Municipal bonds are often an attractive option for insurance companies as they search for high-quality credit to anchor their blended portfolios. But, as most insurers know, the tax-exempt muni market differs from the broad taxable market in key ways, so special considerations need to be made when integrating municipals into a fixed income mandate. The 2008 credit crisis resulted in even more factors to consider when investing in munis, including a profound shift in risk dynamics (new considerations around creditworthiness) and a market that has become fragmented and localized – and large, with $3.7 trillion worth of bonds outstanding.
While this new municipal market paradigm adds new complexities to the investment process (especially when evaluating relative value), PIMCO believes it also creates potential opportunities which can be exploited by sophisticated investors with robust research capabilities. (All references to munis and the muni market throughout this article are specific to tax-exempt munis, except where otherwise noted.)
Considering relative value
Here are some of the features that are driving muni valuations and are particularly relevant to insurers:
- Recent transformation to a credit market
- Different and diversifying form of credit risk
- Structural bias toward long duration and embedded optionality
- Periods of supply/demand technicals and reduced liquidity
- Future tax rate uncertainty
- Trading inefficiencies around pricing transparency and inability to short
The transformation of the municipal market to a credit market: Insurance investors typically make a large allocation to credit sectors. However, the credit profile of the muni market has changed significantly. In the years leading up to the credit crisis, the perception of safety in the municipal bond market had driven many investors to the point of complacency. This was understandable given the low historical rate of defaults in the sector and the widespread use of default insurance to enhance the credit quality of new issues. The majority of the municipal market was viewed as a rates-based space, with a large portion of the market rated AAA and little yield differential for similarly structured securities. Put another way, creditworthiness was not typically a primary factor in muni sector analysis or valuation.
The 2008 credit crisis significantly altered this dynamic. In the early part of the last decade, so-called monoline insurers, whose business had previously focused solely on municipal default insurance, began to write insurance on mortgage-related assets. With the collapse of the housing market they found themselves severely impaired due to their exposures to these assets, which led to the subsequent downgrade of the entire monoline industry to well below AAA. Today, the majority of insured municipal issues trade to the strength of their underlying creditworthiness, and not to the rating of the credit enhancement. Meanwhile, the negative fiscal impact of the recession upon state and local municipal entities – stresses not seen since the Great Depression – introduced additional credit pressures across the entire market. Today, a new primary emphasis in security selection must be placed upon creditworthiness and the relative value of credit spreads within the municipal market.
Sovereign-like credit: Recent stresses in the municipal market create potential opportunities for insurers to diversify credit risk, since munis offer exposure to different credit dynamics than conventional corporate credit. Their sovereign-type credit exposure shifts credit risk to the governmental segment of the economy, where debt service is usually secured by a municipal monopoly or general obligation supported by a large tax base. This has two implications: 1) Municipals require a different style of credit analysis focusing on fiscal dynamics; 2) Municipal bonds represent a complementary and diversifying form of credit exposure
Issue structure and optionality: Another common theme for insurers is the scarcity of high-quality credit in the long duration space. Most municipal debt is issued to finance long-lived infrastructure assets, including transportation, water and sewer systems and public buildings – assets that typically have useful lives of 30 years or more. As a result, the debt structure emphasizes long bonds, often a large 20-year and 30-year tranche incorporating sinking funds features (scheduled principal repayments prior to maturity) along with smaller “serial” issues in the shorter maturities. This structure allows for level debt service which smoothes debt payments to align with tax revenues, but it pushes supply toward the long end of the yield curve. In addition, the retail nature of the market has allowed issuers to retain call options in their issues, leading to reduced convexity (sensitivity of duration to large changes in yields), as most issues tend to have a 10-year par call. This embedded optionality, combined with supply weighted toward the long end of the yield curve, often causes munis to trade cheaper versus taxable bonds as maturity is increased out the curve.
Supply/demand technicals: Insurers may be particularly well-positioned to take advantage of technical factors affecting the muni market, which is subject to unique forces that can create imbalances between supply and demand and lead to opportunities. The market is dominated by household investors, either through direct bond ownership or via mutual funds. Importantly, the major institutional players in the taxable fixed income markets – life insurers, pension funds, central banks and foreign investors who in other markets can serve as a relief valve for technical imbalances – tend to be less inclined to invest in municipals because they do not benefit from the tax exemption. As a result, the demand side is comparatively narrow and sensitive to retail trends. On the supply side, municipals are subject to a unique effect known as “refunding” which can cause surges in new issue volume when interest rates decline, as issuers bring new bonds to market to defease (retire) older, higher coupon debt. The ability of the market to absorb surges in supply is also limited by a dealer network that has declined dramatically in recent years, and the tax limitations on dealer financing of municipal inventory. These technical imbalances can create opportunities for insurers who are positioned to act as a relief valve when market inefficiencies appear.
Tax rate uncertainty: Another reason municipals can trade cheap vs. taxables (even when adjusted for tax effects) is the risk premium that the market demands for future tax rate uncertainty. The market-clearing price of municipals, the price when supply is equal to demand, can be sensitive to tax rates. So if tax rates drop, muni prices can generally be expected to decline as well. Municipals are also subject to a tax quirk known as the market discount rule, where bonds trading at a deep discount to their original issue yield are subject to ordinary income tax for a portion of their return. This can erode value as yields rise or prices fall and bidders take into account the tax haircut associated with deeper discounts. As a result of these tax-related factors, municipals tend to trade with a risk premium which can be attractive, but potential investors need to understand the underlying factors at work. In addition, insurance companies typically pay a higher marginal tax rate than the average household investor, so the taxable-equivalent yields on municipals can be especially attractive for insurers, as illustrated by Figure 2.
Trading inefficiencies: There are several reasons munis trade differently than taxable bonds. Taken together, these factors can reduce liquidity, but they also contribute to the technical aberrations that can create opportunities for insurers positioned to be liquidity providers:
- Many major dealers have exited the market, so the available dealer capital is limited.
- Dealers are not permitted to short municipals, and the ability to finance inventory is limited by tax restrictions.
- Unlike the taxable market, where U.S. Treasuries serve as a transparent pricing benchmark, municipals have no market-based benchmark for valuation. Further, the market is fragmented into many small issues, so there are few large benchmark issues that can serve as a bellwether to help with price discovery.
Investment conclusions
In summary, PIMCO believes the transformed municipal market has put a premium on credit research for proper bond valuation and preservation of principal. At the same time, the increased complexities introduced to the market since the credit crisis have also resulted in inefficiencies. For investment managers such as PIMCO, with a strong investment process and a disciplined approach, these inefficiencies can create opportunities for attractive return potential.
Other takeaways:
- Municipals can serve as a high-quality credit anchor in a blended portfolio for insurance investors, diversifying credit exposures and offering an especially good fit for many intermediate to long-duration mandates.
- The technical nature of the municipal market often creates opportunities to cross over from the taxable into the tax-exempt market. Both life insurers and property & casualty insurers can potentially benefit from these types of crossover trades.
- Trading inefficiencies can reward investors who are prepared to step in to provide liquidity when dealers cannot.
- Tax factors play a significant role and need to be properly understood in analyzing relative value and potential after-tax returns. In addition, current discussions of tax reform among policymakers should be closely monitored in terms of future valuation of municipals.