserve data going back to 2008 the municipal market at the end of 2008 was 3.517 billion. And as we sit here today we just received the most recent data last week for Q3-14, the market sits at 3.63 billion. So not a significant difference in size. And if we look at the composition of holders within the market the same story is told there, not a big difference. At the end of 2008 about 76% of our product was held by individuals. As we sit here after Q3-14 data was released we are at 71%. So not a major difference in the composition of ownership and that's why we saw in 2013, quite frankly, that we are susceptible to these bouts of inefficiency where we get the herd heading for the exit and certainly redemptions are one thing that the fund managers are always worried about. But keep in mind that that can also help to bolster returns in times where the herd is looking to buy bonds and we're in low supply periods. Which there have been period in 2014 certainly earlier in the year where we saw that occur. But as far as what has changed I go on record as saying I think the great financial crises for the municipal market was probably the most transformative event for the municipal market really since the tax reform of 1986. And the reason I say that is four fold and they are on slide 12 if you following along.The first one is let's talk about mono-line insurance. So in 2007 we all know that mono-line insurers blew up in the market and they lost their AAA rating. If we think about what the market looked like in that time period. In 2005 the municipal market hit it's peak with insurers having a market share of 57% in new issue product. 57% of new issues came with one of the mono-line insurers wrapping the credit. If you throw in the secondary insurance that was involved at the time with a lot of people taking advantage of the spread of the going out and insuring bonds in the secondary market, that number was in the low 60's. So you essentially have a fairly commoditized market and what we tell people when we talk about time period is 2007 represented a change in the market. And that's when the municipal market went from being a rates market to a credit market. And certainly all you guys who have been in the market for a while buying individual bonds it was certainly a lot more comforting buying bonds with a AAA wrap on them and often times people wouldn't even look at the underlying rating. And certainly now with the elimination of mono-line insurance for the most part you definitely need a skill set to assess underlying credit. Just to put it into perspective the market share today for insurance in the market is 6%, roughly 6%. So we have gone from a market that was 57% insurance in 2005, primary new issuance, to roughly 6%.

The second thing that I think has played a roll is consolidation within the dealer market. Certainly we saw a number of entities emerge during the financial crises. This reduced the amount of trading debt that we have for liquidity. Certainly firms don't double the amount of capital when they combine two entities. I'll say that we haven't really had, other than last year, where we had the onslaught or the tsunami of redemptions. In 2014 we haven't really had any significant outflows or bouts of inefficiency where we needed to test liquidity but at the end of the day certainly I can envisage markets where, if we do get in a situation where liquidity is in question, the smaller amount of dealers could come into play as far as providing liquidity for the market place. And I think probably one of the most significant aspects during that time period was the creation of the Build America Bond market, or BAB market as we referred to it. Go back to 2009, those of you that are maybe intimately familiar with auction rate securities. Auction rate securities were upside down, essentially the municipal market was frozen and in February 2009 we had President Obama sign the American Recovery and Re-investment Act. In that act was the creation of a new taxable municipal bond that had the added feature of a 25% subsidy. The period lasted for the balance of 09 and all of 2010. 181 billion dollars of debt was issued through the Build America bond market and the only reason I mention it is not for those statistics but Investment Banks like yourselves looked at this market opportunity and I think a lot of them thought that perhaps it was going to be around permanently. And there was a concerted effort on behalf of Investment Banks to literally go global and teach the municipal product to global investors. And while the history lesson would suggest that perhaps that time frame the success level, the success rate, was not that high. And I say that because if you look at the current ownership of BABs the vast majority of those bonds are in life insurance company portfolios. It's the perfect asset with a long term cash flow matching up with long term liabilities. But certainly that introduction to our product I believe has served the market very well during the infamous 60 minutes episode which brought on prognostications from a well known bank analyst of hundreds of billions of dollars of municipal default. We saw 53 billion dollars in outflows result from that.

And certainly last year in 2013 with the post Taper Tantrum outflows it was non-traditional buyers that really came into the market place and began to turn the market around prior to seeing the retail flows turn positive. The Banks did an effective job teaching this product to a vast array of buyers and if you look at some issues today in the market place we see a vast array of accounts emerging market debt buyers are in the market, sovereign debt funds, distress funds, numerous types of hedge funds, core taxable accounts. Traditionally I've been in the market since 1984, traditionally the only dependable 'cross-over' buyer you could rely on were property and casualty companies and their involvement would be predicated on their need for tax exempt income. I will say that this one factor in the markets has made municipal bonds a veritable asset class for total return accounts. And I think as we go through in future markets here and we get into situations where we are not getting liquidity from the traditional holders it will be these non-traditional buyers who know our product now that will aggressively come in and buy bonds when ratios get to certain levels.

29:00
That's really the keys here. Not to go off on a tangent but we look at the market from a crossover standpoint from a taxable equivalent yield basis. We look at municipal ratios where AAA G.O., bases on the muni market data scale, where AAA G.O.'s are trading as a percentage of treasuries, I can't say AAA treasuries anymore. And where municipals get cheap to historical cheap levels, we see the involvement of these type of buyers become very aggressive. And so not to labor the point but I think that the BAB market and the effective marketing that was done certainly is going to serve the market well because we have broadened our audience, is the bottom line from the municipals perspective. And the last point I want to make is that time period obviously brought a lot of scrutiny on the economy. The weak economy, government spending and particularly the nations deficit essentially what we eventually got was higher tax rates. And we can all attest to that having visited our accountants last March and April. Higher tax rates have only made the municipal product a value proposition. Certainly added to the attractiveness of municipal bonds so I say it's transformative in a major way and again it's the loss of insurance the loss of the mono-line insurance AAA rating and the subsequent loss of market share by those entities, consolidation in the oil community, obviously the creation of the BAB market and the effective marketing of municipal bonds to many buyers globally and certainly higher tax rates.

Zoë Bradley 30:47
Thank you Greg and in speaking about higher tax rates we are all painfully aware about increases last year. Can you tell us how these changes have impacted your market.

Greg Gizzi 31:12
Certainly, I think the best way to look at the impact of taxes is to look at what we call taxable-equivalent yields and this is going to be found on slide 13.Taxable equivalent yields simply stated is a formula that calculates what an individual investor must earn from a taxable investment to equal the tax exempt return from a municipal bond. And on slide 13 what we have done here is use a bond that exists in the market today, New York City Water & Sewer 5 Sub43 at that 3.26 yield that we are showing there. And if you go back to the pre-2013 tax hikes if you look at that bond in the taxable equivalent yield to investors that bond did a 3.26 return 5.74 under the prior tax rates. So irrespective of any other change just simply from supply demand, irrespective of all those factors. If you just look at the impact of higher taxes and you go to our new higher marginal tax rate which for a New York city resident would be 51.07% that same bond at that same yield as a result of higher taxes now yields a 6.66. So an investor has picked up over 90 basis points of taxable equivalent yield just as a consequence of higher marginal tax rates.

Zoë Bradley 32:29
That leads me to our next question Greg. I have been hearing a lot lately that financial advisors are using municipal bonds in their IRA and tax deferred accounts.

Greg Gizzi 32:41
Yeah, it's a question we've gotten on the road quite a bit, you know I've gotten an account this week and why are there muni's in an IRA? And it goes back to the ratio example I just spoke about in the last response. What that means is basically an F.A. was able to buy a municipal bond that had very similar characteristics to taxable alternatives. So similar maturity, similar coupons, similar credit rating etc. But they were able to buy a bond that was trading on a nominal basis in excess of 100% of where the taxable alternative was. So irrespective of its tax exemption which obviously in a tax deferred account you are not concerned about, they were actually getting higher return from those bonds. So it is not uncommon to see that and we get that question all the time now.

Zoë Bradley 33:42
You mentioned the muni market experiencing negative supply in 2014 and that we potentially will be seeing the same conditions moving into 2015. What is causing this lack of supply and what would have to happen in your mind to change that?

Greg Gizzi 33:57
The supply demand technical I referred to earlier we have talked about the drivers of demand side, with positive cash flows into the funds and the amount of refinancing that has gone on, maturities and redemptions occurring. But from the supply side there is really a confluence of a few factors that has caused supply to be diminished here in this environment. And the first one really is the function of our hangover from the great financial crises. I would say we are still in a belt tightening mentality, certainly at the municipal level, as far as new issues go. There has been, I would say, an uneven recovery in certain states. Particularly the coast and certain oil producing natural resource rich states in the centre of the country have done very, very well and recovered quickly. Other states not so well. And while states are still contending with high unemployment rates and worrying about pension contributions we are not in a mentality of going out and spending, borrowing and spending, to create projects and, quite frankly, I would argue that now is probably an opportune time to do that. Certainly being near historical lows in rates it certainly looks like a cost effective time for issuers to take advantage of that.

The second factor contributing to lower supply is the structure of the market place. And again those of you who buy individual bonds will know exactly what I am talking about. If you look at where most deals are priced, from an institutional perspective certainly, if you have a 5% coupon somewhere in the 10 or 15 year part of the curve and you are pricing that bond back to a call the dollar prices that are in the market, there is a significant amount of premium. You are paying 120 odd dollars for bonds out there so if an issuer needs to raise money premium is considered. So let's say an entity needs 200 million dollars for a sewer project, they can probably obtain that with the amount of premium only selling it at 175-180 million dollar deal.

The next factor is one that is difficult to get data on but certainly we have seen a distinct pick up in the amount of direct lending that banks are doing directly to municipal issuers. Circumventing the normal underwriting process. It's something that we are looking into further that maybe we can talk about some time but again we know it's been higher we just don't have any significant data on it. Lastly, I'll share some comments that came from a conference I attended in D.C. that Morgan Stanley sponsored this summer. Where there was an issuer panel discussing this exact topic about suppressed supply. And I thought there were two interesting points that came out of that panel. The first relating back to our BAB example. We had a fairly large utility C.F.O. that basically told the audience that when BAB's were made available he used the BAB market because of its cost advantage and basically pre-funded his cap ex for the next five to six years. So what he said as far as this current new money supply in tax exempts was concerned typically that would be between 300 and 400 million dollars a year. He told the audience that if he did a 100 million dollars a year for the next three years that would be a lot. So certainly that has probably been a factor in a lot of issuers taking advantage of BABs and therefore pre-funding a lot of the needs that they were going to see in the future.

The other thing that came out of that that I thought was interesting, given the competitive environment in some parts of the country, we had an issuer tell us that... this was a very large toll road issuer, told us that when they put out their contract for the actual work when the bids came back they were significantly lower than the estimates they had used on what it was going to cost. So they found themselves borrowing less. But certainly it's not any one of these factors Zoe, it's a confluence of all these factors. The mentality, the belt tightening mentality that still exists, the market structure adding premium to issuers pockets, the amount of direct lending that is going on, that we really don't see but we know is going on. And certainly the competitive environment suppressing costs of projects, which has led to lower supply from the issuers standpoint.

Zoë Bradley 38:52
It sounds to me like you are suggesting that conditions will remain somewhat the same in the near term. Would that be a fair assessment?

Greg Gizzi 38:56
Yeah, I think it's fair to say the factors that exist in the market place today can certainly be effecting us as we move into the near future here. But before we give you guys this information we appreciate the inherent bias in what we are going to tell you based on where it's coming from. But on slide 16 a report came out this summer from the American Society of Civil Engineers and they estimate that by the year 2020 we need 3.6 trillion dollars in repair and refurbishment for our infrastructure. Do you want to guess what the size of the market is?

Zoë Bradley 39:43
3.6 trillion?

Greg Gizzi 39:54
Yeah 3.6 trillion. So in essence what I am saying is there is a shadow market out there a shadow calendar if you would, of significant infrastructure need that is going to need to be financed. President Obama two and a half/ three weeks ago just got back from China, I don't know if you had the opportunity to hear this but, he said that he was so impressed with the infrastructure that existed on his trip to China. He got back to the U.S. and he called the state of our infrastructure 'embarrassing'. And certainly anecdotally you guys can all attest to your local papers when not a week goes by where some bridge isn't out or a gas line has ruptured or a water main break has occurred. There is a significant need for infrastructure financing. Unfortunately the question becomes when is this a high enough priority for the constituents to attack this problem. But we do think it is going to occur and so the good news is for investors I do think there is going to be ample supply in future. One of the things that we anticipate will happen and we have seen some of this already occur in certain sectors in the municipal space. We see an increase in the amount of what we call P3's, or public private partnerships. And essentially what that is a municipality will team up with a private investors or private investors for the design, construction and financing and ultimate maintenance and operation of a project. And like I said typically we have found these in the transportation sector so far but certainly we envisage other sectors like water, maybe gas utilities, certainly other areas which we think the P3 structure will be a viable form of financing for our market.

Zoë Bradley 41:32
Earlier you talked about the Build America Bonds and how they came into play in 2009. What is the possibility that that market could be potentially resurrected?

Greg Gizzi 41:45
Zoe, it's a question we get asked all the time and I think the answer is not likely. We certainly have seen BAB like structures introduced in various pieces of legislation. Last year President Obama proposed we create America Fast Forward Bonds, which essentially was a BAB like product with lower subsidies. It wasn't a 35% subsidy it was a 28% subsidy. I don't believe much in this situation with just simple infrastructure financing. I don't believe the political will is there for continuing or resurrecting a BAB market. So I don't think that is going to happen any time soon.

Zoë Bradley 42:25
Okay let's move on to a hot, hot, hot topic that seems to be coming into play lately - liquidity. Would you agree there is still strong liquidity in your market.

Greg Gizzi 42:37
Yeah, I would say overall that liquidity is good despite ... I mentioned that we were concerned the potential impact that consolidation may play on the market at some point. But liquidity is good and I think the key for you guys out there to keep your eye on is really the weekly fund flows. As long as there is ample enquiry that is coming from buyers who are looking to invest liquidity will be good. Certainly we all know that under the volcker rules new banking regulations will go into effect. Various analysts out there talk about below historical holdings for dealers currently in the market place. Look we are in a market that has done well. It has both traditional and non-traditional buyers in the market currently right now. But certainly if we get in a situation like 13 where there is a tsunami of redemptions we will get tested. The joke on our desk is that muni liquidity is good until it's not. And I think that still holds true. But currently right now liquidity is good.

Zoë Bradley 43:46
So in your opinion what should investors be focusing on as the market rally has brought muni rates down near to their all time lows.

Greg Gizzi 43:55
I think the key for investors obviously is the elephant in the room - when will the Fed begin to raise rates. And certainly that calculus has become a lot more difficult here in the recent weeks as we have seen re-igniting concern over Europe. China and Japan again slowing. Oil sending signals out to the market place, some good , some bad. But essentially the key will be when in fact the Fed begins to embark on its rate hikes. And certainly I think from our perspective while the consensus moves with each piece of data it seems, but the consensus seems to be some time in the middle of 2015. I think the only thing that we would add from a Delaware perspective would be we think the goal of the Fed, particularly Chairman Yellen, at this point would be to make sure when they embark on this rate rise that the economy is going to be able to withstand it. Our call would be they have different targets that are in the market place certainly we are not even close on the inflation target but presumably if we get to that point we think that the Fed will demonstrate some patience to be sure that the market can withstand rate hikes before they embark on this. Because the last thing they want to do certainly is to start hiking rates and to have to reverse course. But from an investing standpoint it's extremely difficult to tie markets. Fair to say that we believe the next major rate move is higher not lower but certainly it may take longer to come to fruition than I think a lot of people believe at this point.

Zoë Bradley 45:41
Greg, with respect to market cycles and timing, in your opinion is there a preferred entry point where investors should put money to work?

Greg Gizzi 45:47
So this is one of my pet peeves because the introduction of what I'll call the group of total return players has I think somewhat distorted the view of muni's in the traditional sense. We think thta muni bonds still represent a real specific role in a portfolio. And specifically what that is is a tool for the preservation of wealth. It's not a tool for the creation of wealth although with some of the outsize returns that we've had in recent markets 2012 and certainly this year, it certainly looks like an equity like instrument. I want to remind investors that from historical perspective and I think even today the real effective use of muni's is for getting a stream of taxes and income, optimizing that stream and minimizing the risk in doing so.

So preserving wealth but certainly optimizing the income you can derive from that wealth I think is the key. And again I don't want to harp on this but I think the key to investing is diversification and I think from an investment standpoint I would argue that if an investor gives an F.A. a million dollars to put into the market place, if you put a million dollars into a fund, a typical Delaware fund, you are going to get a couple of hundred if not more holdings in the fund. You are certainly not going to get a couple of hundred holdings in a million dollar ladder portfolio. So again I encourage people to consider using funds. But let's talk about timing the market or trading the market. If you are taking a gain or trading the market most likely it's to take a gain and if you look at 2014 as an example we spoke about the rate rally being the key. Our ten year AAA MMD scale has fallen about 80 basis points and it's about 130 basis points on the 30 year. So you certainly had ample opportunity for capital appreciation. But let's think about what that really means. So if I am buying a bond and I turn around and sell it because I have a 130 basis point gain on it it's a nice gain but I am creating a gain where typically I am trying to use that instrument to have a long term cash flow, a tax exempt cash flow, off that instrument. And something that is near and dear to our hearts, when you do that the fact that you are able to do that you are reinvesting in a much lower rate environment. So you have what we call a reinvestment risk that you have to try to time. And what I mean by time is you're certainly not going to sell a bond at today's level and when it cheapens up 10 basis points put the money back in because all you have done is significantly affected your cost basis and impaired the investor. There is a time to sell and to create a lot of trades in a portfolio I believe. I think it's really in the other case when we get rates rising significantly and in those cases you have the ability to do what are called tax swaps. Where you can take an instrument and swap it for another instrument and increase your yield not decrease your yield in the portfolio. And we certainly do that, being a tax efficient manager at Delaware, we do that every opportunity we can.

And the other thing I want to point out to investors, I think it's pretty important to understand, if you look at slide 18, if you go back to the inspection of the municipal Agg. and we are using the muni Agg. as a proxy for the market. The average return of the municipal Agg., the Barclays municipal Agg., since its inception in 1980 is up 7.3%. So again go back to my statement about what we believe muni's are for. For the wealth preservation part of your portfolio that's a very handsome return in my opinion for something that is a fairly staid asset class. And if you look at that slide a little bit closer it has the ten year average standard deviations. Muni's have a significantly lower standard deviation than certainly corporates or obviously equities. So I guess what the return experience suggests is that buy and hold is certainly a viable strategy in the municipal product.

Zoë Bradley 50:13
And in speaking about risk, one of them being reinvestment risk what other factors should investors be concerned with and more importantly Greg, what worries you?

Greg Gizzi 50:22
It's anything that is going to cause a tsunami of redemptions that we saw in 2013. Anything that could repeat that. And there is really three things to consider and again this is where we started our conversation - anything that can spike treasury rates given our high correlation is a threat to the market place. We certainly don't see that right now but you have got to be aware of that potential. Any new credit scare and the reason that I want to underscore 'new credit scare' something else that investors should be aware of. The news tends to navigate towards the municipal market when bad new hits. It's typically not front page Wall Street Journal news when something good happens in the municipal market. But typically we get a fairly consistent response when bad news comes out a credit scare like we saw in Detroit. Most investors, the retail herd, will sell first and ask questions later. What typically happens in all credit scares you get somewhat of a compartmentalization of things and new news on an old topic becomes less impactful. Any further news on Detroit or Puerto Rico at this point I think people understand the issues and pretty much understand what the most likely course of events will be in those situations. But any new credit scare of that type of magnitude could precipitate redemptions as well. And the last thing is tax reform. Certainly we talked about taxable yields being enhanced by higher taxes. If we saw significant tax reform where brackets were lowered, perhaps even the exemption was capped, that certainly would change the value proposition of municipal bonds. Those really are my three concerns on an on-going basis.

Zoë Bradley 52:17
And then speaking of tax reforms in the wake of the November elections how likely is tax reform in the coming year?

Greg Gizzi 52:23
Well the mid-term elections came in almost exactly as analysts had predicted. The Republicans kept control of the house, took a majority in the Senate. Did not gain a large enough majority, however, to over-write a veto. And with two years left in President Obama's term I think the obvious answer is that what we are going to see is grid-lock. So I don't expect we'll see any significant attempt at tax reform until we get an new administration in the White House.

Zoë Bradley 52:54
Thank you Greg you have given us a lot of very good information so far. But in closing can you share your thoughts on overall outlook for the market in 2015.

Greg Gizzi 53:23
Sure, as we head into 2015 as I said earlier there is certainly a litany of factors that could contribute to a lower for longer scenario. I mean lower rates for a longer period of time. We weathered a lot this year and though certainly there seems to be a dichotomy occurring whereby the U.S. economy continues to recover. Certainly on a sub-standard basis if you look at post recovery, historical recoveries, but a consistent basis. And that is off-set by the fact that things seem to be getting worse globally. And the one thing I want to advise investors is to keep your eyes on international flows. We may mention to our investors all the time, it was marketing this summer where I suggested that if you looked at where U.S. ten year treasury yields were in the global landscape. I was marketing back in August and talking about those two, Italy and Spain, being only 30 and 40 basis points respectively behind U.S. treasuries when at the height of the crises they were close to 600. And as we sit here today those two Sovereign Debt issuers are trading through U.S. treasuries. So there is a value proposition attached to U.S. treasuries from a return standpoint and certainly with a stronger dollar an incentive for flows to come into the U.S.

Even if we were to, let's say, stick onto the consensus schedule, which is for rates to begin rising by the middle of next year, I think there is an argument to be made that we may not get a significant rate rise. Particularly on the long end of the market. We at Delaware are looking for a bare flattener to occur, whereby the front end of the curve adjusts more than the long end of the curve. But I think the real key for us again will be treasury rates since we are so highly correlated. But more specifically the muni's will be flows. And certainly if the Fed embarks on a rate rise and the trajectory of rates is one that is consistent and well telegraphed we think that 2015 can still, despite where we are from a historical rate perspective, we still think 2015 can result in positive flows. As income earner will out weight any kind of price degradation occurring from higher rates. We are optimistic, certainly, that things could go well in 2015 again.

Zoë Bradley 55:46
That is good news for investors for sure. Greg I really want to thank you for your time today. We very much appreciate your thoughts and insights.

Greg Gizzi 55:55
Yeah and I want to thank all of you for taking the time to spend some time with us this afternoon. On behalf of the Delaware municipal bond team I want to wish everybody healthy and happy holidays and certainly a prosperous New Year in 2015. I think Erica has a couple of things...

Erica 56:10
Yes thank you again to Greg and Zoë for sharing this conversation with us this afternoon. If there is any questions or for more information on the municipal bonds markets or other investment commentary from the muni bond team, such as their 2015 outlook which will be out in the middle of January, please visit Delawareinvestments.com. To learn more about the evolving advisor practice management program follow us on Linkedin or visit our website. Or give your regional director for Delaware Investments a call. To find out who that is visit delawareinvestments.com/practice-management CE credit for this event will be e- mailed to all live attendees one hour following our event today and again if you have a minute we would love to hear from you using our survey widget below. Thank you again for your participation and to echo our presenters - We at Delaware wish you a very happy and especially us a healthy holiday season. Thank you.


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