Municipal Bonds: Demystifying Tax-Free Income With Gregory Torretti
Welcome to Season 4, Episode 5 of Meet the Expert® with Elliot Kallen!
Ever dreamt of tax-free income? This episode dives deep into the world of municipal Investing with Gregory Torretti from American Century Investments. We crack open the secrets of municipal bonds, explore their tax advantages, and discover how they can fit into your investment strategy, especially if you live in a high-tax state. Gregory also unpacks the impact of the current economic climate, interest rates, and even Federal Reserve policies on municipal bonds. Feeling overwhelmed by investment options? We discuss the pros and cons of individual bonds versus mutual funds and ETFs, and explore how working with an investment advisor can boost your returns and save you time. So, buckle up and get ready to unlock the power of municipal bonds for a more secure financial future!
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Municipal Bonds: Demystifying Tax-Free Income With Gregory Torretti
I’d like to welcome you to another episode of the show. Exciting as always. I love doing these and I’ll tell you why, because we interview interesting people that bring great topics, financial topics, to the surface. They’re germane, topical, and interesting. We want you to read this and this episode will be no exception at all.
We’ve been doing this now for years. We’re in the top 2% of all financial shows. The best ways to reach me is Elliot@prosperityfinancialgroup.com or (925) 314-8503 or ProsperityFinancialGroup.com. Reach out, ask questions, or whatever you need to do. We are talking with Greg Torretti from American Century. Very exciting what’s going on. He’s an ex-New Yorker who lives in Connecticut. Let’s not hold this against him. Although, if I can swing to get him some good New York pizza in New York, Deli, I’d be thrilled to do that. Greg, welcome.
Thank you, Elliot. Thanks for having me.
American Century is give or take, a $300 billion entity out of the Midwest. They do a lot of value-based. Value meaning core value. I don’t mean value in the marketplace. They are very associated with the hospital and helping kids. They do some wonderful things there. His team runs the $8 billion of municipal investments. That’s what this show is dedicated to.
Municipal Bonds
If you’re somebody that wants to get state-free Money, federally tax-free money and you want to know, “How do I do better with that by throwing my money away, by getting less than I could in other places but I’m gaining tax-free money or tax-free status?” We’re going to answer that. It has been a wild ride for tax-free income. It went for good for a whole bunch of years. It turned not very good, then look what’s happening. Let’s first talk about what is municipal investing. First, Greg, welcome.
Thank you for having me. Thanks for joining us.
I will try to pin you down a little bit on a food later on in a show. Do you mind mailing the address for that food? Those people who know me personally, I am somebody that I want you to know me personally. I like a very personal side of it. I’m not a standoffish guy. We talk about food quite a bit and red wine. Those are subjects I always talk about with people because that’s what I love. Both those things. Let’s talk about fixed income. Why don’t we talk about not just fixed income but municipal fixed income, tax-free fixed income. Let’s define it and let’s begin to understand it a little bit.
Again, within the world of fixed income, a fairly large pocket is what we considered to be a municipal bond. These bonds are loans at the very basic issued by states and local governments. Over the life of the bond, investors will receive income or coupon payments. This income, as you were leading to, is exempt from federal and sometimes state tax exemption.
For example, if you’re an California resident and you purchase California-based domiciled municipal bond. You will be exempt from federal as well as state income taxes. Given the fact that tax rates are relatively high, especially for in-state residents in California. That’s more so. These bonds, the income exemption aspect of them make them appealing, especially to folks in the higher tax brackets where it makes much more sense to own them.
Let’s define a little bit what that means because when I think of Minnesota bonds, we’re thinking of a city like San Francisco and New York. Those two cities, I don’t think they’re going to default. I hate the way their bond or Chicago in there. Whatever you want to do, big cities are in major trouble, but the market is way broader than just municipalities, isn’t it?
You mentioned a couple of the poster children for bad financial management over the years. That’s certainly true for Chicago and increasingly San Francisco. As you alluded to the fact, the bond market of $4 trillion quite diverse and there’s a lot of breath to it. We divide the world into two. There’s general obligation bonds, which can be both state and local. The State of California issues debt to fund their expenses and their expenditures.
Different cities and towns also issue debt. Those are called general obligations. It’s backed by the full faith, credit and the ability of those states and local governments to raise taxes effectively and to levy taxes to pay for the bond, coupon, and interest payments. The other part of the municipal bonds, which is a lot bigger and a lot more broad and where we find more value, frankly, over time. It’s a little bit less traffic than there are fewer people looking at it are areas like bridges, toll roads, and schools.
You and your readers touch municipal bonds very much every day in your life. Whether you’re riding a subway, driving on the free way, and bringing your kids to school. Even more so nowadays there’s various sectors that entail public private partnerships. If you live in a new community in the Bay Area that has a cul-de-sac. They build out the road and the sewage and the infrastructure. Some of those might be financed by municipal debt.
It’s a very dynamic part of the market. It’s a little sleepy part of the market, too, but there are a lot of areas that we touch and feel every day that people probably don’t realize that are helped in Finance by municipal bonds, hospitals, or another area that people probably don’t realize municipal bonds might be pay for them or a park in their community.
Federal Reserve
The Federal Reserve Board touches the municipal world indirectly. How does that happen? What do they do? Whether it’s good or not, what do they do that make municipal bonds a place I’d want to be?
From the sense that they are setting the short-term interest rate.
They’re changing interest rates. They’re slowing the Economy. They take action all the time and it’s changes people view municipal bonds versus, “I’m not going to do that. I’m going to put my money somewhere else.”
From that perspective, it is what we consider the risk-free rate, the reference rate, and where you can put your money with very little risk and Sleep at night. Otherwise known as cash for a lot of us. That’s been appealing to people because the Fed has raised rates most to five, five and a quarter. I think a lot of you can find some opportunities, whether you’re looking at CDs or short-term or bank notes in that ballpark.
Municipal bonds, though, are fairly appealing even though the overall rate of interest might be lower than the Fed funds rate, as you alluded to. It’s the tax exemption that’s the benefit. For example, you have to do a little bit of bond math to go through this and for it to make sense. Say you can earn 3% on a California municipal bond and an after-tax yield. That’s equivalent to more like a 6% yield on a tax of bull bond like a treasury or something like a CD. While the Fed has increased rates and you might say, “I can park my money in cash.” You have to think about the overall impact on an after-tax basis when you’re investing in our market then it becomes a lot more appealing for people.
To put your math together because we’re talking a lot of math. What Greg just did is he said, if you take the highest federal tax rate and you take the highest California rate. You put the medical tax on top of that, you’re pushing 50% all-in. If you’re getting a tax-free yield, tax-free payout of 3%. If you’re in a 50% bracket, then you double it to get that 6%, if you were paying full taxes. You’re making 3% than you were putting your money in the bank at 5% because it’s equivalent to 6%. I don’t want to get confused and get into weeds of math, but that’s how you figure this stuff out.
Thank you for that context. I didn’t mean to gloss over that but effectively, I didn’t mean to salt in an open room. Folks in California are paying 13% plus 38%. It’s North of 50 bordering on the Scandinavia. For back of the envelope, we say double. If you can pick up three and change on a muni, you double that to sip and change.
The US Vs. The World
I don’t think taxes are going down at least in the state of California or New York or New Jersey or Illinois anytime soon. How does this compare with the rest of the world?
In terms of where we are as a country, there’s a lot of headlines out there probably on the extreme on one side or the other. I think we’re doing fairly well compared to other countries. Whether it’s in Europe or compared to other economies in Asia such as China, for example. We have our issues with inflation and high debt levels. I think a lot of it caused by COVID, whether it’s the inflation from the spending that took place.
When you look at other major economies, Europe’s export-centric, for example. Countries like Germany do manufacturing. Their service sectors have contracted. They have other issues with rising interest rates and high inflation. They also have somewhat slower Growth, too. Similar situation in the UK, where inflation is elevated and interest rates are high. DITO for Asia. The Chinese economy agreed more so the issues in the property market in China.
I think no one’s knows that the full knock-on effects yet and how that’s going to play out. They’ve tried to do monetary and fiscal stimulus. That’s failed to ignite growth. Despite the dysfunction in Washington, we’re still better off on a relative basis. For that reason, we’re perceived to be as a safe haven whether it’s the dollar itself.
Despite the dysfunction in Washington, we’re still better off on a relative basis. For that reason, we’re perceived to be a safe haven.
What I hear sometimes and this is cute saying, some might describe the US as the cleanest dirty shirt in the laundry. What it says is, if you’re being chased by the shark you don’t have to be faster than the shark. You have to be faster than the guy next to you. That’s a little bit of a way to describe. The US economy is being a little bit better off than most other developed countries.
Sometimes I feel like the best looking works of a glue factory.
That’s one too.
Municipal Bond Market
Interest rare now, Greg, are more or less peaked, at least for the moment. They’ve been rising. They had a mercuric rise and a high fastest rise in interest rates in American history. That just destroyed 2022 and part of 2023. Now we’re topping it out. I don’t have a crystal ball but there’s a likelihood that by the end of 2024, interest rates may soften because the economy may soften. It might be time to begin to lower interest rates. Does that generally lead to a bull market in bonds because we’ve had a bear market for a few years now in bonds? How does that affect the muni market?
We think that’s a catalyst and a positive in two different ways. For munis, the first is that we typically do have an intermediate to longer duration. Duration on most municipal. The market broadly is around 6 or 7 years if you were to pick an index or the broad market. What that means to your point is, if interest rates do fall, which a lot of firms are included are anticipating in the back end of the year. You’ll get some benefit in terms of a price appreciation.
As rates go down, bond prices rise. That’s one benefit if we do see rates drop toward the end of the year. The other is the high-quality nature of the asset class. Rates are going to be falling. We anticipate due to the fact that there’s an economic slowdown coming. This is on our view in American Century. When that happens, there’s considered to be a risk off environment. In munis, other than US Treasuries are considered to be the second safest place you can be overall and broad investments.
One that’s got that strong credit quality of in history of paying you back and even some of the riskier parts of the muni market have a strong history of paying you back. Again, as I mentioned, you get that benefit of owning some duration when rates fall. A good place to be if we do experience some volatility and some economic softness.
On that same note, 3or 4 of the biggest state issuers of bonds would be California, New York, New Jersey, and LA. They are the states that are having the fastest exodus of high net worth people in the United States. They’re going to places like Texas, Florida, Tennessee, and Nevada. They’re going to those places. That has to affect the ability for revenue to be collected to pay these bonds because that’s how it works. I want to make sure everybody understands as we talked to Greg from American Century about the municipal bond market.
When a bond issue or a hospital or municipality says, “We’re going to raise $30 million or $300 million.” They’re counting on a fact and we voted it in in California. You can’t say that nobody knew what was happening. They have to raise that principal maybe over the next 5 to 20 years back. They’re going to pay a reasonable amount of return to the investors. If this tax base is shrinking because the money is leaving, that could have a challenging impact on the results. I don’t want to say adverse. What do you think of that? Go ahead and finish out then I’ll do a follow-up question with you.
That’s true and that’s something we’re watching in the market. There’s other issues too that have been chronic in the market. Things like unfunded or underfunded Pension liability. That goes hand-in-hand with firefighters or teachers leaving Illinois and going to move to Florida for retirement and that check goes down to Florida.
It’s a double whammy of not only you paying people a lot of money and in retirement. You’re also sending the money to a different state. You’re not getting that multiplier effect and benefit to the home state and a couple of states that you mentioned. That’s real. Unfortunately, while it’s a problem, it’s a little bit of a slow-moving train wreck where we’ve seen these demographic trends for years.
There has been some planning for them. I don’t want to say that we’re pollyannaish and we have rose-colored glasses and we think that everything’s going to be rosy, but we are mindful of them. I think it’s reflected in the fact that you can earn a higher yield on states like Illinois and some pockets New Jersey. The other thing I would say, too, is from an investment perspective, we have the ability to look outside those states.
We are overweight to some of those others. We’re underweight to California. We’re underweight in many cases to Illinois as well as New York and New Jersey. As active managers, we can avoid some of those what we consider to be slower moving train wrecks. I don’t want to scare anyone to think that there’s going to be a default in any one of those particular states. Over time, as you mentioned, the demographics are untenable and unsustainable.
That means that money management versus an index is very important, isn’t it?
Yes, and again, you mentioned two. They’re larger states and they borrow a lot that they’re most indebted. They’re the biggest percentage of if you could go buy a passive solution or an index option. You’re going to get the higher pro rata of a market value that’s more representative and more indebted states and municipalities.
I know there’s less than a 1% default rate. In California, we were West of Stockton and Vallejo. Two cities have filed bankruptcy and defaulted under bonds. What happened to those bondholders?
In those cases, there are various bonds underlying them over various maturities. Some of those investors or most of those investors got a lot less money. There is a recovery value what we consider to be recovery value then the process allows investors to claw back some money from their investors. It wasn’t a total loss, yet, investors typically don’t end up being made whole.
I would say that those two, while they’re probably top of mind for many of your viewers and they’re local to the area. They are an anomaly. They do overall, even the riskiest parts of the municipal bond market default on average of less than 1%. In those cases, when they do default, people tend to get their money back.
Stockton and Vallejo are certainly cases to be weary of. They are also in a moral hazard type of way. A good thing for the muni market. If you think about, unfortunately, the ramifications of filing for bankruptcy. That tends not to go well for those cities and towns over time. You don’t want to be delinquent on your debt because it then means that you can’t go back to the visible bond market and borrow from investors.
You don’t want to be delinquent on your debt because it then means that you can’t go back to the municipal bond market and borrow from investors.
While it might be perceived as a short time, a best solution or a best option for, again, Vallejo or Stockton. Not going and being able to tap the market at low interest rates has put a lot of strain on those communities from perspective of hospital teachers, or firefighters. It can even have a negative feedback loop of impacting property values. A cautionary tale, the market sniffs that out. Over time, cities and towns have realized that paying their interest, coupons, and principal while painful is a lot better solution than filing for bankruptcy. I want to be sure. I just convey to you that again anomalies are more of the exception than the rule.
What’s The Duration
We’re talking with Greg to ready of America Century, a large multi-billion dollar entity in Kansas City. He’s on East Coast managing an $8 billion mini world. I’m Elliot Kallen, (925) 314-8503 or www.ProsperityFinancialGroup.com. A few more questions, Greg. This has been great. For people that like munis and trying to get more in that market. This is great information. Some people talk about how long is this bond going to be around for? In other words, what’s the duration? Should I buy short, medium, or long? How do you define that? What does that mean?
Duration means a couple of different things from the bond side of it and the investment side. We’re bond geeks. What we think of it is it has the impact that interest rates bear on our investment. From our perspective, when we say a duration of five years, if interest rates go up 1%. The price of the bond will go down 5%. It’s also a measure of time as well. It’s a measure of interest rate sensitivity. It’s also mentioned time, duration. How long on average does it take for you to get paid back from this particular investment? It means volatility as well as time to get paid back in the bond world. That’s how we think about duration.
Which is better?
Our view is we’re in the intermediate part of the market. For us, that means about six year duration. We’ve been extending our duration a little bit longer. By that, maybe to six and a half year. On the margin, we’ve been extending duration. The reason for that, like in with a question earlier or made it more of a statement rather. Interest rates are likely going to trend downward call it six months the next year. As I just mentioned, the definition of duration. With that, the more you extend duration, interest rates sensitivity. If interest rates go down, the price of our portfolio and the price of our bonds will go up. The longer we extend duration, we think we’ll benefit from a drop in interest rates.
The longer we extend the duration, the more we will benefit from a drop in interest rates.
Bonds, Mutual Funds, And ETFs
That’s good to know and we can do all of it. You could buy a bond. You can also buy mutual funds and ETFs with bonds, bond funds. What’s the difference? Why would I want to buy one over the other?
There’s three of bonds. A Bond, bond funds and ETFs is the three you wanted to compare? There’s a lot of different variables. I’ll maybe break it down for a couple of different things like liquidity. There’s diversification. There’s how much you’re going to invest. There’s also a degree of customization. You have to implore folks to work with you to determine their liquidity, diversification needs, minimum investment, and how they want to customize.
If it’s liquidity, for example. Bond, mutual fund, or an ETF is probably the best way to go so they can buy and trade that ETF or that mutual fund either daily or intraday to get their money back or to invest. That’s appealing. In terms of diversification, we mentioned Stockton and Vallejo. If you held all of Stockton and Vallejo, you didn’t do very well. The key is you talked to your clients about the benefit of diversification is that there are dozens of positions that diversifies the risk that you might have to one particular bond.
Diversification from mutual funds and ETFs are also very good. In terms of a minimum investment, most mutual funds and ETFs have a lower initial investment threshold making it easier for individual investors to contribute over time and build their investment. Individual bonds, on the other hand. If you’re going to go out and buy a bond, it’s typically very expensive to do that because you’re trading with a broker who might not be very nice to you as a particular individual and/or it’s very difficult to find bonds sometimes at the denomination for a value less than $50,000.
On the flip side in terms of customization, it might make sense for folks to work with you if you offer individual bonds or you can help them procure individual bonds. They can target whether it’s a specific horizon, yield, and a risk profile that they have in mind and come to you and give you all these criteria. You might be able to help them build a portfolio with individual bonds. Again, it depends in terms of those main needs that you might have as an investor.
Professional Management
I want to continue that for a moment because there’s something called SMAs or separately managed accounts in municipal bonds. I’m assuming you do that, too.
We can.
Client comes to me in a high tax bracket, a million or $5 million or $10 million or $20 million or $30 million to invest. We’ve decided that the municipal market is a place he or she needs to be. I can go to a Schwab backroom and begin to look at bonds. All that would give me a yield and yield to worst and yield to best. There’s some numbers that I can look at and the rating. I don’t trade bonds every day and you do. What’s the advantage of me not going to the Schwab or fidelity backroom and building stuff versus bringing in an SMA like manager like you that does this every day and we work together on it?
There’s a couple of reasons. First of all, it’s what you’re good at in your time. Thinking about what is efficient for your time and what’s the cost to do that. It’s something that’s probably not one of your greatest skills. No offense to you, but you’d probably be better spending your time elsewhere rather than going on Schwab, for example, or another provider looking at Q-Sips, looking at risk or trying to determine what the real of that particular bond might be or determine whether or not the value and the yield of that bond is reflective of the risk you’re taking then sizing the duration.
We talked about the time horizon for a particular investor. There’s a lot of work that’s entailed on that. To offload that to a financial institution like ours is probably well worth your money in terms of basis points to have us do that risk, do the due diligence on that portfolio and customize that for you. It makes a lot of sense for people to think about having that outsourced to an investment advisor rather than doing it in-house.
Also, there’s other things too where we typically tend to get very good pricing because we’re going to buy in larger blocks than you might. Even though you might have an investor with $10 million or $12 million dollars. Our funds are in the billions. We tend to get improved pricing due to the size and scale that we have in the market. There’s advantages that we have on our end that we can pass through to you and your investors.
I want people to know that the average financial advisor in the United States is about 1% on fees, but in an muni market, it’s not that. It’s significantly less because if you’re only making 3.5 % on a municipal bond. You’re not losing 1% to the advisor. Don’t go in thinking that, “I can’t afford the advisor.” If the advisor is doing a great job, by far you can avoid them and they’ll make you money. They might say, “It’s time to sell that bond. Let’s get rid of that bond. We’re not holding it for twenty years until maturity you’re 70.” Maturity would be a silly conversation to have.
That’s right. To your point being, we’re not just doing the due diligence upfront. When we purchase, it’s a constant continuous process where we’re evaluating everything we own on a daily basis with in-house analysts. It’s that professional management that you’re getting access to for a fraction of the price.
I take over bond portfolios. When I take over bond portfolios and interest rates are dropping. You’ve got bonds that are selling at $106 or $105 at premiums. I’m selling them because that’s as good as it’s going to get. Let’s make our money for the most part and take advantage of something new.
It’s a lot of work, though.
It is. Let’s end on this quality thought for a moment, Greg, because there is such a low default rate out there. The difference, I want AAA, AA, A, BBB, BB, high yield, or unrated because lots of hospitals are unrated. You buy the entire hospital. One organization buys it. They don’t need to go to a rating agency and save that money to do that.
By the way, what happens for the consumer that you don’t understand behind the scenes is that every time you hear about a AAA or BBB, that company or that organization has paid money to a rating organization to do an evaluation. Probably hired a big ten accounting firm, big 15 or big 20 accounting firm. They’re called a big five, but they’re hiring a top accounting firm to do the math. There’s a lot of cost that went into that. It lowers the rate because somebody’s got to pay for that. Sometimes high yield and unrated can be a better deal for a consumer, low default rate, why don’t we do more of that?
That’s the thing because of the high cost to get a rating. The folks are automatically going to get a lower coupon and in most cases, a lower return. It goes back to what you were describing before in terms of what we offer at American Century. We have a group of professional analysts, portfolio managers, and traders. We have a group of people in-house who are following the market and who are able to take advantage of that knowledge that we have of the market. Whether it’s a hospital that’s non-rated.
Non-rated because they didn’t want to go out and pay for that rating from S&P. Whether it’s a park, a charter school, or a higher Education bond, we are in the market assigning our own rating for those “non-rated” bonds. You can find some real good deals. You can also find some Vallejo’s and some Stockton’s out there.
Our job and what we’ve been pretty good at throughout the years is identifying the non-rate and doing the due diligence on our own. We don’t look at a rubber stamp up from S&P or Moody’s or Fitch. We all know that S&P and Moody’s or Fitch do a good job generally, but they’ve gotten it wrong before. I don’t know if any of you follow the housing market and the CLO market back in the 2008 and 2009 period. They don’t always get it right. There’s a little bit of an arbitrage where we can, as fundamental research analysts, our team can uncover some good deals in the high yield and the non-radiant market that again might not have as many eyeballs on them.
Risks: Cyber Attacks
Greg, I’d be remiss if I didn’t ask you a closing question on risk. For people that buy municipal bonds, we know there’s a 1% default rate, give or take or less. Is there any other risk that the consumer and the high net worth investor should be aware of here?
I think we talked about interest rate risk. There’s always that outside risk of interest rates going back up. That’s another one. The risk we’re talking about for people in terms of like black swans is we’re increasingly tense geopolitical situations around the globe. We could have things like cyber-attacks. We have utility bonds that are part of the municipal bond market. Hospitals are part of the municipal bond market.
You’re seeing increasingly on the fringes and on the margin. You don’t see them publicized, but things like targeted attacks and cyber-attacks. That could hit any portion of our market or any portion of broadly the general investing market. Since we do operate in essential services, things like utilities, hospitals and education. We could be susceptible to something like that. I don’t want to be fear-mongering.
I do say that Munis are, in general or particular, as I mentioned, very rock solid and long history. I think the last state that defaulted was Alabama or Arkansas during the great Depression, where they also had a hurricane come through. The great depression had something else happen. It was like the cataclysm. That’s the most recent example we have of a default from any state.
There are risks if you’re buying fairly high quality and/or you’re paying someone to do research on high yield and non-rated. You’ll probably sleep pretty well at night. Hopefully, better than you do buying Crypto or global growth stocks or small cap stocks. We like to be the sleepy part of the market and the boring part of the market in your portfolio.
Greg, this has been great. I’ve been talking to Greg Torretti of American Century. They do a fabulous job on municipal investing. If this is something that you want to learn more about, then give me a call at (925) 314-8503 or ProsperityFinancialGroup.com. It’s been great, Greg. I want to thank you very much for being part of our show.
Thank you, Elliott. Nice to be here.
Folks, if you want more information on any of our shows, they’re on the website Meet the Expert with Elliot Kallen. There are 60 plus episodes there with more to come.
Important Links
- Elliot@prosperityfinancialgroup.com
- ProsperityFinancialGroup.com
- American Century
- Meet the Expert with Elliot Kallen
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