Foreign investment into Taxable Munis – a trend or a trade?

November 2017

The search for yield by global investors has resulted in the US municipal bond market gaining increasing international exposure. As the value of the asset class’ characteristics gain appreciation, the amount of municipal debt held by foreign entities has increased. As of the end of second quarter 2017, foreign investors held $US98.6bn in municipal debt which represents 2.57% of the $US3.837tn municipal market (these holdings are presumed to be taxable given relative yield levels to traditional tax–exempt municipals). Since the end of 2014, foreign ownership has increased by $US18bn, a 22% increase (excluding indirect ownership where for example foreign investors hire a US manager).1

As the current appetite for taxable municipal debt appears to be insatiable, the question is “Will this trend last or are foreign investors simply in a relative value trade?” In our view the evolution of municipal bonds in achieving a permanent role in the portfolios of global investors as a diversifier to global credit allocations should only be constrained by the opportunity set. 

Foreign demand for municipal debt

Municipal bonds have experienced consistent investor demand, particularly from investors with long dated liabilities, such as insurance companies or pension funds. These investors are attracted to a high quality asset class, that has experienced fewer defaults than US corporates (as shown below), with long dated structures, and yields that are attractive relative to US corporate credit. 


10 year average cumulative issuer-weighted default rates

Municipal rated debtCorporate rated debt
  
AAA
0.00%
0.38%
AA
0.02%
0.78%
A
0.07%
2.22%
BBB
0.40%
3.93%
Below investment grade
8.17%
29.70%

Source: Moody’s Investors Service, US Municipal Bond Defaults and Recoveries 1970-2016.

The demand for municipal bonds gained a further catalyst in Europe during 2016. The European Commission (EC) passed an amendment to the Solvency II Delegated Act which gives preferential capital treatment to qualifying infrastructure investments. The vast majority of the infrastructure related municipal debt in the revenue bond sector qualifies for these lower capital charges, further stoking demand for the asset class. Additionally, there are countries in Asia that are aiming to implement Solvency II like regulations and are using the EC regulation as the model.

The opportunity in taxable municipals has averaged approximately $US30bn a year in new issuance over the last ten years. This excludes the Build America Bond program which was in effect from the second quarter 2009 through fourth quarter 2010, and generated approximately $US181bn in supply. The taxable municipal market is approximately $US480bn, or roughly 13% of the overall $US3.837tn market. Investors have become familiar with the role the municipal market has historically played in the development of US infrastructure, accounting for approximately 75% of the financed component of infrastructure spending. 

The supply of municipal debt

The current state of infrastructure is classified by the American Society of Civil Engineers (ASCE) as “poor” due to decades of underinvestment and neglect. The ASCE calculates the unaccounted for financing need to refurbish US infrastructure at $US2tn by 2025. Given the current state of infrastructure needs in the US, the municipal markets could see a significant boost in financings if the state and local governments start to prioritise addressing these needs. The infrastructure of a geography plays a crucial role in the economic viability of that region. In some cases these projects will become an absolute necessity due to their essential functions. An example is the $US24bn “Gateway” project which includes railway tunnels connecting New York City and New Jersey under the Hudson River which sustained irreparable damage during hurricane Sandy in 2012. The rail tunnels, which handle 80,000 commuters a day from the Washington DC to New York City corridor, are estimated to become obsolete by 2020. Officials from both states are fervently working on various options to obtain financing for the various parts of this crucial project.

The key for a significant expansion of the municipal opportunity set is the prioritisation of addressing infrastructure needs by state and local governments. To date, the focus has been predominantly on recovering budgets, pensions, and healthcare over their infrastructure needs. In some cases the sheer necessity of some projects may become unavoidable. The Trump administration cited a potential $US1tn infrastructure program as one of the top three priorities to address when taking office. The first goal, repeal of the Affordable Care Act, failed, and the second, tax reform, is in the opening round of what may be a contentious period of battles between various self-interests and legislators. It is logical for state and local governments to want to understand the landscape before embarking on significant infrastructure spending. That delay must be considered against a fortuitous rate environment that currently exists for financing.

Taxable municipal debt outlook

While it is very early in the tax reform process, changes in the draft of the Tax Cuts and Jobs Act, released on November 2nd by the House Ways and Means Committee, may be a positive for the taxable municipal market. The proposed legislation curtails the eligibility to issue certain types of tax-exempt bonds including private activity bonds, which includes airports, toll roads, private hospitals and universities. Tax-exempt bonds for professional stadiums would also become ineligible. This may shift this financing from the tax-exempt market into the taxable market if these provisions survive the final bill.

Summary

The taxable municipal asset class offers attractive risk adjusted returns while providing duration and diversification for investors. The asset class’ characteristics have gained the attention of entities with long dated liabilities, such as life insurance companies and pension funds, and have become a diversifier in core fixed income strategies. The number of mandates continue to increase as global investors have recognised and begun to capitalise on the opportunity in the asset class. The adoption of the product by global investors, as a permanent allocation to their global fixed income allocation, will be impeded solely by the growth in the taxable municipal market. 

1 Federal Reserves Z1 report