JAMES ISELIN Head of the Municipal Fixed Income Team and Senior Portfolio Manager JASON PRATT Head of Insurance Fixed Income and Portfolio Manager NOVEMBER 2016 US MUNICIPAL BONDS AND NON-US INVESTORS At close to $4 trillion, the market in US municipal bonds is one of the largest in the fixed income world, and yet some investors outside the US have no exposure, let alone a dedicated allocation. We believe this is changing, driven by a search for reliable yield that does not compromise portfolio credit quality. Participation in taxable municipal bonds the most attractive to non-us investors is growing as the market recognizes how much yield pick-up is available, from both intermediate and very long-dated bonds, secured by revenues from high-quality infrastructure projects sponsored by US states and cities. In Europe, in particular, clarification around the capital charge levied against infrastructure investments under the Solvency II Directive makes taxable US municipal Revenue Bonds a compelling asset for insurance company portfolios. Now is the time to re-assess this surprisingly attractive asset class.
AT A GLANCE Low yields in non-us dollar core bond markets are encouraging investors to consider US dollar assets. Some of these assets offer a substantial yield pick-up even after accounting for currency-hedging costs and US taxable municipal bonds are among the most compelling. Taxable Revenue Bonds, in particular, have many attractive properties for non-us investors: Investment-grade ratings. Default rates that have been lower than similarlyrated corporate bonds. Bonds at all points on the maturity curve, from short-dated to 30 years-plus, supporting longerdated liabilities. Backing by critical-services infrastructure cash flows, which makes them likely to benefit from very favorable capital charges under Solvency II, relative to corporate bonds with a similar risk profile. Higher yields come from the complexity and fragmentation of this highly-localized, overthe-counter market not from a higher default expectation. A suitable portfolio-management partner requires established relationships with dozens of local dealers across the US to access the market. Given they are issued in US dollars, it is not entirely surprising that non-us investors have not regarded US municipal bonds as a natural fit for their portfolios. But the low and even negative interest rate policies implemented by the world s major non-us central banks have made US dollar yields ever more attractive, even when accounting for currency-hedging costs, just as the municipal bond market has been growing. Non-US institutions increasingly recognize that a market of this size, reliability, credit quality, default-risk profile and maturity spectrum might be a good fit after all. If they have been searching in vain for infrastructure debt opportunities to match long-dated liabilities, the fit looks particularly sharp. And if they are regulated under the European Union s Solvency II Directive, they should certainly read on. While growth expanded rapidly during 2009 2010 to finance a post-financial crisis fiscal stimulus, US municipal bonds are one of the oldest and largest fixed income markets in the world, with a history almost as long as that of the United States itself. The credit and default profile is therefore one of the best-understood in the world of fixed income. By the end of 2015 there was $3.7 trillion worth of bonds outstanding from more than 50,000 state, city and municipal issuers, for whom they represent the primary source of capital-markets financing. Among the many ways of categorizing this market, perhaps the most helpful is to think of two dichotomies: between bonds whose coupons are tax-exempt for qualifying US investors, and those whose coupons are taxable; and between General Obligation Bonds and Revenue Bonds. General Obligation Bonds account for around one-third of the market: they are backed by the full faith and taxing power of the issuing entities. The other two-thirds are Revenue Bonds financing a range of long-standing, critical projects, from industrial and agricultural investments to critical infrastructure such as toll roads, hospitals, airports, schools, social housing and water and sewer systems, primarily secured by the projects cash flows. Both types of bond include some tax-exempt and some taxable issues. As an incentive to private financing of state and local government, around 85% of the total market is tax-exempt. The taxable market has long existed to top-up financing of projects that cannot be fully funded with tax-exempt bonds under US tax rules, but it expanded rapidly with the Build America Bond program (BAB) during 2009 2010, which, as part of the government s post-financial crisis economic stimulus efforts, offered subsidy support to taxable bonds issued to finance infrastructure projects. Almost $200 billion was raised through that program, and since then further, non-bab issuance has grown the taxable bond market to just under $500 billion. FIGURE 1: THE MUNICIPAL BOND MARKET HAS GROWN TO ALMOST $4 TRILLION New Issuance ($bn) $500 $400 $300 $200 $100 $0 05 $3,019.30 06 07 08 09 New Issuance ($bn) $3,772.10 10 11 12 13 $3,714.80 14 15 Outstanding Debt ($bn) $3,900 $3,800 $3,700 $3,600 $3,500 $3,400 $3,300 $3,200 $3,100 $3,000 Source: Securities Industry and Financial Markets Association. Data as at 31 December 2015. For reasons that we go on to describe in this paper, we believe that non-us investors should be most interested in taxable Revenue Bonds. The average yearly issuance of these bonds has amounted to a modest $30 billion or so, historically, including the six years since the end of the BAB program. We believe it is reasonable to expect a further expansion of taxable municipal debt markets through a second phase of BAB to finance the infrastructure Outstanding Debt ($bn) US MUNICIPAL BONDS AND NON-US INVESTORS 2
spending promised by the incoming US administration. With federal government debt already very high, there is likely to be a preference to push this financing down to the state and municipal level. Nonetheless, even as it grows we will see that this remains a complex and fragmented market that poses many challenges to investors looking to navigate it for the first time. DIVERSIFICATION AND HIGH CREDIT QUALITY ACROSS MATURITIES As one might expect from issuance related to infrastructure, taxable Revenue Bonds can be very long-dated. Alongside a sizable market of short-dated and intermediate taxable muni paper, more than $100 billion of outstanding debt has a maturity of 20 years-plus, and more than $20 billion is dated longer than 30 years. That makes designing liability-matching portfolios along the entire curve possible in a way that just isn t the case with the much smaller, highly competitive, still-developing market in European infrastructure debt, for example. US municipal taxable Revenue Bonds also diversify the risks associated with long-dated corporate bonds. This is particularly the case where the corporate market is heavily tilted towards financial issuers, as it is in Europe, but it is also true that the municipal credit cycle tends to be different from the industrial credit cycle. In an upturn, industrial corporate bonds face the risk that issuers become the target for acquisition, with all that implies about potential balance-sheet expansion and credit-quality deterioration. That risk simply doesn t exist for an AA-rated municipal infrastructure project Los Angeles Water Authority won t be taking over New York Water Authority in a hostile bid. In a downturn, industrial issuers can protect credit quality more responsively than municipal issuers, through workforce redundancies, asset sales or equity issuance, and so corporate bond valuations tend to recover more quickly coming out of a recession. On the other hand, municipal infrastructure operators have deeper wells of credit-quality protection at their disposal, simply because demand for water systems, hospitals, housing and schools is extremely inelastic relative to rent, rate and toll increases. That is why more than 85% of taxable Revenue Bonds are rated single-a or higher, and also why default rates have been substantially lower than for corporate bonds the default rate on Baa-rated municipal bonds has been similar to that on Aaarated corporates (figure 2). Even on the very rare occasions when a municipal bond issuer has defaulted or gotten into distress, recovery rates have tended to be higher than for equivalently-rated corporate bonds because a critical local infrastructure asset has always continued to generate revenues that have accrued to bondholders. FIGURE 2: MUNICIPAL BONDS HAVE EXPERIENCED LOWER DEFAULT RATES THAN CORPORATE BONDS Cumulative Default Rates, Municipal Versus Corporate Bonds, 1970 2014 Cumulative Default Rate, 1970-2014 7 6 5 4 3 2 1 Aaa Source: Moody s. Municipal Issuers Baa-rated municipal bonds have lower historical default rates than Aaa-rated corporate bonds 0.48% 0.01% 0.06% 2.72% 4.41% 4.11% 0.99% 0.37% Aa A Baa Credit Rating Corporate Issuers 18.69% Ba 17.48% 39.16% B 16.88% 63.77% Caa and below FAVORABLE CAPITAL CHARGE UNDER SOLVENCY II This quality profile is one important reason why US taxable municipal bonds are so attractive for investors regulated under Solvency II. This helps to limit the solvency capital charge levied against them when they are held as assets against regulated insurers liabilities. By far the biggest positive impact on the solvency capital charge, however, is the fact that the capital charge against infrastructure investments under Solvency II is expected to be around 3 lower than the capital charge against corporate bonds with an equivalent risk profile, as long as the projects concerned are within the OECD which means that most US taxable municipal Revenue Bonds qualify. 1 That impact can be seen in figure 3. The capital charge against US taxable municipal Revenue Bonds increases with duration, but not as much as it increases for corporate bonds. That means the capital charge for Revenue Bonds is not only lower than that for European or US corporate bonds at intermediate maturities; the longer-dated the maturities are, the greater the capital-charge advantage over corporates becomes. For Solvency II-regulated investors with long-dated liabilities, this is a substantial benefit. FIGURE 3: US MUNICIPAL REVENUE BONDS DELIVER A SUB- STANTIAL CAPITAL-CHARGE DISCOUNT UNDER SOLVENCY II Solvency II Capital Requirement (% of Asset Value) 14% 12% 1 8% 6% 4% 2% EUR Corporate Intermediate Bonds (A-rated) Capital charge discount grows with longer-dated bonds U.S. Corporate Intermediate Bonds (A-rated) U.S. Taxable Muni Revenue Intermediate Bonds (A-rated) U.S. Corporate EUR Corporate U.S. Taxable Muni Revenue 0 2 4 6 8 10 12 14 16 Duration (years) Source: Bloomberg, FactSet, EIOPA. 1 See the European Insurance and Occupational Pensions Authority (EIOPA), Final Report on Consultation Paper no. 15/004 on the Call for Advice from the EC on the Identification and Calibration of Infrastructure Investment Risk Categories, at https://eiopa.europa.eu/publications/consultations/ EIOPA-BoS-15-223%20Final%20Report%20Advice%20infrastructure.pdf US MUNICIPAL BONDS AND NON-US INVESTORS 3
COMPELLING YIELDS RELATIVE TO CORPORATE BONDS Investors would be forgiven for assuming that this Solvency II capital-charge discount compensates them for losing some of the yield they would otherwise get from riskier corporate bonds. In fact municipal bonds need not lower the overall yield of a high-quality, liability-oriented portfolio at all. This is where the dichotomy between tax-exempt and taxable bonds becomes important. Tax-exempt bonds are not particularly compelling for non-us investors. For a start, those investors are not eligible to receive the coupons tax-free. Second, because of the tax exemption for US investors these bonds tend to trade with slightly lower yields even than US Treasuries that is how they serve as such cost-effective financing for state and local government. By contrast, the taxable bonds that have grown to be such a substantial part of the market over recent years trade at a considerable spread over Treasuries and even, as figure 4 shows, at a spread over comparable European and US corporate bonds. This is despite the fact that the credit rating of the same issuer s tax-exempt and taxable bonds is identical. At the end of October 2016, the average yield-to-worst of the Barclays Taxable Municipal Bond Index was 3.29%, with modified duration of 9.5 years. FIGURE 4: MOVING FROM CORPORATE BONDS TO MUNICI- PAL BONDS DOES NOT MEAN GIVING UP YIELD Municipal, Corporate and Government Yield Curves Yield 5% 4% 3% 2% 1% -1% 1 5 10 15 20 25 30 Maturity (years) U.S. Taxable Municipal Bonds (A-rated) U.S. Taxable Municipal Bonds AA-rated U.S. Treasury Bonds Source: Bloomberg. Data as at 26 October 2016. EUR Corporate Bonds (A+, A, A- rated) EUR Corporate Bonds AA+, AA, AA- rated) EUR Germany Government Bonds Note that figure 4 shows US dollar yields gross of the costs of hedging back to euros, sterling or other base currencies. Those hedging costs have increased over recent months as many non- US central banks have committed to easier monetary policy as the Federal Reserve has prepared for its second rate hike of the current cycle. Even so, the current high cost of hedging dollar exposure back to euros, for example, which is around 150 170 basis points, still does not erode a substantial portion of the yield pick-up over euro-denominated government or corporate bonds with an equivalent risk profile. What accounts for this substantial pick-up in net, risk-adjusted yield? The fact is that US municipal bonds are not the easiest market to work in, from a practical perspective. It is a highly localized, over-the-counter market in more than 50,000 distinct issues, and some of the best value is to be found outside of the bulge bracket, with smaller, regional broker-dealers. Participating in the primary market, which is necessary when only $30 billion or so of new debt is issued in an average year, necessitates relationships with these firms. An effective portfolio manager may need to maintain relationships with more than 80 dealers nationwide, and should expect to trade with every one of them in the course of an average year. This sort of complexity simply isn t an issue in investmentgrade or even high-yield corporate bond or loan markets, and it poses real challenges for investors. Furthermore, the importance of a portfolio manager occupying the sweet spot in terms of size should not be underestimated when it comes to offering the taxable-bond mandates that are most attractive to non-us investors. Smaller firms may not have established the extensive network of dealer relationships required, but very large firms may find it difficult to create diversified portfolios of taxable-only bonds as such, many will have to work to model portfolios containing as much as 5 in tax-exempt bonds and attempt to fill them with taxable bonds over an extended period of time. This reflects the fact that $50 75 million issues through regional dealers are much more frequent than the large-scale deals offered by bulge-bracket firms. As a result, no one investment manager can dominate the market, and deep, market-wide relationships are key to building and managing taxable-only portfolios. CONCLUSION Selecting a suitable partner with whom to navigate this market is essential and requires substantial due diligence, but we believe the benefits outweigh the effort. In our view, the size and quality of the market, the long maturities outstanding, the range and security of the underlying projects and revenues, and the yield relative to comparable corporate bonds all combine to make taxable US municipal Revenue Bonds a compelling opportunity for non-us investors. For European insurance companies, their treatment under Solvency II makes them a particularly powerful liability-matching asset. In summary, their underlying quality can deliver diversification, yield, and long duration to investors without requiring an investor to flip their asset risk profile upside down. US MUNICIPAL BONDS AND NON-US INVESTORS 4
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