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.


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.


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