LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Every week, we analyze what's happening in the markets and discuss how it might affect your investments.

So Kathy, here we are again. We have said this many times on the show. One of the, I guess, risks or opportunities or just facts of life these days is that U.S. trade policy can change on a dime. And this week, or at least the past weekend, that's exactly what happened. So I'll turn to you first. What do you think about the markets, particularly in your part of the world, and the reaction to not just the de-escalation announcement that we got over the weekend, but just in general, the whiplash nature of markets these days.

KATHY: I think the markets continue to get caught in the cycle of discounting a certain narrative and then having to go back and un-discount if that, that's not a word, but you know, go back to where they were before. And we've certainly seen this in the Treasury market, you know, within this very wide range just sort of going back-and-forth and back-and-forth and that's in, say, the 10-year, but when you look at the short end, same story to some extent with discount, you know, two, three, four rate cuts by the Fed over the next year. Then, no, we're back to two, and maybe one, and then back to three. And the market's just really having a hard time because policy changes so rapidly, getting a read on what the economic outlook is going to be, what the inflation outlook is going to be, and what the policy outlook is going to be. And so I really think that we're stuck with elevated volatility for the time being because everything changes. And by the way, this is just trade policy. We haven't even talked about budget policy yet, which is substantial and is moving forward. So you know, I think here we are, you know, just back-and-forth and back-and-forth. And that's going to open up opportunities, I think, when yields kind of poke up really fast. And I think that creates opportunities for investors looking for decent yields.

But you do have to be kind of cautious about how you maneuver in a market like this because you can get caught on the wrong side very, very quickly. What about you, Liz Ann? I think we just have so much volatility in equities as well.

LIZ ANN: Yeah, and Kathy, it's not just trade policy and, as you mentioned, budget policy, which means needs to come into the fore here, but ongoing DOGE-related spending cuts, you know, Department of Government Efficiency for those who aren't familiar with what the acronym stands for, but also immigration policy, the absence of any true immigration that's coming in and the impact that that has on the labor market via labor force participation, so there's so many facets of this that impact the economic outlook, to the extent that you can even have anything but a murky outlook at this point. 

And what we did get with the over-the-weekend announcement out of the Geneva talks between the U.S. and China was admittedly a delay and a de-escalation in terms of the proposal of where tariffs will be, but you know, even though a move from 145%, which was what was announced on Liberation Day, down to the assumed 30% now, if that had been announced on April 2nd on Liberation Day, that would have been a bit of a pill to swallow in terms of the economic outlook, given how significantly higher those were than where we were before. 

So I don't think this really … it might lower the near-term odds of this becoming a recession, because what we know now with the data that's come in, in the last few weeks, is that the economy was on pretty decent footing, including the labor market heading into this. But to me, what I think will be really important is, we've talked about it on these episodes in the recent past, is that you, much like in the early part of COVID, you had a rising number of companies just withdrawing guidance altogether or stating guidance via a scenario analysis of "If everything gets de-escalated, we're pretty comfortable that we could reach what was our base case for, say, a full-year outlook prior to all of this volatility. But under some sort of significant-hit-to-growth/recession scenario, here's what were likely to see in terms of hit." 

I don't know that this unleashes some air of clarity here that means that companies have a better sense of how this is going to unfold, what that means for their capital spending budgets or plans around their own labor force, or even how they might try to protect profit margins because tariffs, even with the bit of de-escalation and delays, we're still talking about a tariff regime that is significantly higher than, call it pre-Inauguration Day. And I think there's also been some interesting forces to consider over the past month or so. 

We saw a lot of the economic data kind of swayed by virtue of a lot of the tariff front-running. A tremendous amount of ordering either of inputs or consumer buying of goods on which tariffs were going to be placed. Now, in the case of companies as they try to plan for the near term, a couple things could be happening. That buildup of inventories gives them a little bit of a cushion, but it also might give them the ability—and also the time associated with delays—the ability to kind of play around with pricing, see what sticks so that they can get a sense, particularly if this doesn't fully de-escalate, and 90 days comes and the tariffs go back on, or even if we're stuck with tariffs at the original proposal pre-Liberation Day, the question is whether companies are going to have to eat some of it in their margins or be able to pass that on to the consumer. 

One other note, I probably should have said this up front, I don't know if you've had the experience, but as recently as just last week, speaking to some investors, the angle of the conversation around who actually pays the tariff at the outset, I had more and more people still say, "I didn't know that that's how it worked. I thought it was the targeted country that was paying the tariff to the U.S." So I'm usually pretty good at remembering to remind people of that at the outset. I just decided to plug that in here because, again, in terms of impact on their outlooks, impact on profit margins, it's the U.S. companies that are bearing the brunt of this and are trying to put it into their calculus in terms of their forward-looking outlook, especially around profit margins.

KATHY: Yeah, and I did a quick sort of back-of-the-envelope attempt to quantify what this means for the economy. If these are the tariff levels that we're talking about going forward, if you freeze time and say, "This is where we are," which is ridiculous; we can't. But it's still probably going to subtract nearly half of 1% from GDP and push up inflation. So yes, it's a less bad situation than we thought we might have. And maybe people feel like they now have a sense of where the administration will pivot, right? What's the limit? And therefore they feel more confident that if things look really dire, there'll be some sort of compromise. 

LIZ ANN: The blink trigger or the pivot trigger. 

KATHY: Exactly, and I think people are gaining a little bit of confidence that it won't go down the worst possible scenario, but nonetheless, we're not looking at a real positive outlook based on where we are today in terms of the tariffs. So going to be a very interesting summer. I have the feeling as we really get into the heart of summer here, the heat's going to stay on in these markets.

LIZ ANN: Yeah, and you know, the Fed outlook is so tricky, too. I just looked at fed fund futures market to see how the market was building in expectations, even just around the June meeting. And you did see more than a doubling of the probability that the Fed does nothing at the June meeting. They didn't at the May meeting, obviously. So that could still swing around based on data as it comes in, but that was one of the initial sort of knee-jerk reactions was a bit more of a pricing out of a cut in June.

KATHY: Right, and in fact the market's only pricing in two cuts now this year, which is kind of where we were six months ago. And it's where we've been all year because we just can't, we decided not to change our minds because we didn't have a basis on which to change it, so we left it there. And I think that the market's kind of coming around to that view, but that could change again in a heartbeat if there's some other development policy-wise.

LIZ ANN: Yep. So Kathy, you touched a bit on Treasuries, and we talked a little bit about the Fed and obviously, you know, my areas, the stock market and the volatility therein. But I'm going to turn it back over to you and our colleague Cooper Howard to discuss one particular bond strategy and why it's important. So tee it up for us.

KATHY: Yes, we're talking with Cooper Howard, who's been on the show before, about the municipal bond market today. Cooper was on in January, and he was discussing munis and climate shocks after the fires in California. Cooper is a Chartered Financial Analyst charterholder. 

Cooper has been widely quoted in financial publications like The New York Times, Bloomberg, Wall Street Journal, CNBC, and The Bond Buyer. 

Cooper, thanks for being here.

COOPER HOWARD: Of course, well, thank you for having me, Kathy. I'm happy to be back.

KATHY: On one of the last episodes we discussed that munis are an area our team likes right now. You know, valuations look attractive, so I wanted to bring you in to discuss more about this because these days in markets things are moving around so fast it's good to find something where we've sort of consistently found some value in the market. So let's start with the basics. What are municipal bonds and why should someone consider buying one?

COOPER: So a municipal bond is just a bond that's issued by a city, a state, or a local government. Now, the municipal bond market is fairly large. It's about $4.0 trillion in size. And it can range from bonds issued by any state on the coast all the way from, say, Maine out to California and everything in between.

There're bonds that are issued by cities. They can be higher-education institutions, water utility districts. So it's a fairly diverse market, pretty difficult to paint with a broad brush. But really the two main reasons why we think that investors should own municipal bonds in most environments, or any environment, comes down to tax benefits and then credit quality. So our colleague Collin Martin was on the last episode, and he brought up a very good point of one of the things that you should consider when you're considering municipal bonds is what account type do you own them in? And they're really only appropriate to invest in if you're in a brokerage account, something that's fully taxable, because you do get those tax benefits that municipal bonds offer. 

The second piece why we think munis can make sense is credit quality. So about 70% of the broad municipal bond index is either AAA or AA rated. So seven out of 10 of those bonds are going to be in those top rungs of credit quality. If you compare that to corporate bonds, only 7% of corporate bonds are either AA or AAA rated. So it tends to be a market that's very skewed toward higher-rated investments. Now part of the reason is that how they're structured and how they derive their revenues. A lot of municipalities rely on revenues that are not subject to a lot of economic fluctuations or kind of lag the overall economy.

There are also lot of revenues that are pretty independent of certain things. So for example, water and utility districts, regardless of the economy that we're in, tends to be that people are going to pay their water and sewer utility bills. Now this really translates into lower default rates or lower missed interest and principal payments. And if you look at a basket of 10,000 bonds over the course of five years, about four out of those 10,000 default over that five-year period. Compare that to the corporate bond market, and roughly 80 out of those 10,000 default over a five-year period. So again, given the high-credit-quality nature of municipal bonds tends to translate to lower rates of default, and then combine that with the tax benefits, and that's one of the reasons why we like municipal bonds.

KATHY: OK, so we've got good credit quality and tax exemption, which for most people, getting a tax-exempt stream of income is a good thing. So let's get now down to the topic at hand is why do we think munis are attractive right now?

COOPER: Yeah, so if we fast forward to where we are right now, the simple fact is that we do think that yields are attractive right now. And if you look at that broad index that I had mentioned earlier, it's yielding about 4%. So that's taking kind of your average municipal bond that's out there. That's going to be something that's higher credit quality, a little bit lower credit quality, shorter term, longer term, looking at them all together and saying, on average, what does a municipal bond yield? And that's about 4%. 

And again, this is something that it's usually exempt from federal income taxes. So if you were to look at that and say, "Well, what would that yield be if it were fully subject to federal income taxes, as well as state income taxes for an investor who's in a high-state-tax bracket?" And that's about above 7.5%. So we think that given other alternatives, that's pretty attractive. That's near the highest that it's been over the past two decades.

Even if you look at something that's much more risky than an investment-grade municipal bond, let's say a high-yield corporate bond, that yields roughly 7.7% today. So given where we are in terms of credit quality and relative yields, that's one of the reasons why we think that munis can make sense today. And there was this kind of long-known misbelief or misnomer, I should say, that municipal bonds are only for investors in the top tax bracket. That's not the case today. 

So today, for the average municipal bond to yield more than the average corporate bond after taxes, an investor would only need to be in the 22%-and-above tax bracket. Also, if we look over to credit quality right now, credit quality still remains attractive.

One of the metrics that we commonly look at is a rainy-day fund. And a rainy-day fund is akin to a savings account for a state. So just like you or I would have a savings account where we stock away some money in case we need to tap into it for a rainy day, states have the same. Now there are certain restrictions on how much they can tap into or why they can tap into it. But if we look at the growth in rainy-day funds, a lot of coming out of COVID, we saw a significant increase in tax revenues.

We saw a significant increase in federal funding that was provided to state and local government. And they really used that—they socked it away and put it into their rainy-day funds. And if you were to look at how long could a state run solely off of their rainy-day fund prior to the pandemic in 2019, only six states could run for a hundred or more days solely off of their rainy-day funds. Fast forward to where we were in 2023, which is the most recent data available, and that's increased from six states up to 34 states. So that gives a lot of states and municipalities a long runway in case we do see a slowdown in revenues, which we're not seeing a significant slowdown in revenues as of yet.

KATHY: So let's dig into credit quality a bit more. You know, on the federal side, there's been a lot of discussions about cutting federal funding that flows down to the states. Are you concerned about this? How would it impact the muni market?

COOPER: Yeah, so there are a lot of kind of issues that are out there. I think that there are a lot of headwinds. Overall, we see this as relatively manageable, especially given the starting point of where we're at. I mean, some of the headwinds that we're seeing are higher inflation. This is going to flow through to higher infrastructure costs, potentially higher wages. We're also seeing public resistance to higher taxes. If you look at many studies that are out there, overall trust in the federal government is low. So voting for higher taxes, voting for increases in taxes, it's not that likely right now. So we don't see that as something out there. 

The other potential risk is risk from proposed federal policies. And I'd really bucket these into two different categories. The first one is how does money flow from the federal side of things down to the states and then eventually make its way down to local governments and other municipalities? The other piece of it is changes to federal policies that could have an indirect impact to state and local governments. So for example, stricter immigration policies that could result in smaller workforces for certain areas of the country or less foreign students that could result in some pressure for higher-education issuers. But I want to go back to the idea of how does federal money flow from the federal side down to the states. And one of the unique things I think about the municipal bond market is that it deals with fund accounting.

This is a little bit different than a corporation to where all revenues flow into one account. In the municipal bond world, if it's a state or a local government, revenues flow into a specific fund, and then that fund has to be used specifically towards what it's designated for. So a way that you can see this is if you look at your property tax bill. A lot of people don't really look at the details of it, but there are going to be mill levies, and each line item on it is going to be a specific amount that's designated for a specific cause. You might see something for local school districts, community college, parks and recreation, etc. So it's important to know where are the cuts coming from, and how ultimately would that impact a lot of things on the municipal bond side? 

Now, one of the more severe cuts, I should say, that would impact states are cuts to Medicaid and potentially cuts to disaster relief. So Medicaid, it helps cover medical costs for some lower-income individuals. That's not to be confused with Medicare. Medicare is health care for retirees. So Medicaid is a joint program that's issued between the federal government and states. Now states administer the program, but they also receive federal funding. And it's based on a complex formula. So about two-thirds of the overall funding comes from the federal side of things. 

But if there were to be a cutback on Medicaid funding, ultimately the state would have to make two choices. One, they'd actually have to either cut benefits, or they'd have to tap into their own revenue sources, potentially that rainy-day fund, to help offset some of those declines on the federal side. So that's one area that we're watching to see how this goes going forward. But again, I'd say, given the strong starting point that we're at, we're not too concerned about a significant slowdown.

And we think that the high credit quality that munis generally exhibit should still continue going forward.

KATHY: You know, there's another area when you touched on briefly was higher education. And we've seen some impact from the federal side on various higher-education institutions. And there's also been some problems with just demographics in higher ed. So you've got an aging population and a declining population of students entering college. How concerned should an investor be in higher education right now?

COOPER: You know, that's a great question because obviously there is a lot going on in the higher-education space, both long term and then short term with what's happening with kind of the current administration. But I think it's important to start with the lay of the land in the higher-education space, because like I mentioned how the municipal bond market's $4 trillion in size and runs the gamut in types of issuers, within the higher-education space, it's a pretty bifurcated market. 

So if you look at it, we have public institutions. They have a higher, larger reliance on state aid. They're usually higher rated as well. And then the flip side is going to be private educations. There's a larger reliance on tuition revenue. And in terms of credit ratings, they also run the gamut a little bit more. So they have a wider range of credit ratings. You see a little bit more lower-rated private education institutions relative to public institutions—they tend to be higher rated on average.

Now, if we look at the sector as a whole, Kathy, the number of downgrades has been outpacing the number of upgrades recently. So we look at studies from many of the rating agencies about how many bonds, how many issuers, are they downgrading relative to how many are they upgrading? And that's kind of a trend of overall credit quality in the space. And what we're seeing is that there are two downgrades for every one upgrade. 

So like you mentioned, longer term, there are demographic shifts, longer-term trends that are negative on the space. But if we look at the … kind of what's on the table for federal policy, one of the things that we're watching that would be a negative is reduction to federal grants and research funding. For larger private institutions with large research institutions or large research arms, this would be a negative. They'd either have to cut down on some of the funding there or cut down on some of the research or potentially make reductions overall. The other piece that we're watching is, just yesterday, this is being recorded Tuesday morning, but just yesterday the GOP released their tax bill, the proposal of the tax bill. Now I will give the caveat that the proposal of the tax bill is ultimately not what's going to happen in the end. It has to be debated. A lot of the pieces of it could change from what we're originally seeing right now.

So what we're seeing right now may not ultimately come to fruition. However, one of the pieces in it is that it did increase the tax on endowments for these large institutions from 1.4% potentially all the way up to 21%. Now this is going to be something that's based on the size of the endowment, as it's written today. So again, this would be a potential negative to some of those larger private institutions, but they generally do have significant endowments, so maybe they'll be able to navigate through this going forward. 

The second piece that we're watching is the threat to the tax-exempt status. One of the provisions in the new tax bill, it would allow for the removal of a tax-exempt status if the entity is declared as a terrorist-supporting organization. The other thing that we're watching is reductions in visas for foreign students. So for those institutions that have a high reliance on foreign students, if there's a reduction in the visas, this would put further stress on their revenues. So a lot is going on with the space, but I would highlight that it is a very bifurcated market. So you do see a lot of institutions that may not be facing some of these headwinds, and some are facing the headwinds to a greater degree overall, Kathy.

KATHY: I mean, that's a lot going on right now. And you're right. It probably is … careful selection sounds like it's really important. But let's go back, zoom out a little bit. So if you're interested and see this opportunity in municipal bonds, it fits your risk profile and what you're trying to do in your portfolio, where on the yield curve would an investor focus?

COOPER: Yeah, really where on the yield curve an investor should focus should start with "Why are you investing in bonds?" And then that's going to drive where on the yield curve you should focus. So there's three reasons why we like investing in bonds, not just municipal bonds. And that's going to be income, diversification, and then capital preservation. So starting with the income piece, we do think that it makes sense to broaden the definition of income, not just consider your interest income, also consider that principal coming due. So consider when do you need the money back? And then that's going to be something. 

So one of the strategies that we'll commonly suggest, Kathy, is like a ladder strategy. And we know that if you build a ladder strategy, and all that is, is you buy incremental amounts into bonds that mature at different rungs. So say you were to buy a five-year ladder strategy, and you have some money coming due in one year, two years, three years, four years, five years, that's going to help create a paycheck for you because you know when that money is coming due. 

The second piece is going to be diversification. That's the other reason why we generally think that it makes sense to invest in bonds. And if you look at diversification, right now we'd suggest about an intermediate-term benchmark for the municipal bond index. A good starting point is about six years for an average duration. That's going to include some shorter-term bonds, some longer-term bonds, but we think keeping that average at about six years can be appropriate in this environment.

And then the third reason is going to be capital preservation. So we know that a bond at its most basic nature is just a contract between you, the investor, and the issuer. So they're going to agree to pay you back that principal amount at a set date, barring some default. So if you have a kid's college expense coming up in four years, that you know, generally makes sense to probably focus on a four-year maturity. So that's really where you'd want to focus on the yield curve depending on when you have that liability coming due.

KATHY: So Cooper, a lot of times when people look at municipal bonds, they think, "I have to buy the bonds in the state that I live in to get the maximum benefit." Does that always make sense, or sometimes should I look outside of my state?

COOPER: Yeah, it doesn't always make sense. And really, there's only two instances where we suggest focusing on municipal bonds solely from your home state. And that's going to be if you're an investor in California or an investor in New York. Like you mentioned, oftentimes people like to focus on munis from their home state because, generally speaking, if they buy a muni from their home state, it's exempt from state income taxes, so they can save on that. However, one thing that they're oftentimes not looking at is the loss of diversification benefits.

So for issuers in California and New York, tends to be that there's a large number of issuers. You can get adequate diversification by focusing just on munis from your home state. For a lot of other states, even though you are saving on some of those state tax benefits, you're giving up on the diversification benefits. So we think that that really in those 48 other instances outweighs saving on the state tax benefits, and we'd suggest looking at municipal bonds from outside of your home state.

Additionally, I would add even after having to pay a state income tax, you may come away with a higher after-tax yield. So it is something that, yes, you could be saving on state taxes by focusing only on bonds from your home state, but you might not be getting the highest after-tax yield.

KATHY: That's terrific. Thank you so much, Cooper. I always learn something when we chat about municipal bonds. So I hope this was as enlightening for our listeners as it was for me.

COOPER: Thank you, Kathy. Thank you very much for having me.

LIZ ANN: So Kathy, usually at this point in these episodes, we try to assess which upcoming indicators, economic or otherwise, matter most in the coming days. And obviously, anything tied to the Fed's dual mandate, employment data, inflation data, is going to continue to be important, but we know that that policy and the mercurial nature of policy and how it's announced will undoubtedly be the biggest driver, certainly in terms of the psyche of investors across both of our worlds, but anything else that's in general on your radar that could move the fixed income side of things?

KATHY: Well, we're certainly keeping an eye on inflation and how that might affect Fed policy. But we're also … I'm keeping an eye on the dollar and what it might mean for investment flows in and out of the bond market because that's been a big factor recently. What about you, Liz Ann? What do you think investors should be paying attention to?

LIZ ANN: I'd pay attention to the differential between the soft economic data and the hard economic data. We've talked about it on episodes before, so for those not familiar with those terms, soft data, survey-based data, so it would be things like consumer confidence, CEO confidence, even a metric like the Institute for Supply Management readings on manufacturing and services side of the economy, a lot of that is survey-based, so it's attitudinal measures.

And then the hard data is the actual hard economic data. So it would be metrics like GDP more broadly or retail sales or industrial production, some of the housing data. So I'm going to be keeping a close eye on whether we see any convergence between the two, given the de-escalation, at least as we're recording this in the trade war, it could mean that we see a little bit of catch back up in the soft data to what has been pretty resilient hard data. I think there still may be some coming softness in the hard data, but we might be at that point where we get a bit of convergence between the two. So that's the way I'm thinking about data in the near term.

So that's it for us this week. Thanks as always for listening. And you can always keep up with us in real time on social media. We both post regularly on both X and LinkedIn. I'm @LizAnnSonders on X and LinkedIn. 

KATHY: And I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And you can always read our written reports, including charts and graphs, at schwab.com/learn.

LIZ ANN: And if you've enjoyed the show, we'd be so grateful if you would leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. 

I do also want to put in a plug for next week's episode. I'm going to be speaking with long-time market technician and social media fave Helene Meisler. I've known her for a long time, and she is brilliant and kind of a hoot, too. So be sure to stick around for that one, and we will talk to you next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.