On this episode of The Long View, Jim Murphy and Charlie Hill of T. Rowe Price’s Municipal Bond Investment Team break down their perspective on the past few years in the muni market, the impact of the recent interest-rate cut, and the role that geography plays on the tax-exempt market.
Here are a few highlights from Murphy and Hill’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.
Why Investors Need to Think About Geography When Building a Muni Portfolio
Christine Benz: We wanted to ask about geography. We’re talking to you today from Illinois, both Dan and I are in the Chicago area. It’s obviously long been a problem child from a fiscal perspective, though you referenced that things have improved a little bit. So, maybe you can talk about how you think about state-specific regional issues as you go about putting together muni portfolios. And maybe you can weave in how you think about population shifts that we’re seeing, where people are moving away from some of these higher-tax states toward Sunbelt states. And then also, the related question about the Sunbelt states and some of the climate-change impacts that they’ve had where it seems they maybe have more of a need to do rebuilding and address some areas that have been hurt by some of these big storms that we’ve been seeing.
Charlie Hill: As far as state issues, I think you’re talking to us from Illinois, and Illinois has obviously had issues over the years. I think it’s very difficult to come in and buy a local geo or a healthcare credit or a water and sewer credit, even if the state general obligation debt is trading at a widespread or even distress level. It’s hard to give yield to go into other bonds within a state, ignoring what the general obligation debt is doing. And we saw that in the 2007 to 2010 time frame in the state of California, where Cal revenues declined precipitously during the global financial crisis, spreads widened considerably. And as such, other spreads in other California-exempt debt also widened. So I think your opinion, your outlook for the state general obligation debt does make a difference. You can’t necessarily draw a direct line to another credit being weaker, but you can definitely draw a line to the perception of other credits within a state getting a little less attention than they otherwise would.
As far as the migration question, we’ve seen out migration in California, Illinois, New Jersey, New York for a number of years now and in migration to Texas and Florida. I think specifically with Texas and the other side of it hurting the states where populations are leaving, the amount of debt that we’re seeing issued from the state of Texas just to handle the educational needs and other infrastructure needs within the state has increased issuance out of Texas tremendously. So to the extent that California may be hurt, or Illinois may be hurt from out-migration, you’re not seeing the corresponding issuance pressures that you’re seeing on some of the states that have a lot of the net in-migration. On the Sunbelt state questions and rebuilding, and I hate to throw Puerto Rico into the mix, but a couple of hurricanes really brought a tremendous amount of money into Puerto Rico, and I would imagine to the extent that we’re going to see considerable rebuilding needs in North Carolina and Florida that that will only create mini booms in those areas of the country once they get their feet back on the ground.
Dan Lefkovitz: Jim, did you want to add anything?
Jim Murphy: That was well said, but I think we are spending as much time as we can really looking at some of these coastal regions more carefully and understanding that maybe we’re supposed to demand a little bit of a yield premium on a place like Miami versus Atlanta. And so I think we’re doing that. I think the market is in the early stages of doing that. And I would echo some of the second, third derivative effects of the migration shift. We invest in charter schools. So you look at places like Arizona, Texas, and Florida that have all been growing. And so charter schools have been a really, really interesting, nice outlet for the public school system. And a lot of times, if you’re in a pretty static population growth environment or a declining and you drop the charter school into one of those areas, there could be some real friction because the public school system in that charter might be fighting for the same tax dollars. Well, that’s absolutely not the case in Texas. In fact, in Texas, you see that once a charter school gets to a certain critical mass of students in financial solidity, the PSF—Permanent School Fund—will actually come in and wrap that system and allow them to borrow at even lower rates. So there are some really interesting second- and third-tier nuances to this migration shift. But we watch them closely and try to take advantage of them.
Does Puerto Rico Have Risks on the Horizon in the Muni Market?
Lefkovitz: Well, you mentioned Puerto Rico earlier. You also mentioned the famous Orange County, California, default. City of Detroit was another bankruptcy, high-profile bankruptcy in the muni market. Do you see any major risks like that on the horizon today? And it also might be interesting to hear how you’ve moved in and out of Puerto Rico. It looks like you’ve got some exposure to Puerto Rico now in your portfolio.
Murphy: Yeah, are there any Puerto Ricos in the offing? No. That was a $70 billion problem. And the thing about the municipal market is most of these very big thematic distressed credit problems. I’m not talking about the one-off project finance deal or trains down in Florida; these are slow-moving train wrecks. The beauty of having research is we really got the Puerto Rico question right, let’s call it, from 2010 to 2015. It was very clear to us that they were so massively overleveraged as soon as the market started to starve them from capital, they were going to have a big problem, which is exactly what happened. And what had been the case, and Charlie mentioned Orange County, prior to something like Puerto Rico and Detroit was a lot of big municipalities somehow got bailed out at the last minute and averted any type of real substantive loss to the investor. Post-GFC places like Detroit and Puerto Rico, the populace in Washington, said enough with the bailouts and allowed these places to fail, which as a credit investor, I think is very healthy. It was so disappointing to get something like that right and then just have some white knight come at the end and bail these places out.
So we think it was, we got Puerto Rico right, we had very little exposure to Puerto Rico when that happened. And if you take the blueprint of Detroit, what happened? They passed PROMESA down in Washington, which is a bill that allowed for the Commonwealth to actually reorganize under a bankruptcy-like framework and fix their problems. And with that, they imposed upon them a financial oversight board that was going to hold and has held local officials and leadership accountable to their finances. So a) when you get it right and you don’t have any, and then it defaults and it goes down, you get rewarded for not owning it from a performance perspective. And then from an opportunistic, certainly high-yield perspective, to be able to look at that distressed debt with a much more sober eye of how are they going to recover? And frankly, Puerto Rico has done a pretty good job of rightsizing their debt profile. And the FOMB has imposed upon them fiscal discipline. And as Charlie mentioned, a lot of revenue has hit the island both from hurricane relief and covid relief. So you have this really nice beneficial credit tailwind happening in Puerto Rico at a time when they rightsize their debt profile. So yeah, we reengaged in most of the boxes—when I say boxes, the general obligation credit, the sales tax credit, which is known as Cofina.
We had owned the water sewer system, which never defaulted. So that was a good situation. The only real disappointment that we see with Puerto Rico today is a real obstinance to face and fix the problems at their electric utility company, which is called PREPA. For some reason, they are really fighting very, very hard where the debt is really not the big problem in Puerto Rico for PREPA. It’s the cost of fuel, but they seem to be just in a very aggressive legalistic way, be taking that out on bondholders who did nothing but loan them $6 billion of money. So that’s the last part of Puerto Rico that needs to get fixed. And we’re hoping for a good resolution there as well.
