Top of the Morning: Munis - Implications of California wildfires
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, our conversation will refocus in on the municipal bond market. We are joined today from the UBS Chief Investment Office by both Sadiq Merkerji as well as Janine Lennon. So with that, Sadiq, Janine, thank you for joining us. I know it's timely you're on with us today. The Municipal Market Guide from the Chief Investment Office was published last week.

A lot going on in muni markets at the moment. We see yields are at or near one-year highs. Federal policy continues to create uncertainties. You have to factor in as well the wildfires in Southern California. Although more contained as we speak, it does continue to be on the minds of investors. There is a report out there as well from CIO titled Impact of California.

California wildfires on munis. That was published last week and was very helpful in providing CIO's views on the affected credits. So with that, Sadiq, could you and Janine talk briefly about these issues and how should investors be positioned? Thank you, Dan, and good morning, UBS. I'm

So, yes, a lot going on in the muni market, as you mentioned, Dan. So let me hit upon some of the high points and the recommendations that were in the MMG, and then Janine will talk about the wildfire situation ongoing in Southern California. So just to start out,

In 2024, the muni market return was fairly tepid. Volatility was also low, and we expect both those things to change in 2025. We expect stronger performance over the year, but also higher volatility, especially in the first half, given all of

that is going on in the treasury market as well as federal policy uncertainties. More on that a little later. The real key point here is that puny yields are at or near a one-year high.

Tax equivalent yields are particularly attractive for investors in the highest tax brackets, especially in the high-tax states. So yields are attractive. That's really the key takeaway there. But while yields are attractive, we also have the backdrop of a hawkish Fed, the possibility of long credit rates rising in the near term.

And all of that is going on in the federal policy arena with a lot of uncertainty on tariffs, on trade, on immigration, on fiscal policy and taxes. All of that combined can drive volatility higher in the first half especially. So given that combination, we are now pivoting to a barbell performance

preference in terms of where investors should be on the curve. We like the two to five year front end of the curve, which is really a defensive posture given the elements that can spur volatility. But we also like the 17 to 30 year range going out on the curve.

on the AAA tax exempt curve, given these attractive yields. Both those can be an effective way to position, given that we don't know a lot as to how the markets will evolve, especially in the near term.

Overall, we are recommending a portfolio effective duration of around seven years. The index is at around 6.4 years right now, so slightly longer than the index.

Coming to policy, tax exemption was a focus since the election. And in fact, the election actually, the outcome of the election actually increased the potential risk and uncertainties on the policy front. A lot has been proposed previously.

President Trump has signed a number of executive orders pertaining to immigration, but the tariff situation is still unfolding. There is the possibility of tariffs being imposed, which could be

inflationary in the short run, but could possibly also affect growth negatively in the longer term. And it's not at all clear as to how exactly that will pan out. We don't think that all of that that has been said so far will be implemented, but it remains a fluid situation there. So

on policy and immigration and taxes fiscal policy given that there is this possibility of rate volatility in the treasury market. That's one of the reasons why we pivoted to a barbell preference liking the front end of the curve.

The muni market, as we all know, is covered by technicals. In the short run, supply-demand factors are very important. And supply took a dip in December, as was expected. It's come back sharply, and we expect...

this year to be a high issuance year as well as just like 2024. So there will be some pressure on that, might be some pressure on that long end because of that high supply. But a counter to that is that we expect fund flows or demand to also be strong. There was a patch late last year where you saw

Net outflows and that situation has reversed. We have now have had inflows lately in funds so overall there is potential for volatility, but overall we think that Strong inflows will damp will be able to absorb the the strong strong supply Coming to credit

High yield and triple B spreads remain compressed. We had 2024 as really a risk-partner year.

So, high yield has done very well. In fact, high yield has done very well for two years in the row now, and after the two years of strong performance, both high yield and triple B look rich to us. So, we continue to prefer higher quality bonds, especially for extending duration. As I said, we have a bar reference, the front end of the curve.

uh... to five and then turned into thirty for the third of thirty years it's really advisable to stick to uh... the double the interplay uh... you don't want to take too much credit risk uh... in that part of the court so we prefer high quality bonds for when our foot on the court uh... but that said uh... and on the shorter maturity side high-end to be used to look attractive so uh...

the two-year high-end specialty can be invested with a high risk tolerance and focus on that and get some opportunities there. So,

So overall, the market still is constructive. We do expect volatility in the first half of the year, primarily driven by the Treasury market and policy uncertainties. But we expect 2025, when the dust settles by year end, the mini market should deliver a better performance than it did in 2024.

And obviously then there is the question of wildfires, and Jeanine will talk about the credit impact on affected issuers in the area. But just broadly speaking, the impact on the broader muni market and even the broader California market seems to be limited, fortunately, even though

there's been tremendous destruction and suffering with the fires. But it's an evolving situation, and we have to watch it carefully as to how things evolve, especially for issuers in that region. And then...

uh... just coming back to to to party for a second that did not have been proposals uh... in uh... uh... you know uh... bumpy proposals off uh... that intention being taken away from for for local state government barnes and and uh... hospital barnes and and uh... so

this is an evolving situation. We will know more as policy proposals unfold and legislative actions become a little clearer. That said, two points to be noted here that actual legislative outcomes could

could be moderated given their slim majority in the House and Senate. So not all that is being said might be enacted. So that might be a bit of a moderation in terms of actual policy outcomes. We do expect some impact, but

with respect to tax exemption being taken away for some kind of muni bond. We've written about this in the MMG and even prior to that.

especially for higher ed, for private activity bonds. There could be some impact on healthcare as well. But even if that happens, existing bonds are very likely to be grandfathered. That may actually push up their value because of scarcity value, but all of that remains to be seen. So

I think the broad message here is that the market is constructive, yields are attractive, barbell positioning provides investors with exposure to these high yields at the back of the curve, but as well as a defensive posture in the front end of the curve.

And then on credit, we expect the spreads are compressed. We don't see too much of spread widening. But that said, from a relative value perspective, we'll stick to the front end, shorter maturities on lower-rated credits. So let me stop there and pass it on to Janine to give a...

a summary of what is going on in California and what the current status is with the wildfires and the impact on credit there. Thanks, Sadiq. Thanks for having me on today to briefly discuss the wildfires and their potential impact on municipal credit. First and foremost, like Sadiq said, I hope our listeners and their families are staying safe in the new year, especially those currently being impacted by the tragedy.

As everyone is aware, several fires began and quickly spread on January 7th, fueled by powerful winds coupled with very dry conditions in Southern California. Here we stand on January 23rd, still 16 days later, and the two largest fires, the Palisades and Eaton, are 70% and 95% contained.

Due to ongoing weather conditions, though, there are still new fires emerging as we are watching the Hughes Fire in northern L.A. County approach Eaton Size with over 10,000 acres burned just in the last 24 hours.

While it appears that this fire is seemingly brush and forestry land located in the state park with no structural damage thus far, the new blaze highlights how evolving the situation truly is. As such, we will continue to monitor the fires, which are very reliant on wind speeds and direction.

In response to the original set of fires, which began on January 7th, our team published a report last week titled, "The Impact of California Wildfires on Munis." In looking at our coverage universe, we identified seven entities in the region as being impacted by the wildfires, as well as the state, who we expect will have an active role in both the emergency response and rebuilding efforts.

In looking at those issuers, we changed the CIO risk category on two obligors, both the water and electric revenue bond structures issued by the Los Angeles Department of Water and Power, more commonly referred to as LEDWAP, while affirming our remaining entity CIO risk categories.

We view LADWAP as being most exposed to credit risk, particularly in these types of natural disasters, due to the doctrine of inverse condemnation, which subjects the utility to significant financial liabilities if its equipment or infrastructure played a role in the fires, even if there was no negligence by the utility.

While we haven't seen any litigation filed against the power utility, there has been one filed against the water system thus far, citing water shortages for the Palisades Fire Region.

Given the evolving nature of the situation, though, it's still too soon to fully assess the damage or impact on muni issuers by the fires, but we do not expect municipal defaults on our active issuers thus far. Given federal support, which was boosted from typical FEMA rate of 75 to 100% funding levels, state aid, which has also been proposed in the amount of $2.5 billion by Governor Newsom, private insurance monies, and strong credit fundamentals.

Munis historically have shown limited long-term credit impact from natural disasters. However, liquidity may be pressured as issuers are forced to pay the upfront emergency and cleanup costs in the short term while they apply and await reimbursement from FEMA.

Sadly, these fires bring extreme weather events and physical climate risk to the forefront for municipal credit once again, given the increased frequency and cost related to extreme weather events across the U.S. As always, we will provide updates as necessary as we learn more about the evolving situation. With that, I'll kick it back over to you, Sadiq.

Thank you, Janine. That was very useful. So just to recap in terms of how investors should be positioned, we think yields are attractive. A barber preference sticking to the front end of the curve and the 70 to 30-year provides investors with both some defense and offense opportunities.

supply and demand will remain balanced this year. Credit conditions are generally good, but high yield will be spread or compressed, so we urge investors to focus on the short-dated maturities in those segments. And then finally, I think you missed this point earlier, in terms of sectors, I think we

continue to be a little cautious on smaller private higher ed institutions and hospitals, especially given what is going on on the policy front and with tax exemption. But generally speaking, credit conditions remain benign. We do expect the credit upgrades to moderate further this year. But overall, we remain fairly constructive on the money market with some expectation of higher volatility in the first half of the year.

Okay, well, Sadiq, Janine, thank you both for spending some time today with our listeners and our clients here on Top of the Morning to keep them current on CIO's views when it comes to the municipal bond market. As you cited, a lot of developments at the moment, including, of course, the impact of California wildfires on Muni. So thank you both again for your time today and for joining us.

Thanks, Dan. Thank you. And again, today we have been joined by both Sadiq Merkerji as well as Janine Lennon from the UBS Chief Investment Office. A couple of related publications that both Sadiq and Janine had cited during today's episode, those being the latest Municipal Market Guide as well as the report Impacted.

Pact of California Wildfires on Munis. Both of these publications can now be found up on ubs.com forward slash CIO. For clients of UBS, simply reach out to your UBS financial advisor if you would like to receive a direct copies of these publications. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.

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