Joe Gotelli Discusses Advantages of Active Municipal Bond Strategies

Nicholas Wodeshick: Broadly speaking, all this uncertainty from the U.S. equity market is causing many investors and advisors to pivot to more fixed income allocations. What do you think munis offer at this moment that could be more attractive than other fixed income strategies?

Joseph Gotelli: The uncertainty that we saw in the month of April created a dislocation in the tax-exempt market in particular. Concerns around either federal funding cuts, the budget that’s going to be necessary to extend the Tax Cuts and Jobs Act, or even the longer-term implications of tariffs really incited a lot of this volatility. The muni market was already more or less on edge coming into the end of March, where seasonal headwinds of less demand paired with supply that had been front-loaded into the year really had brought us to a point where, not only from an absolute level, but from a relative basis, the muni market was looking pretty attractive for retail investors in the United States. 

We have seen some retracement from the volatility experience in early April. But the muni market still sits in a position where total returns across most sub-segments of the market are still in negative return territory year to date. You can compare that to various taxable fixed income indices, which are up anywhere from 100 to 300 basis points. 

Gotelli: So, you’re seeing a point in time where the muni market could offer some excess return potential, given the shift in relative value versus other asset classes. On top of that, if we think on a go-forward basis, what the liabilities will look like for individual investors… At best, you’re going to be in the situation you’re in today, where the Tax Cuts and Jobs Act gets extended. So, we can start thinking about the absolute level of yields that are tax-free, then converting those to taxable equivalent yields and really getting a sense for the value proposition that the asset class has to offer. Those are some of the key points that investors should be looking at as they think about shifting their allocation and building a more diversified portfolio.

Wodeshick: While all this discussion of volatility is ongoing, investors are still trying to see how the Federal Reserve handles interest rates. How should we expect the Fed’s interest rate cycle to affect muni bonds this year? 

Gotelli: The muni market typically is a longer duration market, so it will have some interest rate sensitivity. I think that will ultimately benefit investors. Our view is that we’re moving into more of a growth scare with downside risks into a recession scenario. That leads us to believe that there is some room for the Fed to operate in terms of lowering rates at some point in the second half of the year. That doesn’t need to be the ultimate outcome for there to be a good outcome, in terms of returns and opportunity in the market. 

If we think about the muni space in particular, there will be challenges, particularly in the public finance space, around things like cuts to Medicaid and other impacts that will likely have a transmission mechanism from the states to the local entities, to even hospitals. In our space, for the most part, it’s a very high-quality asset class. Having some duration and a higher-quality asset class in an environment where the yield curve has steepened over the course of the year, should position investors to start building long-term positions.

Wodeshick: Joe, you manage two of American Century Investments active municipal portfolios: the American Century Diversified Municipal Bond ETF (TAXF ) and the American Century California Municipal Bond ETF (CATF C+). Obviously, these are two different strategies, but what do you see these funds offering for investors looking to build their muni exposure at the moment?

Gotelli: They are two different strategies in the sense that one is national and the other is state-specific. The opportunity set of having strategies that really lean into diversified sources of return to achieve their core mandate really will benefit investors through periods of uncertainty. It allows us to uncover opportunities within the municipal space, given the levers that we have to pull. For TAXF, it’s been almost seven years that the fund has been around. It has history through cycles of slower growth, like in 2019, with COVID, and fiscal and monetary actions post-COVID. It’s lived through zero interest rates, rising interest rates, tighter spreads, and wider spreads. 

As you can see, those strategies allow us to leverage our fundamental credit expertise to move in and out of sectors, and to move up and down in credit quality, as well as our allocation to high yield. These are long-term core investments and not necessarily trading vehicles. The benefit of these strategies being within the ETF wrapper is that, as we are making those allocation changes, the shift from rating category or sectors can be done in a much more tax-efficient way. 

Gotelli: As a California resident myself, when we launched TAXF, I couldn’t wait for us to launch the strategy in a California form. I felt like this was something that investors we were speaking to, who are longtime owners of our intermediate and our high-yield strategy, could appreciate accessing this blended strategy within the ETF form. We think about the value of the tax-exemption to California residents, for a fund like CATF, which right now has an SEC distribution yield of about 3.84%. For those CA investors in the highest marginal brackets, that kicks to over an 8% taxable-equivalent yield on that portfolio. When you start to frame it in that way, for folks that don’t really think their tax liabilities are going down anytime soon, that is another big advantage of CATF and TAXF.

Wodeshick: American Century is no stranger to actively managed muni strategies. What advantages do you see active management offering over a passive muni index? 

Gotelli: This approach that we have for active management allows for duration and yield curve management, along with adding sectors that passives typically would exclude in the marketplace because they require fundamental credit research. This includes sectors such as land-secured, charter schools, tobacco settlement, and others where we can add incremental yield and actually reduce volatility over long periods of time. These strategies give us levers to lean into our bottom-up fundamental research, as well as some top-down views. It really means that it’s a portfolio of curated positions and securities, rather than just providing factor exposure. 

You can own this as a core vehicle in your portfolio over the cycle, knowing that the active manager is making the appropriate adjustment, regardless of what is going on at the Fed, at the fiscal level, and within sectors in the muni space. You know that active management is there, and it does not require the investor to move from high yield, to investment grade… It’s all brought to you in one package.

Wodeshick: Here at VettaFi, we’ve seen a lot of internal polling data showing that more advisors are looking to build their muni bond exposure this year. That being said, some folks still struggle to navigate the different types of muni bonds, along with the tax implications. What advice do you have for individuals who are looking to educate themselves on muni bond strategies?

Gotelli: Knowing what you own, and understanding the investment team’s strategy and transparency into those results, is really important. For example, the peer groups that some market data providers group funds into can be very broad, and the outcomes therefore can be very different. Sometimes, understanding where a portfolio sits, and ultimately what the goals of that portfolio are over time, is very important. 

Within the municipal market, there’s various ways that the distribution to clients can be impacted. So, really understanding what you’re looking to get out of the strategy over the long term means understanding how portfolios reach a certain level of total return or reach a certain level of yield. This should be indicative of the need to dig deeper.

Wodeshick: Is there anything else that you’d like our readers to know? 

Gotelli: Since the ‘80s, American Century has been actively managing strategies that revolve around core fixed income in the muni space, as well as high yield. We run mostly intermediate and high yield strategies, both for national and California clients. Our choice to launch TAXF and make the extension into CATF is clearly an extension of these capabilities. We believe we do well for clients in these areas, and we’ll continue to expand upon that in the future. 

This is indicative of the expansion of active management within ETFs, within municipals specifically, and there are now a lot of choices for investors. That also provides a lot of opportunity for investors as they shift from potentially a preference for mutual funds to ETFs. You can expect American Century to continue to innovate and be front and center in providing products and strategies to meet investors’ needs.

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