European insurers are still hunting for yield and the US municipal bond market may provide an interesting and capital efficient solution. Bob Sharma and James Bradbury, EMEA Insurance Relationship Managers at Wellington Management explain.
The municipal bond market is a $3.7trn source of funding for states and cities throughout the US. Historically, this market has drawn little attention from foreign investors, but this is now changing due to the appealing properties of revenue bonds. This subset of the wider municipal bond market is backed by revenue streams from infrastructure providers, such as electricity utilities and toll roads, and may therefore qualify as infrastructure assets under Solvency II. This would enable insurers to pick up competitive spreads for securities with a low historical default experience whilst benefiting from favourable capital charges.
In this article, we set out what attracts insurers to the revenue bond market, and in particular, how this sector offers an accessible alternative to traditional infrastructure investment, whilst outlining some of the key considerations around implementing an allocation within a fixed income portfolio.
Market overview
The municipal bond market has long been attractive for many US investors on account of the tax free benefits of most securities, meaning that the income earned by bondholders is not subject to federal or state income taxes. As a result of this favourable tax treatment, market yields on tax-exempt municipal bonds are typically lower than similar-quality taxable bonds (e.g., corporate bonds). Tax-exempt municipal bonds are generally inefficient investments for an investor who is not subject to US income taxes and who therefore cannot benefit from the tax advantages of these instruments. However, not all municipal bonds have tax-exempt status. The issuance of taxable municipal bonds boomed following the enactment of the Build America Bonds programme in 2009, which was designed to stimulate the US economy in the wake of the financial crisis. Issuers were able to tap a much broader investor base, including investors not subject to US income taxes, who were attracted to these bonds paying a higher interest rate, for which the US Treasury compensated the issuer.
At the end of July, the Barclays Taxable Municipal Bond Index comprised 373 issuers with a market value of $323bn, which can be broadly split into two types of credit:
- general obligation bonds, backed by the taxing powers and credit of the issuing state and local governments
- revenue bonds, backed by revenues from infrastructure-type assets, such as toll roads, airports, health care providers and utilities.
Infrastructure characteristics
It is the second of these two categories, revenue bonds, that is attracting interest from insurers looking to benefit from favourable yields and capital charges. Revenue bonds make up 67% of the index with tax & lease, utilities, and transportation representing the largest sectors (see Figure 1). The potential for revenue bonds to qualify as infrastructure investments under Eiopa's criteria stems from their predictability of cash flows, the ability to meet financial obligations under a variety of scenarios and stress tests, as well as the protection afforded by the contractual frameworks in place. Revenue bond offering documents often include rate covenants that dictate the circumstances under which rates must be adjusted to meet payments, for example, if a toll road financed by a revenue bond failed to cover debt service by a required margin, the bond trustee could force the toll authority to raise usage fees. Overall, revenue bonds are a high quality asset class with a readily accessible market, this is an attractive quality at a time when the supply to market of traditional infrastructure is not keeping up with demand.
Figure 1 Revenue bonds: Composition by sector
As of 31 July 2016 | Source: Barclays Taxable Municipal Index, adjusted to exclude General Obligation local and state bonds
Frustration with traditional infrastructure
It has long been argued that insurers are a natural fit to finance long-dated infrastructure loans. However, the pipeline of private infrastructure projects has remained limited with anemic economic conditions resulting in many governments reducing their infrastructure spending. In addition to limited supply, insurers are also faced with extensive due diligence requirements to understand the key risks underpinning the cash flows for each project as well as evidencing a deep understanding of the different types of projects spanning the infrastructure universe. Also, the liquidity profile of private infrastructure entails committing capital longer than other alternatives to traditional corporate bond allocations. By comparison, revenue bonds offer many of the same infrastructure characteristics whilst also benefitting from a relatively more liquid market and less intensive due diligence requirements.
ALM and Solvency II considerations
In addition to these benefits, revenue bonds offer a stable cash flow profile and duration of around 9-10 years, which can be useful for ALM purposes. At the end of July, AA rated revenue bonds provided a yield of 2.8%, which compares favourably to 1.5% yield from US treasures, 0.7% from UK gilts and -0.1% from German bunds. The recent potential decrease in capital charges by around 30% for infrastructure debt also makes this an attractive and capital efficient option when compared to corporates with similar ratings and maturities, as shown in Figure 2 and Figure 3.
Figure 2 SCR for revenue bonds
Figure 3 Revenue bonds compare favourably to corporate bonds
As of 31 July 2016 | Source: Revenue bonds - Barclays Taxable Municipal Index, adjusted to exclude General Obligation local and state bond, US corporate bonds - Barclays US Corporate Investment Grade Index. For illustrative purposes only.
Overall, we believe that revenue bonds serve as an excellent diversifier to a traditional corporate credit allocation. Municipal credits typically perform well later in the broader credit cycle because changes in municipal issuer revenues tend to trail overall economic activity. Revenue bonds also offer attractive value versus corporates of a comparable quality, particularly in light of the significantly lower historical default rates experienced by municipal bonds (see Figure 4).
Figure 4 Historical revenue and corporate bond default rates
Source: Moody's
Implementing an allocation to revenue bonds
The revenue bond market is relatively small with less frequent issuance, which lends itself to a relatively concentrated allocation that should complement existing corporate credit holdings. With this role in mind, designing an allocation should allow for opportunistic buying with a focus on the sectors that offer a superior risk/reward profile relative to corporate bonds. The market also has relatively low liquidity and is fairly shallow, so careful selection is important and a long investment time horizon is necessary.
In addition, as the large issuance of Build America Bonds from 2009 – 2010 ages, we expect market activity to gradually decline, and sourcing and selling bonds could become more difficult. This argues for a buy-and-hold mentality, and for accumulating bonds whenever attractive offerings become available.
In conclusion, we believe revenue bonds are a compelling option for insurers seeking infrastructure-type investments. The high quality, long duration cash-flows, with attractive capital charges and accessible implementation, means we have seen interest growing among European insurers. Wellington Management is one of the largest investors in the revenue bond market and has the skills, depth of resources and extensive broker networks required to successfully manage allocations for our insurance clients.
On 29th September, Wellington Management will host a roundtable breakfast in London for clients and prospects on the topic of private investments and infrastructure. For further information on this event, please contact Bob Sharma on 020 7126 6068 or sbsharma@wellington.com or James Bradbury on 020 7126 6464 or JBradbury@wellington.com.
