JAMIE OTTESON: Hello, everyone. Good morning and welcome to Schwab Market Talk, our monthly webcast with advisors, designed to address your questions around the markets and the economy. My name is Jamie Otteson, and I’m a senior manager with Schwab Advisor Services Fixed Income. I’m joined today by Kathy Jones, Managing Director and Chief Fixed Income Strategist; Collin Martin, Director and Fixed Income Strategist, who will be discussing the taxable credit markets; and Cooper Howard, Director and Fixed Income Strategist, who will be covering the municipal markets. Today is April 15th, 2025, and I have the pleasure of posting today’s Market Talk, Fixed Income Edition.

Before we get started, I’d like to review some housekeeping details. First, I’d like to call your attention to a few resources on the webcast console. In the top-right corner, you will find a link to our latest market commentary. In the bottom-right, you will find a link to the April Bond Market Update, an article on municipal credit conditions post-election, and a client-approved chart on municipal bond yields. Live attendance at this webcast qualifies for one hour of CFP and/or CIMA continuing education credit. Watching the replay doesn’t qualify for that CE credit. To get the CFP credit, please make sure to enter your CFP ID number in the window that will pop up on your screen. You should see it now, and in case you missed it, you’ll see the popup towards the end of the webcast as well. Please note that you must watch for a minimum of 50 minutes to qualify for the credit. Schwab will submit your credit to the CFD Board on your behalf. For CIMA credit, you must submit on your own. Directions for submitting can be found in the CIMA Certification widget at the bottom of your screen. The directions for submitting will be available 50 minutes after the start of this webcast. And then finally, just a reminder that the information provided here is for general informational purposes only and all expressions of opinion are subject to change without notice in reaction to shifting market conditions.

With that, let’s go ahead and jump right in. And Kathy, I’ll start with you. Welcome.

KATHY JONES: Thanks, Jamie. Glad to be here. Hi, everyone.

JAMIE: So there has been so much volatility in the treasury market lately. Yields have had some of the biggest swings in years. Can you tell us what’s going on?

KATHY: Yeah, it has been quite a wild ride over the past couple of months, and, you know, I think you could sum it up… here, I’m going to put up the 10-year treasury yield chart. I think you could sum it up with just a lot of rapid change in policies that have led to a lot of rapid changes in yields as the market tries to adjust the economic outlook, the inflation outlook based on those changing policies. So, you know, we came into the year having seen yields fall a bit, and they really tumbled when we introduced tariffs, sort of broad-based widespread tariffs in the first go-around, because tariffs tend to slow the economy. And even though they tend to push up prices, at least on a one-time basis, the expectation was really longer term, it would slow the economy, and that was the going assumption of the market. And then we’ve had these rapid shifts of tariffs on, tariffs off, tariffs on partially, tariffs on with exceptions. You know, and it has been such a rapid rotation of policies, particularly around tariffs that the market has just been roiled by that.
We recently, of course, had also some what I would call probably de-levering that took place in the last go-round, and that just recently when we saw yields really start to rise pretty rapidly. And I think that that has to do with unwinding of leverage positions. We don’t really know at this stage of the game, we don’t have all the answers to who was selling and who was buying, but what we did see was that some pretty rapid unwinding of positions, probably leveraged funds.

A lot of talk about foreign selling. I doubt that it’s… and just to go right to the main question people have been asking, ‘Is this foreign central banks, foreign governments selling US treasuries?’ I don’t think that that’s the most likely conclusion to come to. We don’t get the data on that. That’s from the treasury. It comes out with a lag. So we don’t really get a lot of good data on that in real-time. So we’ll know probably 30 to 60 days from now if that actually happened to any degree. But I think people underestimate the amount of money that has come into the US over the last couple of years from private investors or pension funds, insurance companies, etc., abroad. So we’ve had this period of, you know, strong dollar, US exceptionalism, stronger US markets than everywhere else in the world, and certainly higher interest rates, and that brought in a lot of foreign capital, and mostly private capital. And in fact, you know, that is probably what has reversed since over the last 30 to 60 days or so. And that probably intensified last week when we started to see that selling. So my guess is that it wasn’t central banks unwinding positions because ultimately that’s a negative for them. The dollar is still the world reserves currency. If you drive down the value of the dollar and the value of your assets, you’re doing yourself more harm than good.

So I think that most likely what we’re seeing is private sector selling and some unwinding of leverage positions. But be that as it may, now we’re back at close to 4-1/2%, with the market waiting to see what the balance will be between tax cuts and where we end up on tariffs, which is still a big unknown.

JAMIE: Do you see this volatility coming down or continuing?

KATHY: You know, I think it will continue for a while still. I’m guessing it continues through the summer because we have a lot of policy uncertainty, and the economy is probably already in a position where it’s slowing down. So this is the Move Index, and this is the index that we use to measure volatility in the bond market. And as you can see, it’s really spiked up recently. Now, it’s come back a little bit, but it is at a very high level, and moved up very, very rapidly. And again, this is this uncertainty, this unwinding of positions, people not really knowing where to be on the yield curve, if they want to be in treasuries or in some other part of the market. So I think we’re going to see elevated volatility because it doesn’t look like we’re going to get resolution on a lot of these policies for a while. And keep in mind it’s not just our policies, but then it’s the retaliatory policies that we have to deal with as well. So every time there’s a change in the outlook, the market has to adjust its outlook for the economy, for inflation, for Fed policy. And when you are moving around the underlying assumptions very rapidly, you’re going to see the treasury market which reflects all those factors move around really rapidly. So I would guess we’re going to say elevated volatility for at least a couple more months until things start to fall into place one way or another.

JAMIE: Circling back to something you mentioned a moment ago, there was talk that there was a lot of selling by foreign investors or central banks. Do we know if this is true? Can you expand on that?

KATHY: Yeah, one of the things that happened, which makes me, you know, pretty convinced that there was a lot of foreign selling, that… there was foreign selling, whether it’s public or private is a big question. But what you see, well, is that while the dollar has been firm for quite some time, for years because of the relative strength of the US economy and the relatively high interest rates in the US versus other developed market countries. So when you look at the gold line here, it shows the difference in the yield on the Bloomberg Ag for the US and the Bloomberg Global Ag ex-US. And what you see is that spread has moved up, was moving up even as the dollar, in the blue, was moving down. And so that typically doesn’t happen. When you look at that chart, they typically move together. US interest rates go up. Particularly when they go up rapidly because there’s some sort of flight to safety going on, yields tend to go in the same direction. This time they went the opposite direction. That’s kind of the kind of thing you see in emerging markets sometimes when there’s policy-driven volatility.

So it does signal to me that there was foreign selling. It will take a while to figure out who it was. I continue to think predominantly probably private sector, rather than central bank selling. But even at that we’ve had tremendous inflows over the years from private sector investors in US dollars and US markets, equities, as well as fixed income. And so there could be more of that to come if we continue to pursue policies, you know, where we’re kind of making enemies with our trading partners or other people around the world who hold US dollars.

JAMIE: What does all of this suggest about the economy?

KATHY: We’re looking for a slowdown in the economy. I do think the risk of recession has risen. So we were probably going to see a slowdown anyway as a result of Fed policy persisting to be relatively tight, and we were kind of wearing down, slowing down after all of the hiring post pandemic, and that’s reversed, with the waning of pandemic funding that is working, still the tail end of that working its way through the system. So all of that signal we probably get a slow down in economic growth. And now with tariffs we’ve kind of thrown a wrench into things because it’s just basically unclear where we’re going. And when businesses can’t see forward for six to 12 months at least, they really can’t move forward with investing. And so business investment appears to be slowing down, activity seems to be slowing down. We’ve seen that certainly in some of the regional bank surveys. And consumer spending appears to be slowing down as people get more cautious because, you know, you have the DOGE cuts to the workforce, that’s put a bit of a chill in the labor market, and you have businesses not being confident enough to hire and invest. That’s putting a slow down in that part of the economy. So we are expecting things to slow down.

I’m showing a chart here of some of the indices that you can follow for recession probability. One is from the New York Fed, and focuses on, you know, 12 months ahead, and the other is a much longer leading indicator. Both of them suggest the probability of recession is around 30%. I think most private forecasters think it’s closer to 40% or so. So it’s elevated. It’s certainly not at the highest, highest level, but if it goes back up to 50- or 60%, then that would tell us we’re probably not only on the verge of recession, but probably in a recession. So elevated risk, not quite there yet.

JAMIE: Any idea what the Fed might do in this situation? It seems like they’ve been sitting on the sidelines for while. Is that something they can continue to do?

KATHY: I think that’s about all they’re likely to do at this stage of the game until something changes. So this is, you know, the inflation outlook. We’ve got PCE here, both core and overall. And that should actually… we’re going to get an update on this. So that should edge down a bit. So inflation is edging down, but it’s still well above the Fed’s 2% target. And what we’ve heard from Fed Chair Powell and other members of the Fed is that they’re not comfortable adjusting policy or lowering rates until inflation… they can see that inflation is heading towards 2%. It’s been kind of sideways now for quite some time. So I think that holds them off.
The labor market, although softening, is still in pretty good shape. We’re still… you know, manufacturing, 100,000 to 200,000 jobs a month. Unemployment rate is still in the low 4% area. Wages are growing in real terms. So it does seem as if the labor market is stagnating so that, you know, hiring is slowed down to a crawl, and firing is slowed down to a crawl, and participation rates are starting to edge down a little bit, but it’s not like the labor market is rolling over and looking particularly weak. So until we see that happen, the Fed probably won’t make a move, absent a decline in inflation.
And the third factor I’m sure they’re watching is financial conditions, which have tightened quite a bit. But this is not a financial market problem per se. So lowering the cost of financing may not solve the problem. This is more driven by policy uncertainty, and that is going to be a bigger driver, I think, than financial conditions. Unless, you know, borrowing costs really spike a lot more, and we’re seeing evidence that businesses and consumers can’t get access to loans, I think the Fed is sidelined.
So we do look for them to cut later in the year because we’re looking for some of these things to change—slower growth, lower inflation—but not now. Probably, that’s a third quarter maybe beyond event, depending on how things play out.

JAMIE: What guidance can you share in this complicated scenario?

KATHY: Well, people who are familiar with our work would be familiar with this chart. This is how we big picture look at the fixed income markets. We look at core bonds and then what we call aggressive income bonds. We’ve been sort of hugging the benchmark. So our benchmark is the US Ag, the Bloomberg Aggregate Bond Index and the core bonds kind of reflect that. And our view has been keeping durations of intermediate-term. The Ag is around six years. We think that that’s a reasonable place to be. You’re getting enough yield at that portion of duration to make it work worth your while, but you’re not going so far out in duration that you’re risking a lot of interest rate volatility. On the other hand, if you sit in cash, you know, there is a good chance if we’re right that the Fed eases policy that you have reinvestment risk and you won’t be locking in these coupons for the future.

So we’ve been focusing on the intermediate duration and staying up in credit quality because we are looking for the economy to slow. And prior to a week or so ago, you didn’t really get a lot of extra yield to justify, you know, taking a lot more credit risk. That seems to be changing. I’ll let Cooper and Collin talk about that. But again, you’re getting 4-1/2- to 5-1/2%-plus in core bonds. We think that that’s a good place to be for the majority of a portfolio, and then being cautious on taking other kinds of risks.

And the other thing that I will say that I think is a good thing to communicate to clients, your end clients, is when you’re looking at total return, the coupon is really important, or your average starting yield is really, really important to determining your outcome. And I think this is something I know a lot of clients miss, that they focus on the volatility and the potential for rates to go up. And when we look at this and we say, ‘Well, if your coupon or your yield-to-worst is roughly around 5%, that’s what you can expect pretty much in total return. And that can be reassuring to clients over time that if they have a strategy that just is set to kind of buy and hold for a while, they can expect that return. And in an environment like this, where everything’s really volatile, risk assets are highly volatile, this is something in core bonds you can point to, is like, ‘Yeah, we know what to expect from this portion of the portfolio.’
So that’s where we are in terms of we’re still up in credit quality, kind of intermediate duration, and focusing on the total returns that we know about, the things we can control, rather than focusing on the things we can’t control.

JAMIE: Thank you, Kathy.

Let’s go ahead and turn to Collin and corporate credit. Collin, great to have you.

COLLIN MARTIN: Hi, Jamie. Hi, everyone.

JAMIE: So first question. Tariff concerns have been putting the market on edge, and more and more headlines about slow growth or a potential recession keep popping up. How will that impact the corporate bond market?

COLLIN: We think the corporate bond market is in relatively good shape, but we still have our up-in-quality bias that Kathy talked about, where we really want to focus on, you know, highly rated investments. When we talk about corporate market, what does that mean? It means investment-grade corporate bonds versus taking too much risk in things like high-yield bonds or bank loans.

You know, if we go back before the tariff announcements, fundamentally speaking, corporations were in pretty good shape. This is a chart we like to show a lot. We get the data from the Federal Reserve, and we look at, in aggregate, total assets, or total short-term assets, rather, liquid assets versus short-term liabilities to see what the aggregate non-financial corporate balance sheets look like. And at the end of last year, that ratio, so liquid assets to short-term liabilities, was over 100%. So that means that for every dollar in short-term liabilities, there’s more than a dollar in liquid assets. Now, those liquid assets can be a number of things. I mean, that includes things like stocks. But from a, ‘You know, hey, corporate profits are slowing. Are we able to remain current on our debts?’ This puts a lot of corporations on pretty solid footing.

Now, we’re going to see much stronger corporations with those with investment-grade credit ratings versus those with high-yield. And we’re starting to see that if we do look at a breakdown of, say, interest coverage ratios or leverage metrics, where this is a concern for high-yield bonds. And I’m going to get into high-yield bonds in a little bit, but with rates, you know, still at a relatively high level right now, and kind of a pretty uncertain outlook about Fed policy, that just means higher borrowing rates for issuers, for corporations, and if you’re a high-yield issuer, you’re seeing higher borrowing costs now than you’ve seen over the past 10 full months.

So, you know, fundamentally speaking, corporations are in pretty good shape, but we do prefer those with investment-grade credit ratings just because of all the uncertainty that we’re seeing out there. And if we do get an economic slowdown, or worse, a recession, that would be a hit to corporate profits.

JAMIE: That was a great segue. You’ve been suggesting investors considering investment-grade corporates for a few years now. Are you still considering those more attractive?

COLLIN: Yeah, we still like investment-grade corporates a lot, mainly because of the yields? This chart I like to show, it compares the yields of various corporates by maturity buckets. So we look at this at an index level, so the Bloomberg Corporate Bond Index broken out by those various maturity buckets at the bottom, compared to the same maturity buckets for treasuries. And you can see a few things here. So one, the blue columns, which represent investment-grade corporates, one, they offer a yield advantage over US treasuries. Now, on average, we’re looking at spreads over 1%. If we look at it at a big picture index level, what it actually is, is going to depend on actual credit rating or maturity range. But the second thing that we like about this chart is how the corporate bond yield curve is a little bit more positively sloped than treasuries. Yes, we’ve seen a little bit of a rebound with intermediate- and long-term treasuries over the past week or so, but the curve is still relatively flat, where if you’re comparing, say, a seven- to 10-year treasury portfolio versus very short-term investments, you’re getting less than a half a percentage point in extra yield. You’re getting about 80 basis points or so more if you’re considering seven- to 10-year corporates versus very short-term corporates.

So we think just the actual yield and income offered is very attractive. And I’ll go back to the point Kathy was making before with that scatterplot we had to show that starting yield is a really good indicator of future returns. If you hold these investments for a while and just earn the income that they’re providing, when held for a period that kind of matches what the underlying maturity of a given fund is, for example, that average annualized total return is going to be pretty close to that starting yield.

And just to put the yields today into perspective, I wanted to show where we are for the various credit ratings versus where we’ve been for the past 15 years and where we’ve been on average. So these blue columns represent kind of the range of average yields for double-A, single-A, and triple-B-rated corporates at a high-level index level, with an average maturity, it’s not one specific maturity. And you can see in the post-financial crisis period we were at yields of, you know, 1% to 2% at the lows. We got as high as almost 6% back at the end of 2023. And while we’re off the highs, you can see with those, you know, red diamonds or squares that we’re still at the high end of that range. I think that’s an important point that is important to make with clients. I think we get a lot of investors always trying to time the market or worried about if yields rise. And we just like to highlight that yields have risen a lot over the past 15 years and where they are right now, is a still relatively attractive level.
So if you look at investment-grade corporates, we think it’s a nice mixture of risk and return. If you look at from a credit quality standpoint, you’re looking at low to moderate credit risk because of those investment-grade credit ratings. And if you consider intermediate-term maturities, say, five to 10 years, or whatever is intermediate-term for your clients, that’s a good balance of, you know, extending duration a little bit, but not too much that you’ll be caught off guard if long-term yields do continue to rise.

JAMIE: Let’s turn our attention to high-yield bonds for a moment. They’ve been hit pretty hard by market volatility. I’m curious if you think that makes them more attractive.

COLLIN: You know, high-yield bonds, they’re more attractive today than they were, you know, three, four, five weeks ago, but they’re not at a level yet that is getting us too excited. And we’ve been pretty cautious on high-yield bonds for a little while just because of the level of credit spread. So credit spread, if you’re not familiar, it’s the extra yield that high-yield bonds offer relative to US treasuries. And, you know, high-yield bonds, they have more risks. They tend to be less liquid. They have a greater likelihood of default over time. They’re issued by companies that have, you know, worse credit metrics, you know, a lot of debt relative to earnings, more interest expense relative to their earnings, things like that. So we as investors should be compensated well for those risks, and for a while we weren’t really compensated too well.

That did change a little bit over the last week. So if we look at these two charts here, I kind of want to frame what we’ve seen. The chart on the left is a one-year look at the average spread of the Bloomberg High-Yield Corporate Bond Index. And if you look at that alone, it looks like, wow, this might be a pretty attractive opportunity to get into junk bonds right now, because, I mean ,just looking at it from that scale, it’s a pretty big jump in spreads. You know, they were as low as 2.6% back in mid- to late-February, all the way up to around 4-1/2% sometime last week. As of yesterday’s close, it’s actually even lower than what this chart shows. It’s closer to 4.1%.
If we take a step back and look at a more long-term view of what high-yield spreads look like, and what they can do during periods of market volatility or recessions, the right chart shows that more. So this goes back 15 years or so, and you can see that the recent rise is a pretty small blip compared to how high they can get.

Now, we’re not necessarily suggesting they’re going to get to, say, 10% or 11% like we saw during the pandemic, or maybe even not to 8% or 7% like we saw during other periods of market volatility or stock market sell-offs, but we do think the risk is that high-yield spreads do rise. And I’ll piggyback on the points Kathy made before about the risks to the economic outlook if we do have tariffs. I think it can weigh on consumer demand given the uncertainty, it can weigh on business investment and business just demand given all the uncertainty out there. And if you’re an investor, you want to earn, you know, what you think are attractive yields to take on the risk of things like high-yield bonds.

So we are worried that spreads can move back up. And just for context, the long-term average is around 4.8- or 4.9%. We’d rather see spreads somewhere around that long-term average given the uncertain outlook before we got a little bit more excited. So if we see spreads near 5%, we’ll likely turn a little bit more optimistic on the asset class, but for now we’re a little bit cautious.
From a long-term standpoint… I think it’s important to kind of differentiate, are you a tactical investor or are you a long-term investor? If you’re a long-term investor, the yields offered on high-yield bonds are relatively attractive right now. They’ve kind of gotten the double whammy over the past week-and-a-half of rising spreads like we just talked about, but also slightly higher treasury yields. So now, on average, you can get more than 8-1/2% on an index or, you know, strategy that looks at high-yield corporate bonds. That actually is above the 10-year median.

So I think that’s relatively attractive if you can ride out the ups and downs, and I think that’s a key point. When you look at… going back to the scatterplot that Kathy showed before, when you’re looking at that indexes or strategies that don’t have much credit risk, like the aggregate index or investment-grade-rated corporate bonds, there’s not much credit loss over time. With high-yield bonds, there is credit loss. Corporate bonds do default, and that means, you know, money taken away. It’s an actual permanent loss of capital. So when you look at this 8.6% and yield-to-worse right now, over time the annualized total return tends to be lower than that to account for the potential credit losses when the bonds do default. But it is a pretty good starting point if you have clients that are willing to ride out the ups and downs, we think they can make sense in moderation. We wouldn’t be overweight this asset class. And if we do start to see spreads, you know, trickle up to that 5% or more area, we’ll likely be a little bit more optimistic.

JAMIE: What about preferred securities? They have characteristics of both stocks and bonds, and I find that it’s not always clear how they’ll react during different market conditions.

COLLIN: Yeah, that’s the key caveat, Jamie. And let me skip ahead to it. I mis-ordered my slides. But that’s the key point with preferreds. They have characteristics of both stocks and bonds. And we get a lot of questions from our clients at Schwab, when things go awry, you know, what’s driving that? So when you look at preferred securities, they have long maturity dates and they have, you know, fixed par values. So in that case, they tend to act like bonds, and they tend to follow the direction of long-term interest rates. But they’re also very low in the issuers capital structure, and, you know, they tend to act more like stocks during periods of market volatility, and especially stock market declines. And that’s what we saw after we got those initial tariff announcements. You can see here an index of… the average price of a preferred index that we track in blue versus a treasury index in gold. And, you know, it’s not a one-to-one relationship, but you can see they tend to move in similar directions. Except when those tariffs hit and the stock market fell very sharply, we saw preferred prices fall really sharply as well. That gap has come in a little bit as treasury yields have increased, pulling their prices down a little bit. But I think this is important for the why, that they have those dual characteristics. And I think during periods of stock market declines that they tend to act more like stocks than bonds or treasuries.

That being said, their prices have fallen a lot. When we look at the chart on the left that I’m showing here, the average price of the preferred index, from a long-term standpoint, it does look a little bit more attractive for investors than, say, an investment in high-yield bonds right now, because we think there’s a lot of room for high-yield spreads to move up and prices to move down. With preferreds, we’re seeing prices relatively low right now.

And on this right part of this chart, we just did a study of the starting price of the index, and what the next 12-month total return was on average, and we kind of bucketed out based on what that starting price was. So we’re in that right bucket, an average price below 90. I’d like to say this is not a guarantee of performance. Obviously, there can be a wide range of outcomes. But the idea of, you know, buy low/sell high, investing today at these low prices is more attractive than it was just a few weeks ago. We would caution that prices can fall a little bit further from here, but from a long-term standpoint, and for clients who might be in some of the higher tax brackets because a lot of the preferreds do pay qualified dividends, they can still make sense also in moderation like our outlook for high-yield bonds, but we would give the same sort of cautious outlook that we would expect volatility to remain elevated.

JAMIE: Private credit has been a hot topic lately. It’s probably not appropriate for many investors, but what should advisors know?

COLLIN: We get questions about private credit a lot. Let me go back to this slide here. And we don’t really have a firm view on private credit because it is still so new, and as it’s being open to a wider array, a wider net of investors. But we do exercise some caution when we talk about private credit because it seems like every headline we see or read or hear tends to be how exciting of an asset class it is or how great it is. But it’s still junk debt because that’s what private credit is. It’s highly leveraged sub investment-grade issuers issuing debt in a private manner, as opposed to the public manner. So if you look at our outlook for high-yield bonds, that spreads have increased, but have since come down, and from a long-term standpoint, it’s not necessarily the best time to invest. That outlook kind of translates to private credit as well, because the yields, whether we see them or not and what we’re seeing behind the scenes, a lot of the same themes are going on there. We want to make sure that investors are being compensated for those risks.

Now, one thing I want to show here, this is not necessarily an apples-to-apples comparison, but there is some sort of private credit investment out there that’s been around for a long time, and that’s a business development company. If you’re not familiar with the business development company, they’re traded on the stock exchange, but they’re companies that lend directly in a private matter to leveraged junk-rated often middle market companies. And you can see here on this exercise I did, I looked at the average annual returns and standard deviations of business development companies on the left versus high-yield bonds and leveraged loans. And, you know, what stands out to me is less about the total returns, where BDCs do have higher total returns, but look at that volatility.

Now, you don’t see this if you invest in private credit because you don’t see those price declines, but they’re likely happening behind the scenes, and because they don’t necessarily need to mark-to-market as much as a public investment would, you just don’t see it. So that’s not necessarily saying private credit is good or bad or something to steer clear of. I just think it’s important to not think of it as something that it isn’t. It’s an investment in junk-rated companies that has similar risks to what a high-yield or bank loan investment would have. You just don’t see what’s happening behind the scenes. So if you were to invest in the high-yield ETF and kind of forget what your account login was, and in five years see how it did, it’s kind of like that, where you just don’t know what’s happening behind the scenes, but over time it can make sense. So just a word of caution there, and, you know, treat it as a risky junk-rated bond investment.

JAMIE: Collin, thank you. That was some great info.

Let’s turn to Cooper in the muni market. Cooper, let’s just start high level. What are your thoughts on munis right now?

COOPER HOWARD: Yeah, thanks for having me, Jamie. Thanks, everybody, for dialing in.

You know, Kathy and Collin really discussed a lot of the volatility, a lot of the movement down in prices, increase in yields recently. Where we think that has kind of translated to is that it’s created some opportunities in the fixed income market. And really one of those opportunities in our view is in the municipal bond market.

So what I want to do, Jamie, is I kind of want to spend the next 10 minutes discussing why we believe that that’s an opportunity. I’ll start by discussing where we are in terms of yields, focus a little bit on credit quality because I think it’s a little bit different of a picture than what’s happening in the corporate bond market, and then where should advisors, and where should investors tend to… are areas avoid or areas to be a little bit cautious of?

But if we start by just looking at overall yields, right now, on an absolute basis, Jamie, yields are very attractive. I mean, there’s no kind of getting around that point. And that’s especially so if you adjust them for taxes. So what we’ve done here is we’ve taken the broad index, a Bloomberg Municipal Bond Index, and taken that 4-1/2% yield, which is what the yield is before adjusting for taxes, and said, ‘Well, if that were a fully taxable bond for an investor who is in a high tax bracket in a high tax state like California and New York, where would that be?’ And right now what we’re looking at is we’re looking at north of 8%. So round up, you’re at about 9%, where we are today. Obviously, there’s been a lot of volatility, a lot of fluctuations. That’s moved around quite a bit.

So are we through the worst of negative total returns for the municipal bond market? We might not be, but one of the big points that I want to reiterate that Kathy had highlighted is I love that slide showing where we are in terms of starting yield, and then looking forward, what does that bode in terms of total returns, or what does that kind of look like as far as a total return a couple years out? So if you can look through some of the short-term volatility, some of the short-term noise, longer term, we think that municipal bonds can really have an appropriate place in the portfolio, and really can make sense given what we’ve seen recently.

It’s not just absolute yields that look relatively attractive. It’s also yields relative to corporate bonds and then yields also relative to treasuries. So if we take that 8.7% tax equivalent yield and compare it, say, to just an equivalent corporate bond, right now you’re getting at about a 3.2% additional yield over a corporate bond. As you can see, that’s nearly the highest that it’s been in the past 15 years. So we think that given the tax benefits that municipal bonds offer, that’s really attractive compared to corporate bonds.

And again, it’s not just compared to the corporate bond market, Jamie. We also look at it relative to the treasury market. A similar stories being told there. So right now, one of the metrics that we commonly look at is called the muni-to-treasury ratio, or the MOB spread. If you’ve been following some of our work, I commonly cite it. All that it is, is the yield on a triple-A-rated municipal bond relative to that in the treasury. It’s just a simple ratio. And as you can see, relative to the three-year averages, we’re higher than relative to the three-year averages throughout the yield curve. That’s especially true for the longer-term portion of the market. You can see that right now a triple-A-rated muni for a 30-year maturity yields about 100% that of a treasury before adjusting for taxes. So that’s not to say that we think investors should go all the way out 30 years, but the point is, right now we’re near the highest levels that we have been in some significant time.

So I know that there’s been two questions, or a few questions that have come into the inbox about why municipal bonds have underperformed treasuries just recently, and why this opportunity has existed or has started to pop up. And I think that it’s due to the illiquidity of municipal bonds. So if we go back about a week or two ago, right when the tariffs were initially announced, that led to some concerns in the muni market, and really what we saw is we saw some downside for two large ETFs that are out there. So the market tends to be dominated by two larger ETFs, and there were some redemptions that were the result of that. So that created a lot of forced price pressure and forced selling in the market. So there was a significant amount of supply coming onto the market. There wasn’t necessarily that amount of demand to keep up with it. The other piece of it is that today is tax day, so municipal bonds tend to have a little bit of a seasonality aspect to them. You could have also seen some investors selling their positions to liquidate that to help pay their tax bill. So really what we believe the reason for a lot of the significant volatility that we have seen recently is more just a supply and demand technical factor than anything else.

JAMIE: Could some of what we’re seeing be due to concerns around credit quality? I’m just thinking if the probability of a recession has increased, wouldn’t that be a negative for the muni market?

COOPER: You know, it would be a negative for the municipal bond market, for parts of the muni market, but I don’t believe that what we’re seeing right now is due to concerns about credit quality. A couple reasons for that.

One is where we’re seeing most of the moves is for the whole broad municipal bond market. If it was due to concerns about credit quality, we would expect to see spreads for triple-B-rated issuers increase or spreads for high-yield-rated issuers increase. We haven’t seen that.

The second piece of it is that credit quality for the muni market continues to perform relatively well. And we’ve seen that a lot of state and local governments have really built up their liquidity positions coming out of COVID. So right after COVID, many state and local governments received a substantial amount of fiscal aid. We also saw a surge in tax revenues. And what they’ve done with that amount of money or with those funds is they’ve used them to kind of build up their savings positions. And what I want to highlight is this chart here, specifically, if you focus in on the number of states that could run off of their rainy-day fund in 2019. And as you can see, there were only six states that could run solely off their rainy-day funds for a hundred days or more. Fast forward to where we were in 2023, and that’s the most recent data available, and that’s increased to 34 states. So that just highlights that if we do go through an economic downturn, that many states have a lot of runway and a lot of liquidity to help cushion some of that slowdown in revenues.

The other piece that I’d highlight, Jamie, is that many states and municipalities rely on revenue sources that are either one, not necessarily too economically dependent, or two, tend to lag the overall economy. So like Kathy had mentioned, yes, the probability of a recession has increased about 30- to 40%, but if that actually comes to fruition, we still think that credit quality in the muni market, broadly speaking, should perform relatively okay.

JAMIE: What do you think investors should do, and where specifically do you think the opportunities are?
COOPER: Yeah, so I think where the opportunities are is to focus on higher-rated issuers. Again, we don’t have too many concerns about credit conditions in the muni market, but you’re really just not getting that adequately compensated for taking on that additional credit risk. So if you look at the spreads for triple-B-rated muni issuers relative to triple-A-rated muni issuers, they’re offering about a 90-basis-point additional yield compensation. As you can see, that’s been near the lows going all the way back to 2010. It’s also below the longer-term average of about 1.6%, or 160 basis points.

So I don’t necessarily think that… the point there is that there’s just better opportunities elsewhere in the market, especially if you focus on higher-rated issuers. Also, even though we think that most municipalities will be able to weather an economic downturn, it’s those lower-rated issuers that are likely going to face greater headwinds in terms of if revenue’s slow.

The other thing that we’d suggest is to stick with the benchmark duration. Kathy highlighted this in kind of the broader outlook, but that also applies to the municipal bond market as well.

Now, one of the alternatives though, or one of the things that I would say is a little bit different is I highlighted how the 30- to 30-year muni-to-treasury ratio of now about 100%? That’s just used to highlight that the longer portion of the yield curve on the muni market looks more attractive than, say, shorter term. Now, I’m not suggesting, again, going out in all 30-year munis, but if you do have clients who can take on a little bit longer duration, or you want to be a little bit more of a tactical standpoint to it, there is some opportunity, some value on the longer end of the yield curve. So that’s the other piece that we would suggest, Jamie.

JAMIE: Are there areas or sectors of the market that you would suggest caution with?

COOPER: Yeah, so there’s a couple things that we think you should exhibit caution with.

The first I want to start with is we do think that it makes sense to diversify nationally. There are only two states where we recommend an all-in-state portfolio. That’s going to be California, and also, New York, due to the high state tax benefits there. Also, there are many issuers in those states, so you can generally achieve adequate diversification.

The other piece is that ultimately we don’t know where this trade policy, where the tariff policy, is going to end up, and we don’t know what impact it could have on the broader economy. But for states that are in the Midwest, they tend to have a large proportion of imports relative to their GDP. So if you were trying to dissect, look under the hood, of where geographically it might have a larger impact, it could potentially be the Midwest states.

The other piece that we’d be a little bit more cautious on is looking at sectors, specifically, the higher education sector. Right now, spreads relative to their three-year average, they’re tight for most of the muni market, but spreads for higher ed issuers, they’re seven basis points below their three-year average. And you might think, ‘Well, that’s not too bad in terms of kind of taking a broader longer term look.’ But I do think that that’s a sector that’s facing higher headwinds, or greater headwinds than the rest of the muni market. There’s a couple factors that are coming into play.

So first off, there’s concerns about grant funding. We’ve seen that in terms of the spat that’s going back and forth between Harvard and the current administration, and freezing some of their grant funding. There’s also concerns that their endowment funds might be taxed at a higher rate. Now, for larger private institutions, this likely isn’t too great of a concern because they are larger private institutions with those named benefits being able to attract a diverse student population. Where my concern is, or where I’d be a little bit more cautious, is smaller private education issuers. I think that those are the ones that given those headwinds that they could face, and given that they’re smaller and more highly dependent on student tuition, that’s a little bit of an area of concern.

Now, one of the things that I would say is that, Jamie, the muni market is about $4.2 dollars in size, so it’s a very difficult market to paint with a very broad brush. So even though we’re a little bit more cautious on issuers in the Midwest, on issuers that are higher education private institutions, there still could be opportunities there, but broadly speaking, we would just exhibit a little bit of caution there, and I think that there’s better opportunities elsewhere.

JAMIE: Another federal issue that advisors have asked about is the elimination of the municipal bond tax exemption. What are your thoughts on this, and what do you think the probability is that the muni bond tax exemption is fully repealed?

COOPER: Yeah, pre tariffs, this is probably the number one question that I would get. And I believe that it’s a low probability, but one of the reasons is it would do just more harm than it would do good. But if we look at kind of the current state of the landscape, an important question facing Congress right now is how the Senate Parliamentarian will rule in terms of is the Tax Cuts and Jobs Act considered current baseline spending or is it considered an exemption on it, or it’s set to expire? The reason being is that the tax law bill is going to come down to a math problem. So can they find enough revenues to offset the expenses of trying to cut taxes? And if they consider the current Tax Cut and Jobs Act baseline spending, they’re not going to have to find as many revenue raisers as if they were to rule that it isn’t baseline spending. So that’s one of the important factors to watch on it. The other factor is looking at how much does extending the Tax Cuts and Jobs Act cost relative to the municipal bond tax exemption? And it’s about 17 times the cost of it if you were to make all municipal bonds fully taxable. So given that we think that it’s a relatively low revenue raiser compared to the ultimate cost of the Tax Cuts and Jobs Act, that’s one of the reasons that we think it’s a pretty low probability.

The second piece of it is, again, it would do more harm than it would do good. It would likely raise borrowing costs for state and local governments, other municipalities. That would hurt infrastructure and spending, Jamie. The second piece of it is that it could actually form… or it could actually serve as a tax hike, both on high-net-worth investors and lower income individuals. The reason that it would be a tax hike on higher net worth investors is obviously they would be losing a common tax investment vehicle in municipal bonds. The second piece of it is given that it would likely result in higher borrowing costs, that would probably be passed on to individuals in the form of higher taxes, and those would likely be borne more by lower income individuals, rather than higher income individuals who have a little bit more flexibility in their budget.

So what we do think may be more of a possibility, and again, a lot of this depends on how the Senate Parliamentarian rules, is trimming around the edges. So depending on what Congress decides, they may choose to make some types of municipal bonds issuers exempt from, or repeal the municipal bond tax exemption. So for example, you can see things like higher education issuers, things like private activity bonds, so airports, bonds to fund stadiums. That to me would be a little bit greater of a probability. The other possibility is potentially capping the municipal bond tax exemption. One of the thoughts that’s been thrown out there is capping it at 28%.

Now, again, a lot of this is just speculation. So what we’ve been advising our clients and kind of suggesting is don’t try to trade around or invest around a lot of these big question marks that are happening, because ultimately, we don’t know what’s going to come to fruition, and handicapping is just too difficult in this environment.

JAMIE: Thank you, Cooper. Lots of great information.

This is going to end the presentation portion of today’s webcast, but I can see we have quite a few questions coming in and limited time. So let’s jump right in.

Kathy, I’d like to start with you. There’s a question about how real do you believe the possibility is that China could aggressively sell treasuries and mortgage-backed securities in response to the dispute over tariffs?

KATHY: Well, it’s certainly something that China could do. I don’t think it’s a high likelihood that they will because there’s lots of other things that they can do to retaliate against the US, and we see that they’re doing those. You know, putting tariffs on certain goods, and moving shipments to other places, rallying some of their Asian neighbors to have their own tax, have their own trade zone and push out the US from that area. So I think they’re taking a lot of steps that are actually more targeted towards the US. You saw the news this morning, I don’t know if it’s been verified, but that they would stop orders of Boeing planes. These are things that hit pretty hard at the US economy pretty quickly.
So just to go back, they hold about 700 billion, say, in US treasury securities of various types. That’s in the official information that has come down, although there’s a lot of belief among analysts, particularly Brad Setser over at the Council of Foreign Relations, who has done a lot of really heavy duty work on this, that they actually have shifted some of their ownership to Europe, and they go through Euroclear, so it’s not as obvious to us that they’re still holding closer to a trillion.

But be that as it may, exports for China to the US are important, but they export to the rest of the world, they have lots of other options to use. Selling their holdings of treasuries would put a lot of pressure on their own assets, their own holding of assets, and I just think they’re smarter than to do that. It’s sort of shooting yourself in the foot. A lot of their holdings are shorter-term, in T-bills, etc. So not necessarily going to drive the long end of the market in terms of yields higher. So it might not have that desired effect. So again, I think that they’re pretty smart and savvy about how they retaliate against the US. They’re playing the long game. And I don’t think that that’s the most likely levy of it.

As far as the other part is the currency, China has been allowing its currency to come down. If they were to retaliate, it’s harder to manage their currency within the band they’re trying to manage. Now, they’ve tried to keep a floor under it, but they can certainly allow it to go down further, if need be, to be more competitive in the export markets.

So again, a lot of other things that they can do, which they seem to be doing. You can never say never about any of these things because we’re in kind of uncharted territory, but I don’t think that that’s the first or most likely thing that China would do. I think these other steps they’re taking are much more logical and long-term in nature.

JAMIE: Collin, I’m going to move to you next. How likely is it that short-term and ultra short-term bond funds will outperform money market funds over the next 12 to 18 months?

COLLIN: Yeah, that’s an interesting question. And I’ll say it depends, because there can be a lot of different types of strategies that fall under those kind of Morningstar descriptors. Like if you’re an ultra-short fund, that could be an asset-backed security backed by some sort of loan, or it could be investment-grade corporate bond floaters. So it depends on the level of risk I’d say. You know, if you invest in ultra-short funds and you see a yield that’s higher than what’s offered by the money market fund, for example, there’s likely more risk in that. And with more risk comes the potential that the price can decline to some degree over time. And I’d say with short-term… because then you move from ultra-short to short-term, short-term isn’t, you know, necessarily things with 12 months or less to maturity. Short-term can be one, two, three years, something like that, which does give them a little bit more interest rate risk. So if we were to get some sort of repricing of Fed Funds expectations, short-term funds could end up underperforming a little bit. So it depends on what they own because they’re all a little bit different.

And Jamie, one question I want to touch on before we go back to you for Q&A, we’ve gotten a few comments in here about my discussion about private credit. And I want to make it clear, when I call private credit junk, it’s not my opinion. I’m just calling them… that’s a colloquial term for what a high-yield bond is. A high-yield bond, by definition, is one that has sub-investment-grade credit ratings. Another way of referring to high-yield debt is junk debt. So private credit, it’s junk debt, it’s sub-investment-grade. So whether it’s senior secured, it still has sub-investment-grade credit ratings. Whether it has a high EBITDA, it generally still has sub-investment-grade credit ratings. If it has strong covenants, those strong covenants usually come with sub-investment-grade credit ratings. So it wasn’t my opinion that they were junk, it is just junk-rated debt. And that comes with risks, and that’s for all of you to decide if you wanted to take those risks or not. But it’s like investing in high-yield debt or leveraged loans, just in a private wrapper.

JAMIE: Great distinction to make.

Cooper, I’m going to jump to you for what might be our last question. I’m going to combine two. I’m wondering if you have a specific duration or kind of a sweet spot average duration for munis that you could give guidance on?

COOPER: Yeah, so the average duration of the index that we follow is about six years. So I think that that’s a pretty good starting point. But like I mentioned, if you’re a little bit more of a tactical investor who can weather the ups and downs, longer term bonds, longer term valuations are more attractive than shorter term valuations right now. So again, that’s not saying go all long-term, but if you’re a little bit more of a tactical investor, maybe shifting beyond that six-year duration makes sense. But in terms of how to get there, we do like combining an average of some short-term investments with intermediate- and longer-term. So we think that can make sense in this environment.

JAMIE: Thank you for that.

Judging our time, I want to be respectful of everyone’s calendars, so I’ll go ahead and close us up.

I just want to say thank you for everyone joining the webcast today with Kathy Cooper and Collin, and all of the great questions and the engagement we received from everyone. We hope these insights are helpful to you and your clients, and we’ll send a follow-up email with a replay link.

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The next webcast will be on May 6th. That’s going to be with Liz Ann Sonders, Kathy Jones, Jeffrey Kleintop, and Kevin Gordon. And of course, if you would like to learn more about Schwab’s insights or for other information, please reach out to your Schwab representative. And thank you again for everyone attending.

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