While munis have long been a staple of property and casualty (P&C) insurers’ portfolios, this has generally been less true for life insurers. The bonds’ tax-exempt nature is a big reason: P&C companies have historically paid an effective tax rate of 5.25% on muni income, meaning 94.75% of that muni income is federally tax-free, while life insurers did not receive this tax benefit. Given tax-exempt munis’ lower yields, life insurers were generally better off buying higher-yielding corporates and other taxable bonds. Recent tax reform is changing this dynamic, however, and we believe now is the time for life insurers to consider adding tax-exempt munis to their strategic asset allocation.
New tax exemption, higher yields may give munis an edge over some corporates
Under the Tax Cuts and Jobs Act of 2017, life insurers now enjoy a substantial federal tax exemption on municipal bond income: 93.7% of muni income is effectively tax-free. (The effective 6.3% tax rate is the product of the new 21% corporate tax rate and the introduction of a 30% proration amount for life insurers.) This makes tax-exempt munis much more attractive for life insurers.
Munis with 20- to 30-year maturities and 4% coupons, in particular, can provide higher after-tax yields than corporate bonds with similar ratings and maturities at the new tax rate. This segment of the muni market was traditionally supported by P&C insurance companies and U.S. banks, but the new lower corporate tax rate has curbed demand from these buyers. As a result, yields on these bonds have been rising: AA and A rated munis with 20- to 30-year maturities and 4% coupons now offer an average after-tax pickup of roughly 25 basis points (bps) over corporate bonds with similar characteristics (see Figure 1).
In addition to the potential for higher after-tax yields, we see several other key reasons why life insurers should consider adding muni bonds to their portfolios:
- Diversification. Munis may offer diversification benefits versus a variety of asset classes. Specifically, munis may provide a lower correlation to equities than taxable credit (whether investment grade or high yield). Munis also tend to have a lower correlation to Treasuries than do core bonds (as proxied by the Bloomberg Barclays Municipal Bond Index and the Bloomberg Barclays US Aggregate Bond Index).
- Lower default risk. Municipal default rates remain low relative to U.S. investment grade bonds: Over the past decade, A rated municipal bonds have defaulted at a cumulative rate of 0.07%, compared with 2.22% for A rated U.S. corporates. Munis have also tended to outperform taxable corporate credit during Federal Reserve hiking cycles (see Figure 2). PIMCO expects the Fed to continue to gradually raise rates over the next few years.
- Enhanced asset-liability management. The average duration profile of munis is longer than that of generic corporate bond indexes or structured credit, making them an attractive hedge to life insurance liabilities. The relative cheapness of munis further out the yield curve supports the case for long-duration investors like life insurance companies to own munis.
Tapping opportunities in munis
We believe tax-exempt munis have become more attractive to life insurers relative to taxable bonds, and given their added potential portfolio benefits, the time to consider incorporating them is now. We expect munis to continue to offer attractive risk- and tax-adjusted returns. And with a dedicated team of municipal bond portfolio managers and credit analysts managing nearly $40 billion in investor assets, PIMCO has the experience and resources to help our clients take full advantage of this opportunity.
To learn more about investing in municipals at PIMCO, please visit pimco.com/munis