January 11, 2013
Topic Paper
13 March 2017
Opportunity for Non-US Investment in Taxable
US Municipal Bonds
PERSPECTIVE FROM FRANKLIN TEMPLETON FIXED INCOME GROUP®
EXECUTIVE SUMMARY
With record-low interest rates dominating the investment landscape in Asia and Europe, investors outside the United States are expanding their
search for yield to a hitherto unexpected place: US municipal bonds. US municipal bonds offer generally higher nominal yields than comparable
Treasury securities and lower default rates and price volatility than comparable corporate bonds. As such, we believe US municipal bonds can offer
a compelling opportunity to the non-US domiciled investor.
In this paper we will explore how an allocation to municipal bonds by non-US investors can potentially provide another source of attractive, high
quality income to a portfolio while also diversifying from a credit standpoint. We believe partnering with an expert is critical, given the nuanced
nature of the municipal bond market.
Introduction: Composition of the US Municipal
Bonds Market
Certain US municipal bonds (around 20% of the overall
benchmark index) are not exempt from taxation. The taxable
US municipal bonds represent debt issued by a state or local
government generally used to finance public services or
infrastructure projects such as roads, schools, water and
sewage systems, airports or energy transmission facilities.
Bonds issued by a municipality to finance a public good are
generally exempt from federal and local income taxes which
increases the effective yield available to the US-based investor.
municipal bond market represents over US$300 billion of total
US municipal bonds have generally been favored by US
taxpayers, including high-net-worth individuals and select
institutional investors in the United States, due to the bonds’
tax-exempt status. Over 65% of the total amount of US
municipal bonds are owned by individuals either directly or
through mutual fund products. Additionally, 30% is owned by
institutions such as insurance companies or banks.
funding a project that substantially benefits a private entity, such
Exhibit 1: Composition of US Municipal Bond Ownership
As at 30 September 2016
market size with over 3,000 issuers. Although this market is
smaller than the tax-exempt market, we believe it presents a
fairly large opportunity set for investors. Legislation passed by
the US federal government in 1986 limited the types of bonds
that were exempt from federal taxation to bonds that funded
what could be considered an exclusively public good. A bond
as a sports arena, could no longer offer tax-exempt income to
investors. This new class of taxable bonds is known as private
activity bonds (PABs).
In addition, in February 2009, as part of the American Recovery
and Reinvestment Act, US President Barack Obama signed a
law creating a new class of taxable municipal bonds known as
Build America Bonds (BABs). Although these bonds are not taxexempt, BABs included a federal subsidy in hopes of further
Individuals……….….….......42%
boosting infrastructure spending. This subsidy has helped to
offset the effect of taxation to the investor, making them
Mutual Funds……………....25%
especially attractive to foreign investors. State and local
Banking Institutions.............15%
before the end of 2010 when the program ended. These bonds
governments issued nearly US$200 billion worth of BABs
Insurance Companies….…14%
proved popular with foreign investors and by the end of 2015,
Other……………...……..….4%
the United States. Additionally issuers have always been able to
US$85 billion worth of BABs were owned by investors outside
issue in the taxable municipal bond market to help expand their
Source: Calculations by Franklin Templeton Investments using data sourced from the
US Federal Reserve.
audience beyond the US taxpayer. We have seen a marginal
increase in issuance over the past year.
For Institutional Professional Investors Only. Not For Distribution To Retail Clients.
Exhibit 2: Municipal Bond Investment Universe
As at 31 December 2016
Number Issues (Stats)
Market Value (USD MM)
Yield to Worst Modified Adjusted Duration
Credit Rating
Tax-Exempt Munis
50,140
$1,383,519
1.05
6.24
AA2/AA3
General Obligation Bonds
15,282
$375,069
0.93
6.07
AA1/AA2
Revenue
30,580
$892,419
1.25
6.79
AA3/A1
Taxable Munis
4,517
$299,745
2.18
9.31
AA2/AA3
Build America Bonds
1,822
$167,952
2.21
9.96
AA2/AA3
Muni High Yield
2,986
$82,593
4.82
10.15
B2/B3
US Corporate
5,928
$4,907,198
1.77
7.30
A3/BAA1
Euro-Aggregate Corporate
1,952
$1,681,745
0.86
5.26
A3/BAA1
Source: Bloomberg Barclays Live. With the exception of Euro-Aggregate Corporate, yield to worst is shown as net of hedging costs.
Outlook
Federal and local government spending on public infrastructure
has declined steadily since the 1970s and critical infrastructure
such as roads and bridges across the United States has
deteriorated as a result. Recently, partisan gridlock at the
federal level has hindered meaningful investment at the federal
level, so most new municipal bond issuance has been left to
state and local government. However, newly elected US
President Donald Trump has indicated that one area of possible
bipartisan consensus may be a renewed emphasis on
infrastructure spending, possibly through public-private
partnerships and the issuance of qualified public infrastructure
bonds.
As a whole, investors have remained attracted to the relative
safety of US municipal bonds and tax-exempt income; at the
end of 2016, US municipal bond issuance hit a six-year high of
over US$420 billion, bringing the total size of the US municipal
bond market to US$3.7 trillion. Of this total, investors outside
the United States owned US$93.3 billion as at 30 September
2016. Although this represents a relatively small slice of the
total US municipal bond universe, that number is growing and
has increased from just US$29 billion in 2005.
Taxable vs. Tax Exempt
Nominal yields on taxable municipal bonds are generally higher
than similarly rated tax-exempt municipal bonds along the
maturity spectrum, although there is no difference in credit risk
between similarly rated taxable and tax-exempt bonds. In most
cases, the issuers are the exact same. As at 31 December
2016, 20-year AAA rated taxable municipal bonds yielded over
80 basis points more than 20-year AAA rated tax-exempt
municipal bonds, on average. This is a natural relationship
given the tax-exempt benefit resulting in a lower nominal yield.
General obligation (GO) municipal bonds are secured by the full
faith and credit of a state or local government and are paid
through the General Fund. In contrast, revenue bonds are
secured by a dedicated revenue stream usually from a tangible
asset such as an airport or toll road. In either case, historical
defaults have been extremely rare, with the last state GO bond
default occurring in 1933. More generally, in the period 1970–
2014, the one-year default rate for investment-grade municipal
bonds was less than one tenth of one percent, with the majority
of the defaults coming from issuers in the housing sector.
Exhibit 3: Yield Curves of US Treasury, US Tax-Exempt, US Taxable and US Corporate Bonds
As at 31 December 2016
US
Treasury
1Y
0.82
0.97
1.00
1.13
1.38
0.95
1.00
1.25
1.62
1.29
1.42
1.72
3Y
1.45
1.46
1.55
1.77
2.07
1.71
1.77
2.07
2.57
1.91
2.13
2.52
5Y
1.93
1.79
1.91
2.19
2.51
2.25
2.35
2.65
3.23
2.42
2.62
3.07
10Y
2.45
2.31
2.51
2.88
3.23
3.09
3.20
3.48
4.13
3.28
3.37
3.95
15Y
2.57
2.63
2.87
3.26
3.62
3.60
3.70
4.10
4.78
3.73
3.96
4.55
20Y
2.79
2.90
3.15
3.52
3.88
3.74
3.84
4.16
4.86
3.97
4.21
4.82
25Y
3.05
2.99
3.24
3.61
3.97
3.79
3.89
4.20
4.91
4.08
4.22
4.80
30Y
3.07
3.04
3.29
3.66
4.02
3.83
3.93
4.25
4.96
4.16
4.19
4.74
Tenor
AA Tax- A TaxExempt Exempt
Muni
Muni
BBB TaxExempt
Revenue
Muni
AAA TaxExempt
Muni
AAA
AA
BBB
Taxable Taxable A Taxable Taxable
AA
A
BBB
Muni
Muni
Muni
Muni Corporates Corporates Corporates
Source: Bloomberg, Thomson Reuters.
For Institutional Professional Investors Only. Not For Distribution To Retail Clients.
Opportunity for Non-US Investment in Taxable US Municipal Bonds
2
While investment-grade municipal bonds make up the majority
of the total market, some investors seek increased yields by
buying lower-rated or even below-investment-grade (or highyield) municipal bonds. Investors in higher-yielding municipal
bonds take on increased credit risk based on the financial
strength of the underlying issuer in exchange for higher yields.
Although spreads have compressed somewhat in recent years,
the average yield of the Bloomberg Barclays BBB Municipal
Bond Index is over 100 basis points higher than that of the
Bloomberg Barclays AAA Index. This more aggressive riskreturn profile tends to be more attractive to investors with longer
time horizons and are therefore able to tolerate more short-term
volatility.
Municipal Bonds vs. Corporate Bonds
While municipal bonds are issued by a government entity to
finance primarily public projects, corporate bonds, as the name
implies, are issued by a corporation to fund any variety of
business operations or expansion projects as deemed
necessary by management. Since corporate bond issuers fund
their debt payments through business operations rather than
through tax revenue, as is the case with GO municipal bonds,
corporate bonds are subject to greater credit risk, as any
number of adverse conditions may affect the issuer’s ability to
service the bond. As a result, average yields on corporate
bonds tend to be modestly higher than municipal bonds with
similar credit ratings and maturities.
Although the current difference in average yield between
corporate and municipal bonds is somewhat modest, US
municipal bonds are significantly less likely to default than
corporate bonds with similar ratings and are therefore
considered to be a significantly less risky investment from a
credit perspective. Additionally, the focus on more essential
service type financing helps provide a stronger credit profile for
municipal issuers.
In the unlikely event that a municipal bond does default on an
interest payment, the recovery rate—the amount the
bondholder ultimately receives relative to the outstanding
debt—is usually very high. In the case of GO bonds, the
historical recovery rate is almost 100%, with many
municipalities legally obligated to repay bond holders before
fulfilling other debt obligations. In comparison, the recovery
rates of even highly rated corporate debt can vary widely in the
event of default. During the period 1987–2007, the average
recovery rate across the corporate credit universe was just over
50%. Defaults have proven to be very rare in the municipal
market over the past 100 years.
Looking at more regionalized corporate bonds, we can see a
similar relationship between US municipal bonds and European
corporate bonds. In addition to generally lower credit risk, the
valuations of US municipal bonds versus European corporate
bonds on a hedged basis also currently look attractive, in our
view. Like the US market, the European market also tends to
Exhibit 4: Cumulative Default Rates, US Municipal vs. US Corporate Issuers
Average over the Period 1970–2014
Municipal Issuers
Rating
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Aaa
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Aa
0.00%
0.00%
0.00%
0.00%
0.01%
0.01%
0.01%
0.01%
0.01%
0.01%
A
0.00%
0.01%
0.02%
0.02%
0.03%
0.03%
0.04%
0.05%
0.06%
0.06%
Baa
0.01%
0.04%
0.08%
0.11%
0.15%
0.19%
0.24%
0.29%
0.33%
0.37%
Ba
0.28%
0.81%
1.27%
1.85%
2.39%
2.80%
3.24%
3.59%
3.88%
4.11%
B
2.92%
5.57%
8.03%
10.26% 12.38%
13.82%
14.66% 15.44% 16.30%
17.48%
Caa–C
7.83%
11.01%
12.99%
14.12% 14.71%
15.21%
15.76% 16.37% 16.88%
16.88%
Investment-Grade
0.00%
0.01%
0.02%
0.03%
0.04%
0.05%
0.06%
0.07%
0.08%
0.08%
Speculative-Grade
1.31%
2.42%
3.36%
4.29%
5.13%
5.74%
6.26%
6.72%
7.13%
7.52%
All Rated
0.02%
0.03%
0.05%
0.06%
0.08%
0.09%
0.11%
0.12%
0.13%
0.14%
Year 10
Corporate Issuers
Rating
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Aaa
0.00%
0.01%
0.01%
0.04%
0.10%
0.17%
0.24%
0.31%
0.39%
0.48%
Aa
0.02%
0.07%
0.14%
0.26%
0.40%
0.54%
0.67%
0.78%
0.88%
0.99%
A
0.06%
0.20%
0.43%
0.67%
0.95%
1.26%
1.60%
1.97%
2.36%
2.72%
Baa
0.17%
0.48%
0.86%
1.32%
1.78%
2.27%
2.75%
3.23%
3.78%
4.41%
5.18%
7.55%
Ba
1.07%
2.96%
9.70%
11.70% 13.44%
15.18%
16.90%
18.69%
B
3.71%
8.86% 14.14% 18.82% 23.11%
27.11% 30.82%
33.94%
36.72%
39.16%
14.96%
25.68% 34.29% 41.18% 46.97%
51.21% 54.73%
58.01%
61.26%
63.77%
2.07%
2.43%
2.81%
Caa–C
Investment-Grade
0.09%
0.27%
0.51%
0.78%
1.09%
Speculative-Grade
4.34%
8.92% 13.29% 17.15% 20.52%
All Rated
1.66%
3.37%
4.95%
6.32%
7.49%
1.41%
1.73%
23.48% 26.08%
8.51%
9.39%
28.36%
30.47%
32.41%
10.17%
10.90%
11.58%
Source: Moody’s. Notes: 1) The first cohort considered is the one-year cohort starting on 1/1/70. The last cohort considered is the one-year cohort starting on 1/1/14. 2) Transition
rates are averaged over cohorts spaced one month apart, as opposed to cohorts spaced one year apart. 3) Municipal ratings have been adjusted to be consistent with the Global
Rating Scale.
For Institutional Professional Investors Only. Not For Distribution To Retail Clients.
Opportunity for Non-US Investment in Taxable US Municipal Bonds
3
Exhibit 5: Credit Rating Distributions
Bloomberg Barclays Municipal Bond Index vs. Bloomberg Barclays
Global Aggregate Corporate Index
As at 31 December 2016
60%
investors has been the longer duration of the municipal bond
market versus corporate bonds. This is due to the fact most
municipalities are financing projects with long lives and hence
want to have the financing match the term of the project.
Accessing This Market Requires a Partner with
Proven Expertise
50%
40%
30%
20%
10%
0%
AAA
AA
Municipal Bond Index
Source: Bloomberg Barclays Live.
A
BAA
Global Corporate Index
have a bulk of issuers in the A or BBB rated tranches while
municipal bonds tend to be higher rated. Therefore, European
focused investors stand to benefit through a competitive yield
that is differentiated from European rates while maintaining
exposure to a group of issuers that have tended to be less
susceptible to broader credit cycle trends. In June 2016, the
European Central Bank (ECB) began a program of buying
European corporate bonds across a variety of sectors. This
attempt by the ECB to boost the European economy and stoke
inflation in the eurozone has lowered yields and compressed
spreads among euro-denominated corporate bonds. As such,
even after hedging costs, which currently stand at
approximately 160 basis points per year but can vary
depending on the underlying currency movement, the yields on
taxable municipal bonds remain relatively attractive as
compared to similarly rated asset classes such as eurodenominated investment-grade corporate bonds.1
In addition to lower volatility than corporate bonds and generally
higher yields than US Treasury securities, municipal bonds offer
a low, and sometimes negative, correlation to stocks. As at
December 2016, the rolling five-year correlation of taxable
municipal bonds with global stocks was -0.03. Municipal bonds
also offer a lower correlation to other fixed income assets,
adding an additional layer of diversification to a portfolio. One
additional benefit we have found for non-US based institutional
KEY ARGUMENTS FOR INSTITUTIONAL INVESTORS
•
Yield
•
Lesser sensitivity to credit cycle
•
Longer duration asset class to match liabilities
•
Liquid access to infrastructure related investments
Although municipal bonds share many similar characteristics
and can add stability to a well-diversified portfolio, it is important
to remember that no two municipal bonds are identical and the
range of issuers is broad. In fact, as at 30 June 2016, the US
municipal bond universe was composed of over 117,000 state
and local entities, with over 950,000 total municipal bond
issues. Franklin Templeton Investments has nearly 40 years of
experience navigating this complex universe, having managed
municipal bond strategies since 1977. Today, we are one of the
largest municipal bond fund managers in the nation and have
more than US$75 billion in municipal bond assets under
management. This significant asset base is an advantage when
negotiating terms for municipal bond transactions and finding
opportunities to participate in new bond offerings. Our seasoned
team of 32 investment professionals has an average of 20 years
industry experience (as at 31 December 2016) and offers a full
suite of municipal bond strategies spanning the entire market,
including national and state-specific, investment-grade and
high-yield and long-, intermediate- and limited-term strategies.
Our dedicated municipal credit research team includes 17
investment professionals with an average of over 20 years of
industry experience who have spent their entire careers
analyzing municipal credits. This experience is critical when
navigating the broad municipal investment landscape. Given our
analysts’ focus on a specific sector(s), their analysis is utilized
regardless of region or taxability. We can therefore provide a
consistent view on a credit based on the underlying
fundamentals of a specific issuer.
Our municipal bond team focuses on maximizing income for
each and every one of our portfolios. This focus is driven by the
fact that, historically, income is the primary driver of total returns
in the municipal bond asset class. We seek to provide
diversified portfolios from an issuer perspective so as to reduce
idiosyncratic risk in the portfolios. Our team of analysts is
responsible for conducting research on each issuer under
consideration for a portfolio. The analysts are focused on
evaluating an issuer’s credit strengths and weaknesses and
working with the portfolio manager who ultimately decides what
issuers are included in the portfolio and at what size. This
coordinated process has served our clients well in the nearly
four decades we have been actively managing municipal bond
portfolios.
In conclusion, we feel an allocation to municipal bonds by nonUS investors can provide another source of attractive, high
quality income to a portfolio while also diversifying from a credit
standpoint. We believe partnering with an expert is critical,
given the nuanced nature of the municipal bond market.
For Institutional Professional Investors Only. Not For Distribution To Retail Clients.
Opportunity for Non-US Investment in Taxable US Municipal Bonds
4
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and
should not be construed as individual investment advice or a
recommendation or solicitation to buy, sell or hold any security
or to adopt any investment strategy. It does not constitute legal
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