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Municipal bonds face ‘challenging time ahead,’ strategist says

Jason Appleson, PGIM Fixed Income Head of Municipal Bonds, joins Yahoo Finance Live to explain the outlook for munis.

Video Transcript

- Investors appear to be turning their backs on municipal bonds at a record pace due to rising rates as central banks continue their aggressive hiking path. Those cheaper bonds and higher yields are appetizing for investors who are hungry for a deal. But are there risks you should look out for? Let's bring in PGIM Fixed Income's head of municipal bonds Jason Appleson to talk all things munis. Good to have you on today. I'm looking through your notes here. You said there's been a tailwind through the summer. But September is where things start to turn the corner, especially because of supply. What do you see?

JASON APPLESON: Thanks for having me. Yeah. Supply is always a challenging month for the municipal bond sector. There's higher supply from new issuers. And of course, reinvestment is lower. And those were some of the offsetting or mitigating factors that we saw in the beginning of the year while we're in this inflationary environment. With those technicals turning on us, it could be a challenging time ahead for municipal bonds.

- And Jason, investors are wondering, I mean, should they dip in any areas of municipal bonds? I mean, if you had to choose between some areas versus others, are there some that you would definitely stay away from? Are there some that may pique your interest?

JASON APPLESON: Yeah. So it's interesting. As a sector, municipal bonds have not been immune to the carnage that we've seen in fixed income, higher rate volatility, outflows, et cetera. But municipal bonds are roughly 200 basis points higher across the curve. There is a lot of relative value there, especially in the long end of the curve where municipal yield ratios to taxable ratios are above 100%, not really pricing in some of the implied tax implications there.

That being said, in terms of fundamentals, munis are still very strong. We've seen just on a state basis, 17 states have experienced positive rating actions, while zero states in the last 12 months have experienced negative rating actions. So fundamentals are still pretty strong. The one area I'd point to of weakness in terms of fundamentals is the hospital sector.

And they've really been affected by the perfect storm of lower earnings, expense pressures from supply chain disruptions, and higher cost of nursing. And couple that too with weaker payer mixes and some of the elective surgeries they've had to put on hold as a result of peaking COVID. So in a nutshell, though, municipals seem cheap, more so relative to where they have been in the beginning of the year.

- So you've highlighted some areas to maybe not put your money. But there's a lot of people that are going to be watching this and saying, this is not an area I usually invest in. Where do I put my money? There's some parts that you've highlighted here, something like prepaid gas, charter schools. Walk us through some of the areas you've got your eye on.

JASON APPLESON: Sure. Yeah. You mentioned two sectors that we find particularly enticing. One is prepaid cash, which is backed by some of the largest money centers in the United States. Think Citigroup, Morgan Stanley, Goldman Sachs, et cetera. That sector has gotten weaker primarily because of the technicals of just a lot of issuance in the space. But overall, these are very well diversified money center banks that are more regulated and have more capital than they had certainly before the Great Financial Crisis. We find that sector attractive.

You also pointed out charter schools. Charter schools are also very interesting. The impacts from COVID have really sent demand higher for charter schools because of the flexibility they offer parents. We haven't seen the same sort of flexibilities in general public schools. So higher state funding to charter schools. And the states, again, are benefiting from some of the stimulus packages passed over COVID. And now that can flow down to some of these charter schools, which are now experiencing better operational profiles and financial profiles.

- And are there any tax implications that investors should be paying attention to when it comes to munis? Maybe some aspects that they're not considering?

JASON APPLESON: Sure. I mean, one aspect that we've talked about is the Inflation Reduction Act. And there's a lot of nice little nuggets in there for munis, including incentives for municipal utilities to engage in some green projects. But it also requires a 15% minimum tax for certain corporations. And corporations and other institutional investors represent about a quarter of our market. The concern is, does the minimum 15% tax rate really affect the demand profile overall in the municipal bond market? And we think not just because the primary buyer, who is institutional municipal bonds, would be banks. And banks generally have effective tax rates that exceed the 15% minimum tax.

- PGIM Fixed Income's head of municipal bonds Jason Appleson. Thanks so much for joining us.