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US municipal bonds are likely to go from strength to strength in 2023 due to factors such as foreign investment and divergent market conditions.
Colloquially known as “munis”, these bonds are public debt instruments operating at both federal and state levels. They are securities issued by states, cities, countries, and other governmental entities to fund public infrastructure and finance municipal projects such as building schools, repairing roads, and creating sewage systems.
Due to a wide variety of contributing elements – amongst which are long durations, general stability, higher yields, and ESG concerns – US municipal bonds are currently gaining traction amongst investment teams at non-US life insurers. They are also a fast-growing asset class and one to note particularly due to predicted additional market volatility in 2023 and heightened interest in ESG and infrastructure investing under the newly-announced Solvency II changes.
“Non-US investors are one of the fastest growing segments of demand
in the taxable municipal bond market.”
Jeffrey Burger, Senior Portfolio Manager at Insight Investment, said he believes that the attractiveness of US municipal bonds for investment teams at non-US insurers will only grow in 2023. “Non-US investors are one of the fastest growing segments of demand in the taxable municipal bond market.”
This segment is largely populated by life insurers, he added, as they are uniquely positioned to benefit from investments in revenue-backed infrastructure-related bonds meeting the requirements of qualifying infrastructure investments (QIIs) – which delineate a new asset class released under the Solvency II framework in 2016. QIIs are investments with improved risk characteristics that, in turn, allow insurers to hold less capital against their investment, thus leading to lower overall capital charges.
Other growth factors for this asset class include the strength of its ratings – which are supported by historically low default rates – and its ability to reduce portfolio volatility due to low correlation to other fixed income sectors. Burger said that he believes muni bonds come with a built-in defensive bias due to exposures to sectors that are typically less cyclical, such as health care, health services, and education.
“There been a big divergence between technical and fundamental features
in our market, which has led to attractive valuations.”
Ben Barber, Director of Municipal Bonds at Franklin Templeton Fixed Income, said that he believed the US municipal bond market is primed and ready for 2023. “There been a big divergence between technical and fundamental features in our market, which has led to attractive valuations.”
However, he was on the whole less sanguine than Burger, noting that the technical environment was challenging for muni bonds in 2022, especially given US Federal Reserve rate increases – which triggered underperformance amongst high-quality munis and widening credit spreads.
Nevertheless, he said that the strong credit fundamentals in the muni bond market – combined with attractive taxable equivalent yields – are key drivers over a reasonable time horizon, and should be noted by investors at insurance companies.
When it comes to taxable muni bonds, other potential benefits include a higher gross yield than their tax-exempt counterparts, an attractive combination of yield and quality relative to US corporates, and a higher credit rating relative to US IG corporate, with over 75% of issues rated AA or stronger.
Municipal bonds have long been on the market for US investors, but less so elsewhere. This is because investors have historically thought of them as income-tax-exempt securities on purely a federal level.
Barber pointed out that while this is true for the bulk of the market, there is a growing faction that does provide taxable income. This means that the taxable portion of the muni market can be attractive for investors who are not taxed at the federal level: for example, international investors or domestic tax-exempt entities such as pensions, endowments, and retirement accounts.
“Institutional non-US investors see the taxable municipal bond market as an
opportunity to diversify their credit portfolio away from corporate credit.”
“Institutional non-US investors are becoming more familiar with the asset class,” Barber said. “They see the taxable municipal bond market as an opportunity to diversify their credit portfolio away from corporate credit, while generating an excess spread over US corporate bonds of the same credit quality.”
This is true for insurers regulated in the UK and EU who also benefit from favourable capital treatment of a significant portion of the US muni bond universe, which – as previously mentioned – qualifies as an ‘infrastructure bond’ under Solvency II regulation.
With a large amount of productive capital in the UK set to be released due to a 60-70% reduction in risk margin for long-term life insurers and a 30% reduction for general insurers, it will become easier and more desirable for UK investment teams at insurance firms to allocate that money to social infrastructure and green energy supply. This shifting landscape means investment teams are open to new opportunities in public fixed income.
ESG is also important to muni bonds, a point Barber and Burger emphasised. This is because much of the muni bond market finances public infrastructure, which means ESG initiatives often fuel these projects.
“It is generally financing for the common good. It's an attractive asset class for
investors who are focused on increasing their ESG-oriented investments.”
Infrastructure assets funded by municipal bonds include roads, bridges, and energy and social infrastructure such as education and health care. “It is generally financing for the common good,” Barber said. “[Muni bonds] can be an attractive asset class for investors who are focused on increasing their ESG-oriented investments,” he added.
In the US, current significant infrastructure projects most prominently include Joe Biden’s August 2022 Inflation Reduction Act, a Democratic bill that outlines plans for climate and healthcare spending. This piece of legislation targets renewable energy sources and carbon emissions, aiming to expand the former and mitigate the latter. It includes $369 billion in funds that could help reduce the US’s carbon emissions by 40% by 2030, which is the original Green New Deal net zero deadline advocated for by Democrats in the 2020 election.
However, this development doesn’t come without potential downsides; currently, a Republican distaste for Biden’s package has been on strong display since the bill was passed and has now moved on to encompass ESG as an ‘ideology’, which could complicate matters at the state level and below. Municipal bonds, however – because municipalities have increased tax collections – provide inflation protection amidst a recessionary climate. For Republicans who advocate for both federal tax cuts and decreased inflation, this added benefit is not insignificant.
Other high-profile infrastructure projects underway in the US include the California High-Speed Rail, a publicly funded venture with a $400 million contract over a term of four years with two one-year extension options possible, which has become a focal point in national ideological battles about public money and sustainable investing. Examples such as this one could become more prevalent in the near future.
As the landscape for fixed income investment continues to develop, investors at insurance companies – especially those outside the US that are relatively ignorant of the class – could see revenue opportunity in US municipal bonds.
This situation could be particularly prescient to UK insurers that soon have Solvency II capital to deploy whilst keeping up with ESG demands and still maintaining high yields, protecting from inflation, and reducing portfolio volatility.
For a greener asset class that returns results, municipal bonds could be the way to go.
