Gauging the muni market reaction to the Fed's next moves

BlackRock Head of Municipal Bonds Peter Hayes reviews what the Fed's announcement on tapering and potential rate hikes in 2022 means for muni markets.

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EMILY MCCORMICK: Welcome back. The Federal Reserve's monetary policy decision yesterday included an announcement to speed up the central bank's rate of tapering, alongside signals that we could see three interest rate hikes in 2022. For more reaction on the Fed and what this all means for markets, we're welcoming in Peter Hayes, BlackRock head of municipal bonds. Peter, thank you so much for joining us. I first want to get your reaction to the Fed's statement and press conference yesterday. Now, there was a lot of discussion around inflation and where we are in the path toward maximum employment. Let's take a listen to what Fed Chair Powell had to say.

JAY POWELL: Essentially, higher inflation and faster-- it turns out, much faster progress in the labor market. Really, what's happening is the unemployment rate is catching up-- seems to be catching up with a lot of the other readings of a tight labor market, 6/10 over one cycle.

EMILY MCCORMICK: Peter, when you look at how Fed Chair Powell described this path toward maximum employment, the speedy rate of recovery, the dot plot and the press conference overall, was there anything that really surprised you in these or that you think may have surprised the markets?

PETER HAYES: Well, first of all, thanks for having me back. I appreciate it. You know, one word actually stood out, and particularly, the way Chair Powell emphasized it, and that was much. He said much faster. So I think the Fed has been a little bit surprised here, both the, I think the pace of inflation and the pickup of the employment rate as well. You know, they've used this word "transitory" for a long time. They've taken that out of the statement. So I think they realize that the price pressures are here to stay. And the markets have been sort of skeptical of whether the Fed was behind the curve now.

The Fed, I think, has done a good job of being very deliberate. All along, they said it depends on the pace of economic recovery here in the US. It depends on the pace of the recovery in terms of unemployment, et cetera. So I think now they have plenty of data showing the sustainability of this. And with the markets perhaps guessing that they're a little bit behind, they're actually in a bit of a catch-up mode, coming out and saying that perhaps three tightenings in 2022, which, when you go back six or nine months ago, that's quite a bit more aggressive than where they were.

The interesting part is the market reaction. The market 20 years ago, in the bond market I grew up in, if we saw this type of inflation data, if we saw this type of statement out of the Fed, interest rates in the bond market-- the bond market would have sold off much more dramatically. It started to sell off, and then it come back. Today, a bit of an interesting reaction in that the curve is actually flattening. So the front end is taking out, to some degree, some of the tightening that perhaps it had built in. Maybe that's around this new variant and the slowdown that's in front of us.

ADAM SHAPIRO: Right. Hey, Peter. Good to see you. So for people who want to invest in munis, what should we pay most attention to going forward? Is it the increased pace of tapering or the potential for lift-off with treasuries and interest rates? I mean, it could be as soon as March. What's going to impact the muni market most?

PETER HAYES: So, first and foremost, it will be that the pace of tapering, the pace of tightening, and the reaction of interest rates. It's a fixed income market. If interest rates rise, that will impact municipal prices. They will go down. Now a bit of good news-- municipals tend to do better in rising rate environments than other fixed income asset classes. In fact, there's some other dynamics at play this year that we've talked about on past shows. But nonetheless, when you look at municipal aggregate index returns this year, up about 1 and 1/2%, while other fixed income assets are actually negative for the year.

So there's a bit of protection built into the muni market. But nonetheless, if we see dramatically higher rates from a Fed tightening and a market that begins to expect more tightening beyond the three they're talking about in 2022, prices will be impacted negatively definitely.

EMILY MCCORMICK: Well, and Peter, thinking about fixed income more broadly, what is the case for investors to be allocating a portion of their portfolios to bonds right now? Because many of the strategists that we have on here have been talking about that they still favor stocks over bonds as we head into 2022, even with these potential interest rate hikes. So what do you have to say about the potential benefit for investors in this asset class?

PETER HAYES: It's a hard case. That's why I'm smiling. You know, a bond person and sit here and say, we should be in bonds. Look, the bonds, particularly cash on the front end, is not keeping up and not giving enough income to keep up with the pace of inflation. Whether you believe this rate of inflation is 5% or 4% or 3%, those numbers are all above where you can find yields in most fixed income areas, particularly out through five to seven years. So I think if you want a little bit of income, you probably need to go out the curve.

And the muni market, for example, there's probably some good value in the 15-year part of the curve. You'll pick up some income. You don't have any exposure to the front end if the Fed begins to tighten. But to your point, I believe, it's tough to make a really strong case to allocate a lot of money into bonds at this point in time.

I think the market, you know, that earlier discussion we had about the Fed and what the market is expecting, I think the market still has to come to the realization that the Fed is going to tighten. They're going to reduce their balance sheet. Someone's got to buy those securities. They're likely to want to get paid a premium to buy those securities, which means higher rates. So I think you have to be patient in the bond market and tough to make a case to reallocate in at these levels.

ADAM SHAPIRO: Hey, Peter, when you advise your clients that you're overweight higher quality states, essential service bonds, and then you talk about school districts supported by property taxes, I get that someone who is risk averse, that rings true. But then at the bottom of that, you're talking about select issuers in the high yield space.

In a different part of the note, you talk about how well Puerto Rico did, and they are clearly in the high yield space. It was about maybe five, six years ago, we were talking about potential for default with Puerto Rico. They've lost population. What warnings might there be for people who want the better return and the high yield, whether it be Puerto Rico or perhaps some other municipalities? They're not out of the woods, or are they?

PETER HAYES: They're not quite out of the woods. The other day, Judge Swain, a bankruptcy judge, came out in terms of emerging from bankruptcy and postponed it a bit. But I think the ultimate endgame here will be in the next few months, they will emerge. I think a lot of the price appreciation and the debt, though, has been realized. Those who bought very early on and paid $0.30, $0.40, $0.50 on the dollar actually have made out quite well. So that trade, I think is a little bit long in the tooth.

But you ask a really good question about high yield. High yield, a lot of flows have gone into high yield. You can get a fair amount of income there, which is tax-free. But high yield can be very different. High yield can be sectors like charter schools and tobacco and even Puerto Rico, which probably have a much better-- I think a much better and more optimistic outcome, as opposed to the smaller project finance, which are highly more speculative. So you have to know what you're buying in high yield. And I think you have to be prudent about how you buy high yield as well. It's a really important point.