Taxable municipal bonds: will global investors get another bite at the apple?
This article was produced by Jim Grabovac, Loomis, Sayles & Company CFA, VP, Investment Strategist as part of their valued Industry Partnership to Insurance Investor.
Insurance Investor posted on Thursday, September 23, 2021
The United States Congress is currently debating two important pieces of legislation for the nation’s infrastructure: a dedicated $1 trillion infrastructure package, and the $3.5 trillion Build Back Better Act (BBBA), which includes so-called “soft infrastructure” provisions. The BBBA in particular could potentially include provisions for Build America Bond (BAB) issuance to provide financing to state and local governments.
The bills’ fates are far from certain: the infrastructure bill has cleared the Senate, but the House of Representatives may refuse a vote on it until the Senate passes the BBBA. And, thus far, each chamber has taken a different tact on BABs, with the House legislation including instruction for the bonds and the Senate excluding it.
One thing is clear: if the packages pass, they would be the largest US infrastructure programs in more than a decade. Additionally, if the BAB program is ultimately reinstated as part of the legislation, we think a substantial portion of the funds could be raised with taxable municipal bonds. This could be a situation similar to the taxable issuance boom that followed the Obama administration’s 2009 BAB program. For many investors, particularly non-US investors able to tap the taxable muni market, we believe this could represent a once-in-a decade supply of high-quality, long-duration debt. Here, we explore key questions about this potential opportunity.
How could infrastructure spending affect the taxable muni market?
There are several reasons why we think an infrastructure package could spur substantial taxable muni issuance.
First, using history as a guide, the BAB program, a small component of the $800 billion American Recovery and Reinvestment Act, fueled $181 billion in taxable municipal bond issuance by state and local governments. The current infrastructure proposal would likely include a significantly higher amount of capital investment to fund projects such as transportation infrastructure, clean water, power and broadband access.
Second, overall taxable muni issuance has risen more than four-fold since the 2017 Tax Cuts and Jobs Act (TCJA) prohibited advance refunding of tax-exempt debt with tax-exempt issuance.1
Third, tax-exempt debt is a more complicated prospect for issuers because they must meet certain criteria for use of proceeds.
Finally, there seems to be a real appetite for taxable municipal bonds in the buyer community, and states and localities could reap the benefits that come with selling to a broader base of investors.
What characteristics can taxable municipals offer European insurers?
Taxable municipal debt typically has a number of attractive characteristics, including:
HIGH QUALITY. About 67% of the Bloomberg Municipal Bond Index is rated AA or higher compared with 17% of the Bloomberg US Credit Index.2 Munis have had meaningfully lower default rates than comparably rated corporate bonds, as shown in the chart below. In the event of default, munis have boasted higher average recovery rates (68% percent versus 43% for corporates).
YIELD PREMIUM. Taxable munis generally out-yield corporate bond with similar duration and quality. For AAA-rated munis, this premium can range anywhere from 10 to 30 basis points at a given point on the curve.3 Yields tend to be higher because the municipal market is smaller and less liquid than the corporate market. But for buy and hold investors, including many insurers and pension plans, this liquidity premium is attractive.
LONG DURATION. Roughly half of the Bloomberg Taxable Municipal Index has maturities of 15 years or longer.4 This breadth has helped avoid issues of issuer concentration and supply limitations in the long end of the corporate market.
SOLVENCY II CAPITAL RELIEF. To encourage insurance companies to put money into infrastructure, the European Union has offered lower capital requirements for investments that meet its definition of infrastructure.
How could hedge costs factor in for non-US-dollar investors?
Global investors buying taxable US munis will generally hedge those dollar-denominated securities back into their own currencies. One question for European investors is this:
Even after paying hedging costs, is there enough of a net yield pickup to make the purchases worthwhile?
Currently, the answer is generally yes.
Compared to the yields available on bonds in Europe, where some yields are still in negative territory, US municipal bonds appear attractive.For example, the ICE BofA Broad US Taxable Municipal Securities Index hedged to euro offers a yield to worst of 0.60%. The index has a duration of 9.6 years, with an average credit quality of Aa3 and Solvency II Credit Risk of 8%. For comparison, a duration- matched index of AAA-A rated euro corporates has a YTW of 0.48%. This euro corporate index would offer an average credit quality of A2 and a Solvency II Credit Risk of 9.9%.5
1 Source: Barclays. Data as of 30 June 2021.
2,3,4 Source: Barclays. Data as of 30 June 2021.
5 Source: Bloomberg & ICE Bank of America. All data as of 9 September 2021. Euro corporate index represents a composite of Ice Bof A EUR Corp AAA-A Index and Ice BofA EUR Corp AAA-A 10+Yr Index.
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