Municipal Bonds: the case for inclusion in European Insurers' portfolios

Charles Moussier and Stephanie Larosiliere introduce the two main types of US municipal bonds and explain why European-based insurers may find them worth including in their portfolios.

What are US municipal bonds?

Municipal bonds have played a vital role in building America’s infrastructure. They were a major source of financing for canals, roads, and railroads during the country’s westward expansion in the 1800s, and today, they fund a wide range of state and local infrastructure projects, including schools, hospitals, universities, airports, bridges, highways and water and sewer systems.

Municipal bonds are issued by US state and local governments (municipalities), eligible not-for-profit corporations and territories and possessions of the US (for example, American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the US Virgin Islands). When an investor purchases a municipal bond, he or she is lending money to finance a myriad of public projects.

Traditionally, for US domestic investors, municipal bond interest payments are exempt from federal income taxes, and sometimes state income taxes.

Tax features

For investors who do not pay taxes in the US, these tax features might be considered a drawback rather than advantage, as nominal yields are driven down by investors who can utilise tax deductions.

This is why foreign investors usually focus on taxable issues. Taxable municipal bonds offer higher risk-adjusted yields comparable to those available on other taxable issues, such as corporate bonds.

The taxable municipal bond market represents over USD760 billion of the total municipal market, with over 3,000 issuers (approximately 21% of the overall municipal bond market).

Issuers may choose to issue a taxable municipal bond for a variety of reasons, including access to a broader investor base, the flexible use of proceeds and the fact that the financed activity is not considered tax-exempt.

Issuers of municipal bonds also have the ability to issue debt using corporate cusips. This has created a sub-class of municipal bonds that use a corporate cusip identifier. The aim is to take advantage of the greater liquidity and diverse investor base offered by the corporate market. Typically, municipal issuers access the corporate bond market to issue longer-dated structures that are attractive to liability-driven investors.

Potential attractions for European investors

As well as the tax features mentioned above, US municipal bonds may be worth consideration as a source of long-dated, high credit quality fixed income and a source of potential diversification within existing credit portfolios.

They also provide access to US infrastructure debt in a publicly available form (revenue bonds) and offer potentially higher yields than similarly rated public credit, with a history of lower default rates and higher recovery rates.

In addition, they are worth considering for their attractive relative value compared to European corporate bonds, even after hedging costs.

Two types of municipal bonds

Municipal bonds generally fall into one of two categories: general obligation bonds or revenue bonds. The primary distinction between the two is the source of revenue that secures the bonds.

General obligation bonds at the state level are secured by the state government’s pledge to use all legally available resources to repay the bond.

Examples of issuers of general obligation bonds include states, cities, counties, and school districts.

Revenue bonds are secured by a specific source of revenue earmarked exclusively for repayment of the revenue bond. Water and sewer authorities, electric utilities, airports, toll roads, hospitals, universities, and other not-for-profit entities typically issue these bonds to finance infrastructure projects.

Favourable liability-matching features

There are many features of typical municipal bonds that make them an instrument worthy of consideration for matching insurers’ long-term liabilities. Key features when compared to global corporate bonds include lower default rates, stability of ratings (Figure 1), higher recovery rates and predictable long-term income.

Most state and local governments are highly rated, whereas corporate credits tend to have lower average ratings. The median rating of municipal issuers is Aa3, compared to Baa3 for global corporates.

Accordingly, it is not surprising that municipal default rates have been extremely low, especially when compared to global default rates. The global corporate investment grade default rate is more than 24 times higher than the municipal investment grade default rate. The 10-year average cumulative default rate for high yield global corporate bonds is more than four times higher than the high-yield municipal bond default rate (Figure 2). 

Figure 3 looks at the universe of taxable municipal bonds comparing outstanding issues with municipal cusips to those with corporate cusips. The maturity structure of both sets of bonds is tilted toward the longer end, with the bias for longer-maturity structures stronger in corporate cusip securities. This shows the availability of longer-maturity bonds to match longer-dated liabilities, for example, those of life insurers.

In addition, all taxable municipal bonds are usually noncallable, which is favourable for liability-matching purposes.

Solvency II and infrastructure investments

European-based insurers have been subject to Solvency II and its capital requirements since January 2016. Taking into consideration the market risk module of the standard formula, the capital requirement of a bond or loan is calculated based on interest rate, spread, concentration and currency modules.

In simple terms, the spread risk module assigns a capital charge based on the duration, rating (credit quality step) and risk factor of a bond, where the risk factor charges depend on the sector. For example, European government bonds have a zero risk factor – regardless of rating – and therefore do not incur a spread charge. Aaa/Aa covered bonds have a lower risk factor than standard corporate bonds and benefit from a lower capital requirement. In contrast, securitisations have been assigned a high risk factor.

Given the impact of a bond’s credit rating on the calculation of the spread risk charge, US municipals’ high-quality profile may be attractive to insurers regulated under Solvency II. This may be especially true for insurers searching for “cheap” sources of duration to match longer-dated liabilities.

In addition, US taxable municipal bonds typically pay higher yields than equivalently rated public credit or corporate bonds. This leads to a higher expected capital-adjusted return compared to other types of bonds, even if US taxable municipal bonds are treated as US dollar corporate bonds under Solvency II (which is a popular approach used by some insurers).

It may, however, be possible to gain more favourable treatment under Solvency II.

Revenue bonds (approximately 70% of overall issuance) are in effect infrastructure debt and are linked to revenues from core US infrastructure (universities, hospitals, roads etc.).

In 2016, EIOPA (European Insurance and Occupational Pensions Authority) updated the spread risk module to include a new set of capital requirements specifically for infrastructure investment (both equity and debt). When compared to similarly rated corporate bonds, the infrastructure debt sector requires approximately 30% less capital to be held by the insurer. Identifying municipal bonds meeting the requirements could therefore be favourable.

EIOPA defines a qualifying infrastructure entity as one “which is not permitted to perform any other function than owning, financing, developing or operating infrastructure assets”. These assets must be “physical structures or facilities, systems and networks that provide or support essential public services”¹, such as toll roads and water treatment plants. Also, the asset must have “predictable” cash flows.² Bonds should be investment-grade³ and the insurer should be able to demonstrate the ability to hold these assets to maturity.⁴  Many revenue bonds may meet the infrastructure debt requirements under Solvency II and therefore receive a reduction in the spread risk charge.

Because municipal bonds are issued in US dollars, European investors bear additional risk so must decide whether to hedge the inherent foreign currency exposure.

In the standard formula for calculating the Solvency Capital Requirement (SCR), the regulator specifies the capital required for currency exposures and prescribes that, for each currency, the upside or downside impact on the insurer’s asset-liability value should be calculated, with a standard stress scenario of a 25% fluctuation in the currency.⁵ This results in an additional 25% charge for US dollar currency risk, if the exposure is not hedged back to the insurer’s local currency (for example, euros or British pounds).