Baird's Short-Term Municipal Bond Wins Lipper Award

Duane: While it’s clear that some investors are concerned about the rise in rates, there are just as many that welcome the chance to invest at higher yield levels. The continuing inflows to fixed income funds is the proof. Our view is that rather than fear higher rates, investors should see it as a healthy sign for the economy and ultimately very good for all types of investors. Bonds are purchased for both income and safety. The more income, the more protection they provide against market volatility and turmoil.

Lyle: It’s clear that the market wants to try to push yields higher, but the Fed has been very clear about its intention to hold short-term rates near zero until we reach full employment and inflation has risen to or above their 2% target level. Whether the bond vigilantes will force the Fed to move to a less-easy policy sooner than it wants remains to be seen. If growth is sustained at a higher level but employment falls rapidly, it will be an interesting battle of wills between investors and the Fed.

Erik: We wrote a paper, nearly three years ago now, highlighting the benefits that rising rates offer to various types of investors. It may be even more relevant today in providing a nice counterbalance to investor concerns over rising rates. The good news is that whatever an investor’s outlook for rates, they can choose how much interest rate exposure they are willing to accept. The desire for safety helped drive significant flows into all the Baird bond funds last year, but among municipal funds, the Baird Short-Term Municipal Fund captured more flows than any other.

Joe: Those who know our approach know that we don’t spend a lot of time trying to predict whether rates will rise or fall, and by how much. However, we wouldn’t be surprised to see market rates trend higher over the balance of 2021. Even so, we would remind people that there are still very strong disinflationary trends in place in the U.S., and globally, that should limit the overall rise.

Duane: In a word, technicals! A very favorable supply/demand backdrop has been in place for several months, particularly since the November election. After a record level of issuance in October, supply levels fell through year end and have remained modest so far in 2021. The other part of the supply story, of course, is the growing issuance of taxable municipal debt relative to tax-exempt. Over 35% of 2020 supply was taxable and that portion could grow in 2021, which simply means less tax-exempt supply available for traditional municipal investors.

Erik: The other side of the favorable technical picture is strong demand. Once the municipal market stabilized after the extreme volatility in March 2020, investor demand has been consistently positive. Last year was the fourth highest level of fund inflows on record, an impressive feat considering the heavy selling that occurred last spring. Investors like the safety and security that municipals offer, even with lower nominal yields than in the past. Industry fund flows in January and February of this year were well ahead of last year’s pace even with rates being lower.

Lyle: We are always looking across the entire curve for opportunities, but the intermediate segment of the curve, from roughly 7 – 12 years, currently offers the most advantageous roll-down benefit. Curve positioning is always important, but it creates an even larger contribution to total return when starting yields are low and the curve is upward sloping, as it is today. In rough numbers, a nine-year AAA bond will provide a yield of close to 1.0%, but the roll-down benefit will be almost as much, assuming the curve slope remains the same over the next year. That has been a focus for curve positioning in our intermediate funds and we even have a modest overweight in the 5-year range in the Short Muni Fund for the same reason – to maximize the roll-down benefit.

Joe: From a sector perspective, we have been spending a lot of time looking at hospitals and higher education. I cover the hospital sector for the team and despite the significant Covid-19 challenges of the past year, most of the hospitals we own did an impressive job managing through the crisis. Revenues rebounded nicely once they could safely offer elective surgery again and most did a very good job of controlling expenses. Of course, the assistance they received from the CARES Act was critical as were the advanced Medicare payments, which provided much needed liquidity. I was amazed at how quickly the medical field pivoted to virtual visits, which is a trend that is here to stay and makes the entire process more efficient.

Duane: Covid-19 has presented many challenges to colleges, both public and private. Most had to move to either all virtual or a hybrid model of virtual and in-class learning – which, quite frankly, very few schools were adequately prepared for. In addition to falling enrollment and having fewer students on campus, less auxiliary revenue was generated. Like the hospital sector, Federal stimulus has been delivered and many have adapted quite well. Our higher education analysts, Gabe Diederich, CFA and Lauren Vollrath, CFA, have done a great job helping us separate the winners from the losers. This sector that offers some of the best value opportunities for investors, if you do your homework – pardon the pun!

Erik: It will, and of course it comes on top of the significant support provided in the CARES Act last spring and the $900B Covid relief bill at year end. In the fiscal package being negotiated now, there is also money for K-12 schools, transit agencies, airports, hospitals and more. So, there will be very broad support for municipal entities. Whether they need all this additional money is debatable, since we have seen a sharp rebound in tax revenues in most states, with many running ahead of where they were pre-pandemic. That said, while the fundamental backdrop for municipal credit is solid, not all credits are recovering equally, and bottom-up credit work is still very important.

Joe: A good example is some of the weaker state credits such as Illinois and New Jersey. While credit spreads have rallied sharply across the entire municipal market, as they have in the corporate sector, the challenges that these two states have faced for years have not gone away. In fact, their pension challenges have gotten worse as rates have come down and they face lingering structural challenges that will eventually need to be addressed.

Duane: This is obviously a very big topic today, much more than we can fully cover in this brief discussion. But the municipal market is an important yet underappreciated part of the ESG dialogue. Officially designated “green” municipal borrowings rose to $20B last year, up from $13B in 2019. When you add in issues designated as “social” or “sustainable,” you get an additional $10B in 2020. But one could argue the majority of municipal issuance provides societal benefits. Whether the money is used to enhance water quality, reduce neighborhood blight, provide more affordable housing, enhance the energy efficiency of schools and office buildings, invest in diversified renewable energy sources or countless other projects, we have seen the positive impact the municipal market has provided for society over our careers.

Lyle: There are many examples we could point to, but we recently looked at a City of Detroit borrowing where the money was going for the demolition of 8,000 vacant and dilapidated homes and for the renovation of another 6,000 that could be restored, all with the intent of enhancing the quality of neighborhoods and making them safer and desirable for investment. We applaud that effort.

Erik: Another example is The St. Paul Minnesota Port Authority which recently borrowed money for improvements on a heating and cooling system for many of the buildings in downtown St. Paul. A portion of their energy comes from urban wood renewables as well as a large solar thermal installation. While this wasn’t designated as “green,” it’s a classic example of a beneficial borrowing. This system eliminates the need for every office building to install their own heating and cooling system, which would be much less energy efficient. Municipalities will have to follow the trend of corporations in providing better disclosure regarding the original use of proceeds and what the ongoing benefits may be for the market to receive more “green” designations.