Wells Capital Management
Market insights
Municipal Fixed Income
May 2016
Why non-U.S. investors are turning to municipal bonds
Lyle Fitterer, CFA
Managing Director,
Head of Tax-Exempt Fixed Income
Gabriel G. Diederich, CFA
Portfolio Manager,
Tax-Exempt Fixed Income
Introduction
Basic definitions and market structure
Municipal bonds have long been favored by wealthy U.S. retail investors
and tax-paying institutions that have benefitted from tax features
unique to these securities. The principle that one branch of the U.S.
government will generally not interfere with the financing activities of
another U.S. government entity is the historical rationale supporting
the federal tax deductibility of interest payments. Some issues are
also exempt from state or local taxes on interest income to further
subsidize investment.
Municipal bonds are securities issued for the purpose of financing
the infrastructure needs of an issuing municipality. The municipal
market has been in existence for over 150 years and has financed a
wide range of projects including bridges, roads, highways, airports,
water supply, energy transmission, and other facilities. Data compiled
by the Congressional Budget Office (CBO) show that state and local
governments have historically financed 61% to 85% of all government
spending on U.S. transportation and water infrastructure each year
since annual records have been published, beginning in 1956.5
But for investors who do not pay taxes, these tax features might be
considered a drawback rather than advantage as nominal yields are
driven down by those investors who can utilize tax deductions.
So why would tax-exempt institutions and investors outside the
United States who are not subject to federal taxation invest in the
U.S. municipal bond market? It turns out there are several reasons.
But the average age of infrastructure in the U.S. has been steadily increasing since the pace of major public works spending (including spending
surrounding the construction of the Interstate highway system) began
declining in the 1970s. As Figure 1 reveals, spending on transportation
and water infrastructure has declined in absolute terms for the better
part of this century, and we estimate this slowdown is generally indicative
of wider infrastructure spending over this period. It is our view that the
need for all manner of infrastructure improvements is dire and cannot be
ignored indefinitely. This, coupled with generally improving tax receipts,
will likely ensure robust new municipal bond issuance in coming years.
 For one, a meaningful portion of the municipal bond market is
taxable (i.e. does not allow deduction of interest payments from
taxable income) and therefore offers higher yields in compensation.
The Barclays Taxable Municipal Bond Index is roughly 16% of the
combined Barclays Municipal Bond Index group as of this writing.1
 For the substantially larger portion of the municipal bond market
that is tax-exempt, nominal yields are often superior to those of
competing Treasuries, agencies, and corporate issues in the broader
U.S. bond market.
 The $3.7 trillion municipal bond market is nearly half the size of
the total U.S. corporate bond market2 and is both deep and active
enough to offer a tailored liquidity profile.
 Historical default rates have been lower than corporate debt3 and
recovery rates have been higher among bonds of similar credit
quality. Volatility has been lower than that of U.S. investment grade
corporate bonds.4
 The inclusion of both taxable and tax-exempt municipal bonds
can provide significant diversification benefits in a broad U.S. fixed
income allocation.
Figure 1: CBO infrastructure spending
Public spending on transportation and water infrastructure, by level
of government, 1956 to 2014
Billions of 2014 dollars
5% decrease
350
300
250
State and local governments
200
2003 to 2014
150
100
19% decrease
50
Federal government
2011
2006
2001
1996
1991
1986
1981
1976
1971
1966
1961
1956
0
In this paper we explore some of the key attributes of the U.S. municipal
bond market from the perspective of tax-exempt and, particularly,
non-U.S. investors. We build on this discussion to argue that a dedicated allocation through a municipal credit specialist may provide the
most compelling way to gain exposure to this asset class.
Source:Congressional Budget Office based on data from the Office of Management and Budget, the
Census Bureau, and the Bureau of Economic Analysis.
Note:Dollar amounts are adjusted to remove the effects of inflation using price indexes for government
spending that measure the prices of materials and other inputs used to build, operate, and maintain
transportation and water infrastructure.
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Why non-U.S. investors are turning to municipal bonds | May 2016
Municipal bonds can be segmented into two general security types:
Why would tax-exempt and non-U.S. investors
consider tax-exempt bonds?
G
eneral obligation (GO): these bonds are secured by the full faith
and credit promise to repay debt from the issuer’s general taxing
authority. State and local GOs (e.g. cities, counties and school
districts) are the main subsets of issuers. GOs currently represent
about 28% of the total municipal bond market.
R
evenue bonds: these bonds are secured by a stream of revenue from
a specific facility or asset and, in this respect, are similar to secured
corporate debt. Examples of typical revenue bonds are water/sewer
districts, airports, toll roads, universities, hospitals, and dedicated tax
bonds. Revenue bonds represent about 72% of the market.
Before answering this question, we must note the widely recognized
merits of a taxable municipal bond allocation. Like corporate and
Treasury securities, income on taxable municipal bonds is fully subject
to federal taxation. Securities may be issued in the taxable market for
reasons ranging from the availability of federal government subsidies
for targeted projects, the issuer’s desire to have greater control over
the use of proceeds, or for instances where proceed usages would be
considered ineligible for tax-exempt status by the U.S. Internal Revenue Service (IRS). As a consequence, nominal yields are higher than
otherwise similar securities in the tax-exempt market. Moreover, the
substantial size of the taxable market (we estimate roughly $500 billion
of both index and non-index debt outstanding) suggests sufficient
depth to build a dedicated allocation.
Figure 2: Issuance by security type
18%
15%
Build America Bonds (BABs) are a popular class of taxable bonds
that receive a tax subsidy paid directly to the issuer from the
Federal government. The benefit of this subsidy is often passed
on to investors in the form of higher nominal yields.
12%
9%
6%
3%
Resource Recovery
Housing
IDR / PCR
Electric
Leasing
Prerefunded
Education
Hospital
Water & Sewer
Special Tax
Transportation
Local GO
State GO
0%
Source: Wells Capital Management, Barclays Capital Management as of 1/31/2016
Retail investors, banks, and insurance companies have historically
held the lion’s share of outstanding municipal debt. We believe
the buy-and-hold nature of retail investors, through their sizable
direct ownership of bonds and mutual fund holdings, has been a
significant contributor to the relatively low levels of volatility of this
asset class. But for reasons we describe in this paper, non-U.S. institutional investors globally, particularly European and Japanese financial
institutions, have steadily taken an increasing, if minor, share of the
market. Net flows from non-U.S. investors have been in excess of $4
billion in each of the past three calendar years6 and we believe the
interest from non-U.S. investors will continue to strengthen over the
next several years.
Figure 3: Participation by investor type
4%
4% 2%
7%
42%
9%
13%
19%
Household sector
Mutual funds
Banks
P&C insurance
Money market funds
Life insurance
Other
Closed-end funds
But there are equally compelling arguments for the addition of
tax-exempt securities within a broad municipal bond market allocation:
 Many tax-exempt municipal bonds offer higher nominal yields than
Treasury, agency, mortgage and corporate securities of comparable
duration and rating. We find that these opportunities are greatest in
intermediate and long maturities at present.
 The tax-exempt municipal bond market is roughly six times the size
of the taxable municipal bond market. This is evident in its greater
diversity of issue types and range of maturities.
 The historically low yield environment has also reduced the relative
importance of the tax-deductibility of interest in the context of total
returns. Indeed, we describe in the next section how the importance
of credit risk as a contributor to total municipal bond market returns
has increased significantly in recent years.
An allocation to both taxable and tax-exempt municipal bonds can
significantly improve the risk profile of a broader U.S. bond allocation:
 Figure 4 shows that a broad municipal bond market allocation can
provide substantial diversification benefits through low correlations
to competing U.S. bond asset classes.
 Figure 5 illustrates that municipal bonds have achieved lower
absolute default rates versus corporate bonds for any given credit
segment. Improving tax receipts should continue to reduce the
frequency and severity of defaults in coming years.
The above arguments suggest that the inclusion of tax-exempt
municipal securities alongside taxable securities can significantly
improve the ability of non-U.S. investors to optimize their risk profiles
within a broader US fixed income allocation. An important remaining
question that non-U.S. investors face is how best to access the inherent
benefits of this asset class.
Source: Federal Reserve, as of 12/31/2015.
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Why non-U.S. investors are turning to municipal bonds | May 2016
Figure 4: 10-year correlation of major bond indices as of 12/31/2015
10 year correlation of
major U.S. bond indices
Barclays ABS
Barclays CMBS
Barclays U.S. Aggregate
Barclays U.S. Corporate High Yield
Barclays U.S. Corporate Inv. Grade
Barclays U.S. Government
Barclays U.S. Municipals
Barclays ABS
1.00
0.35
0.37
0.60
0.56
0.04
0.51
Barclays CMBS
Barclays U.S.
Aggregate
Barclays U.S.
Corporate HY
Barclays U.S.
Corporate IG
Barclays U.S.
Government
Barclays U.S.
Municipals
1.00
0.33
0.73
0.49
0.02
0.30
1.00
0.24
0.81
0.87
0.53
1.00
0.62
-0.23
0.35
1.00
0.46
0.56
1.00
0.31
1.00
Source: eVestment Alliance.
Figure 5: Comparative default rates
Municipal (%)
Corporate (%)
AAA
0.00
1.24
AA
0.05
1.59
A
0.14
3.02
BBB
0.58
6.91
BB
4.58
18.91
B
12.86
31.98
CCC/C*
41.72
59.28
Investment-grade
0.20
4.01
Speculative-grade
9.39
28.17
Prudent security selection must take into consideration security
packages, political analysis, coupon/call features, financial analysis, and
trend analysis. Investors must also navigate the risks and opportunities
presented by economic cyclicality, pension funding, and transportation plans both nationally and locally. A well-resourced specialist
can perform the work necessary to avoid mistakes and ultimately
generate alpha in security selection.
The Municipal bond market is diverse
The major indexes account for less than half of total municipal debt
outstanding (about 44% at this writing7), and we estimate that
roughly half of total taxable and tax-exempt market debt falls outside
of the respective indexes. Larger and more liquid issues tend to be
index-oriented while smaller issuers, and even smaller issues of larger
issuers, tend to fall outside the indexes. The fractured nature of the
municipal bond market is evident in Figure 7.
Source: Standard & Poor’s, as of 3/31/2016.
*For U.S. corporate defaults, S&P’s study calculations include all ratings in the C category, from CCC to C.
Why choose a municipal credit specialist?
Figure 7: Depth and breadth of major U.S. asset classes
The rationale for choosing a municipal credit specialist is supported
by the market’s increasing credit orientation and issue diversity. We
discuss these in turn below.
The municipal bond market requires specialized credit research
While it maintains a higher rating profile than the U.S. corporate market,
we note that the municipal market should be viewed as a credit
market. Figure 6 shows larger exposure to A- and BBB-rated municipals
within the Barclays Municipal Bond Index today compared to 10
years ago. Some of the rating shift illustrated can be attributed to the
impact of the financial crisis and the resulting pressure on municipal
fundamentals. Another contributor was the demise of the oncedominant monoline insurance business that enhanced many municipal
securities. The resulting credit orientation has improved the payoff of
examining individual deal structures.
Figure 6: Then and now: Rating tier as percentage of index
Market
Market size
No. of issuers
No. of CUSIPs
Equities
$50.0 T
5,700
10,000
Corporate bonds
$7.7 T
5,000
20,000
Municipal bonds
$3.7 T
46,000
1,100,000
Source: EMMA, SIFMA, Bloomberg, NYSE/NASDAQ, TRACE, GAO, JP Morgan
The credit orientation and diversity of the market are important but
often overlooked considerations for non-U.S. investors. Many non-U.S.
investors have historically accessed the municipal bond market
through a sleeve within a broader core plus-styled mandate. It is typically the case that a core plus manager will lack adequate municipal
research capabilities. The resulting exposure may be merely a factor
allocation of index-oriented bonds which, as described above, can be
limiting from the perspective of alpha generation and risk management.
Percentage of
benchmark
80
2006
60
2016
40
20
0
AAA
Source: Barclays, Wells Capital Management
AA
A
BBB
For larger non-U.S. investors who can make an efficient standalone
allocation, the rewards of dealing with a specialist include access to
improved security selection, tailored credit and liquidity risk management, transparency and deeper market knowledge. Moreover, the
ability to measure performance and hold the specialist accountable
in the manager’s area of core competency can be a significant benefit
for all investors.
This paper significantly benefited from extensive research and development by Matt Alexander, CFA, CIPM, CAIA, product manager Wells Capital
Management.
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Why non-U.S. investors are turning to municipal bonds | May 2016
1 Source: Barclays Live, 4/21/2016
2 Source: Federal Reserve as of 12/31/2015.
3 Source: Standard & Poor’s study period from 1/1/1986 through 1/1/2015 comparing municipal and corporate default rates.
4 Source eVestment Alliance: comparing historical annualized standard deviation of Barclays U.S. Municipal Bond Index and Barclays U.S. Corporate Investment Grade Index over 30-year, 10-year and 5-year periods
ending 12/31/2015.
5 Sources: CBO, Public Spending on Transportation and Water Infrastructure, November 2010 and March, 2015.
6 Federal Reserve Statistical Release, Financial Accounts of the United States, March 10, 2016.
7 Source: Barclays Live, 4/21/2016
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