Insights

Active Insights into Municipal Bonds

Aggressive rate hikes by the Federal Reserve (Fed) have taken a toll on fixed income markets, including municipal bonds, during the first half of this year. I spoke with David Blaire, portfolio manager for Nuveen’s municipal fixed income team, to get his current outlook on muni markets, how active management is adding value, and the increasing demand for ESG-focused bond portfolios.

September 23, 2022

Anqi Dong, CFA, CAIA

Senior Research Strategist

Here are excerpts from our conversation.

Anqi Dong: What's your muni bond outlook for the rest of the year? And is it time for investors to add muni exposures back into their portfolios?

David Blair: Our outlook for the second half of the year is constructive. Municipal valuations were rich coming into the year and we saw sharp price adjustments in response to increasing inflation and response from the Fed. But now we're at a point where the inflation outlook is much better, and muni valuations have become more attractive.

While we're not out of the woods yet, we believe inflation has peaked. So, with Fed hikes largely priced in, growth slowing, and more attractive municipal valuations, we think that now is a good time to add municipals to a diversified portfolio.

AD: How do the fundamentals of the muni bond market look and are there any sectors that are particularly attractive to you?

DB: The fundamentals of the muni market are very strong. Strong economic growth over the past couple of years has produced solid revenue growth. While inflation is undesirable, inflation has translated into even higher nominal growth in tax revenues. Many states and local municipalities have successfully managed expenditure growth and have increased their rainy day funds and reserves.

On top of that, many municipal issuers received government support during the COVID-19 pandemic that really helped to avoid budget pressures.

When you look at credit rating upgrades versus downgrades, upgrades far exceed downgrades over the past year, and we expect that will remain the case in the coming months, even though the economy is slowing. We believe municipal issuers are well positioned to manage through a much slower economy — and even a mild recession.

Certain sectors were impacted more dramatically both by the downturn in the beginning of the pandemic and the structure of the economy that flowed out of the pandemic. For example, less travel and tourism put transportation under increased stress throughout the pandemic. And the spreads for many of those credits widened. Healthcare was also challenged despite the support from the federal government. As a result, the spreads for many of these credits have widened, creating cheaper valuations.

We see opportunities for investment going forward with good issuers in sectors that were affected more by the pandemic and are now trading more cheaply.

AD: In this kind of environment, how can an active muni bond fund manager add value?

DB: Active managers can add value in several ways. The first would be staying ahead of the credit cycle and anticipating difficulties that some credits may experience, resulting in downgrades and a cheapening of their bonds. We believe that credit research is essential as part of the municipal investment process. Nuveen has a large, seasoned credit research and investment team, and we're constantly reviewing what we own to ensure that those credits are positioned well going forward.

Another area where active management helps is by leveraging the flexibility to go down further in credit quality to enhance yield. The funds that we manage on behalf of State Street — the SPDR® Nuveen Municipal Bond ETF (MBND) and the SPDR® Nuveen Municipal Bond ESG ETF (MBNE) — can go down further in credit quality. It's not the core part of the strategy, but we can take on a little more credit risk, investing in BBB-issuers and even below investment-grade to a modest extent, to potentially enhance yield. In doing so, it's important to closely evaluate the issuers, particularly in an environment where the economy is slowing.

At Nuveen, we work to properly manage credit risk, both at the sector rating level and at the issuer level. We also identify mispricing in the market and find opportunities where we think credits are improving.

AD: How do you balance between duration and credit risk when factoring in the growth path for the rest of this year and the inflation trends?

DB: The amount of risk we want to take with duration and credit is more measured now because of the uncertainty regarding the path of inflation and growth, and what that means for interest rates. We think rate volatility will remain heightened, even though we're constructive on the direction of rates and the market. The municipal yield curve is still relatively steep beyond 10 years, so we are taking advantage of this and adding some exposure.

AD: There has been increasing demand for ESG focused core portfolios. What unique values do an ESG muni bond exposure add to an investor’s overall ESG portfolio?

DB: There are two aspects to consider. First, most municipal issuers are public purpose entities that support critical infrastructure and services to promote the health, safety, and general well-being of their communities — and that provides a good opportunity set for ESG focused investing. Within this opportunity set, we seek to identify issuers that excel in environmental stewardship and social impact by evaluating issuers on sector-specific criteria that exhibit alignment with the UN Sustainable Development Goals.

Additionally, some bonds are issued specifically for the purpose of creating a direct positive social or environmental impact. Examples of this include affordable housing, clean water, and clean energy.

AD: Can you elaborate on how Nuveen identifies those ESG leaders?

DB: We have proprietary ESG municipal models that were developed through a collaboration by our responsible investing, credit research, and portfolio management teams. We segment municipal issuers by sector and identify sector-specific factors and outcomes that are aligned with the UN Sustainable Development Goals. We then use this data to rank issuers based on ESG outcomes in order to determine ESG leaders and laggards.

So, for healthcare, for example, factors we’d consider would include quality of care, patient satisfaction, and affordability of care. For other sectors such as electric utilities, we evaluate issuers based on renewable energy capacity and targets, affordability of rates, and the reliability of service.

Municipal issuers’ governments are evaluated on a variety of factors that include, among other things, air quality, housing cost burden, income equality, transportation services, and investment in social services.

Our models are continuously monitored by the responsible investing team, and our credit analysts help provide inputs to the team to refine the models. We also exclude certain issuers from our investment set because some might have a controversy surrounding them — such as funding going toward casinos or other projects not aligned to ESG.

AD: How does Nuveen integrate ESG factors into the alpha generation process?

DB: Generally, alpha generation will be driven primarily by duration, curve and credit positioning. Our credit positioning will be affected by the level of credit risk and sector exposures, both of which should look similar to what you would see in our municipal strategies that are not ESG focused. As we identify the specific issues that meet our sector and credit rating exposures, our ESG process will further differentiate what we can hold.

As part of this credit selection process, we seek to identify credits that present value or that are mispriced. ESG is relevant in that it can be a leading indicator of credit. We find that the ESG evaluation process really reinforces our credit process.

Check out the fund detail pages for the SPDR Nuveen Municipal Bond ETF [MBND] and the SPDR Nuveen Municipal Bond ESG ETF [MBNE] to learn more about these strategies as well as how their positioning changes over time, given the daily updates to the holdings and weights of each security. And check in for more market insight and commentary.

Glossary

Active Management
An investor, a professional money manager, or a team of professionals make buy, hold, and sell decisions designed to outperform a specific benchmark or index. In contrast, passive management replicates a specific benchmark or index in order to match its performance.

Alpha
Describes an investment strategy's ability to beat the market and deliver excess return.

Duration
A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.

Environmental, Social and Governmental Investing (ESG)
A set of criteria that socially and ethically conscious investors can use to screen investments. Environmental criteria look at how a company performs as a steward of the natural environment; social criteria examine how a company manages relationships relevant to its operations; and governance criteria deal with a company’s leadership, executive pay, audits and internal controls, and shareholder rights. An increasing number of investments, including ETFs, are now being marketed as ESG-compliant.

Inflation
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Investment-Grade Credit
A fixed-income security, such as a corporate or municipal bond, that has a relatively low risk of default. Bond-rating firms, such as Standard & Poor’s, use different lettered descriptions to identify a bond’s credit quality. In S&P’s system, investment-grade credits include those with “AAA” or “AA” ratings (high credit quality), as well as “A” and “BBB” (medium credit quality). Anything below this “BBB” rating is considered non-investment grade.

Municipal bonds
Commonly known as a muni, a municipal bond is issued by state or local governments, or entities they create such as authorities and special districts. In the United States, interest income received by holders of municipal bonds is often, but not always, exempt from federal and state income taxation.

Volatility
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.

Yield
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.

Disclosures

The views expressed in this material are the views of the SPDR Research and Strategy team and Nuveen Asset Management, LLC through the period ended August 25, 2022, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.

Past performance is not a reliable indicator of future performance.

Investing involves risk including the risk of loss of principal.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

The values of debt securities may increase or decrease as a result of the following: market fluctuations, changes in interest rates, actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments or illiquidity in debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates.

The municipal market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a debt security to decrease. A portion of the dividends you receive may be subject to federal, state, or local income tax or may be subject to the federal alternative minimum tax.

Actively managed ETFs do not seek to replicate the performance of a specified index. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. The Fund is actively managed and may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.

The sub-adviser’s judgments about the attractiveness, relative value, or potential appreciation of a particular sector, security, commodity or investment strategy may prove to be incorrect, and may cause the fund to incur losses. There can be no assurance that the sub-adviser’s investment techniques and decisions will produce the desired results.

ESG considerations may cause a fund to make different investment decisions than funds that do not incorporate such considerations in their strategy or investment processes. This could cause the Fund’s investment performance to be worse than funds that do not incorporate such considerations. ESG considerations also may affect a fund’s exposure to certain sectors and/ or types of investments, and may adversely impact the Fund’s performance depending on whether such sectors or investments are in or out of favor in the market.

The returns on a portfolio of securities which exclude companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio's ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.

SSGA Funds Management, Inc. has retained Nuveen Asset Management as the investment sub-adviser to the fund. Nuveen Asset Management, LLC is a wholly-owned subsidiary of Nuveen Fund Advisors, LLC, which is a wholly-owned subsidiary of Nuveen, LLC (“Nuveen”). State Street Global Advisors Funds Distributors, LLC is not affiliated with Nuveen Asset Management.

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