Principal Global Fixed Income
Taxable U.S. municipal bonds
make sense for non-U.S. investors
Bernhard Fischer, Senior Fixed Income Analyst (Municipal Bonds)
Highlights:
There has been 27.6% growth in
municipal bond investments by foreign
investors within the past five years.
Taxable municipal bonds have
outperformed tax exempt munis,
U.S. investment grade-rated credit,
and treasury bonds for almost five
consecutive years.
Taxable municipal bonds boast a
favorable return profile, longerdated maturities, low correlation
to other fixed income sectors and
equities, low probability of defaults,
as well as favorable capital charge
treatment, making them an attractive
alternative investment.
Avergaging approximately $US30
billion in annual issuance with
approximately $US 470 billion
outstanding, the taxable municipal
market is smaller than the tax exempt
market. However, complemented by a
robust secondary trading market, an
experienced muni team has the ability
to build a well-diversified portfolio of
municipal bonds in a relatively short
amount of time.
As global investors continue to face falling, low, and negative
interest rates, the need for alternative investments to enhance
portfolio returns and performance has heightened.
Seeking to enhance yield, U.S. municipal bonds (munis) have been drawing increasing
interest from non-U.S investors. In fact, when examining Federal Reserve data over the
past five years, there has been 27.6% growth in municipal bond investments by foreign
investors. And within the muni market, taxable municipal bonds are of particular interest
to non-U.S. investors. As a replacement for, or a complement to, the hard-to-source
private infrastructure debt, taxable municipal bonds have similar characteristics, but are
publicly traded. These factors, combined with an attractive return profile, favorable
capital charge treatment, high credit quality, and longer durations well-suited for
matching liabilities make taxable munis a viable option for insurance companies and
pension funds looking to establish a well-diversified portfolio while enhancing yield.
Taxable munis are primarily highly rated (AA), generally long duration, and primarily
fixed-rate bonds that offer higher yields than tax exempt municipals, investment
grade-rated bonds, and sovereign debt, as shown in Exhibit 1. And although the
taxable municipal bond universe is smaller, at about US$470 billion compared to
US$3.2 trillion for tax exempt, steady new taxable issuance volume as shown in
Exhibit 2, paired with an active secondary trading market would allow an experienced
investment team to aggregate a diverse pool of municipal bonds in a short time frame.
Exhibit 1: The taxable U.S. municipal bond market offers attractive yields
Yield to Worst Comparison (%)
6
When examining yield to
worst data, taxable municipal
bonds have outperformed
tax exempt, U.S. investment
grade-rated credit, and
treasury bonds for almost
five consecutive years.
5
4
3
2
1
0
Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun
10 11 11 12 12 13 13 14 14 15 15 16
Taxable Municipal Bonds
Tax Exempt Municipal Bonds
U.S. Investment
Grade-Rated Credit
U.S. Treasurys
Source: Barclays Indices, POINT ©2016 Barclays
Capital Inc. Used with permission. Barclays and
POINT are registered trademarks of Barclays
Capital Inc. or its affiliates. Data shown is as of
30 September 2016.
Exhibit 2: Taxable U.S. municipal issuance is stable
Total taxable debt issued ($bn)
160
152
140
In 2009, the Build America Bond program
was implemented to help state and local
governments finance capital projects at a
lower cost. The program, which ended in 2010,
resulted in an influx of taxable bonds into the
market. After this spike, new-issuance volume
within taxable U.S. municipals market has been
steady for the past six years.
120
100
85
80
60
40
40
20
0
16 15 13 15
10 14
1996
1998
2000
19
2002
24 25
2004
New money issuance ($bn)
29 29
2006
32 33 32 30 31
24
20
2008
2010
2012
2014
2016*
Total ex. New Money
Source: Bloomberg, J.P. Morgan. Note includes non-pre-funded debt, fixed and zero
coupon, with maturities 1 year or greater. *2016 year-to date through August 2016
The two main municipal bond categories
account for approximately 27% of the total market.
Within municipal bonds, the two main categories of
On the other hand, revenue-backed bonds are secured
issuance are general obligation (GO) tax-backed and
by a stream of revenues from a specific asset, enterprise,
revenue-backed bonds. As illustrated in Exhibit 3, both
or infrastructure such as airports, utilities, toll roads,
types are most often issued in maturities ranging from 1
universities, and hospitals. Representing the largest
to 30 years and across numerous sectors.
portion of the market, revenue-backed bonds comprise
approximately 65% of issuance and are often of greatest
GO tax-backed bonds are secured by the promise to
interest to European investors because of the favorable
repay debt from the issuer’s taxing authority. State and
capital charge treatment infrastructure bonds receive
local governments (cities, counties, schools) are large
under Solvency II.
issuers of these types of bonds. GO tax-backed bonds
Exhibit 3: The U.S. municipal bond market offers a wide range of maturities and sectors
Municipal index,
breakdown by purpose type
Municipal index,
breakdown by maturity
Pre-refunded
8%
Long
20%
General obligation
tax-backed
27%
Municipal index,
breakdown by purpose class
1 year
7%
Special tax
10%
3 year
11%
5 year
9%
20 year
13%
7 year
8%
Revenue-backed
65%
15 year
17%
10 year
15%
The depth and breadth of the U.S. municipal bond market allows
you to match your investment needs to the right opportunity.
Leasing
7%
State
16%
Water &
sewer
9%
Local general
obligation
14%
Education
8%
Transportation
17%
Power
6%
Industrials
3%
Hospitals
9%
Housing
1%
Source: Barclays Risk Analytics and Index Solutions. Data shown is as of 30 June 2016.
Taxable U.S. municipal bonds make sense for non-U.S. investors 2
Enhanced regulation and low defaults
The next benefit of U.S. municipal bonds lies in the
A benefit for non-U.S. investors seeking to add U.S.
average default rate in 2015 was notably lower within
low probability of default. As shown in Exhibit 4, the
taxable munis to their portfolio is related to recent
U.S. municipal bonds than fixed income corporates – at
strides in regulation. The U.S Securities and Exchange
all credit qualities. This is largely due to the nature of
Commission (SEC), the Municipal Securities Rulemaking
government-generated revenues that are used to repay
Board (MSRB), and Financial Industry Regulatory
municipal bonds. For example, for GO taxed-backed
Authority (FINRA) have proposed practices and rules
bonds, the willingness to pay is strong, given the need
that have yielded tangible benefits, such as improved
to access capital markets in order to finance long-term
publically available financial reporting, material event
capital projects. In the case of revenue-backed bonds, the
disclosures, and enhanced valuation and trading
issuer has pledged specific revenues for debt repayment.
information. While improvements in regulation have
In fact, some of the largest revenue-backed bonds are
been made, the fundamental budget process of
issued for infrastructure projects where tolls or fees are
governments is done on an annual basis, which results in
weaker reporting than that of corporates. However, an
experienced muni credit team who monitors municipal
credits and issuers can provide significant value to
global investors seeking to capture opportunities related
to enhanced regulation.
charged – providing a steady stream of revenues to repay
outstanding bonds. It is for this reason that revenuebacked bonds are usually very stable, publically traded,
long duration bonds – characteristics that are reflected in
their generally high ratings and the reason these bonds
receive favorable treatment under Solvency II regulatory
requirements.
Exhibit 4: Taxable and tax exempt municipal bonds have low default rates
Rating
U.S. Municipal Bonds
U.S. Fixed Income Corporates
AAA
0.00
1.21
AA
0.07
1.55
A
0.18
2.95
BBB
0.69
6.60
BB
5.02
18.75
B
12.73
31.19
CCC/C
41.15
58.54
Investment grade
0.25
3.89
Speculative grade
9.62
27.70
In 2015, average default rates
of U.S. municipal bonds were
lower than fixed income
corporates at all credit levels.
Source: S&P Global Market Intelligence, a division of S&P Global Inc. Data as of 6 May 2016.
Harnessing the benefits of diversification
bonds can provide you with enhanced yield potential.
Another key benefit that municipal bonds can offer
benefit of low correlation, non-U.S. investors will likely
investors is diversification. For investors looking to
invest in municipal bonds, both tax-exempt and taxable
municipal bonds have strong potential to help increase
your overall portfolio yield with low correlation to other
fixed income sectors. Using Exhibit 5 as a reference, it
becomes easier to understand how diversifying your
already-robust fixed income portfolio with U.S. municipal
And although tax-exempt and taxable both offer the
be most attracted to taxable munis in order to avoid any
negative tax arbitrage and to benefit from the favorable
capital charge treatment associated with revenue-backed
infrastructure bonds. In addition to low correlation
scores with other fixed income sectors, munis also offer
low correlation to equity markets, which is beneficial to
investors seeking a more stable investment opportunity.
Taxable U.S. municipal bonds make sense for non-U.S. investors 3
Exhibit 5: Municipal bonds offer low correlation to other fixed income sectors and equities
Year-to-date
Municipals Taxable muni Treasury Corporate High yield
Municipals
1
Taxable muni
Equities
0.75
0.79
0.21
-0.33
-0.51
1
0.90
-0.21
-0.81
-0.62
1
0.03
-0.69
-0.64
1
0.68
0.61
1
0.81
Treasury
Corporate
Taxable high yield
Equities
One year
1
Municipals Taxable muni Treasury Corporate
Municipals
1
Taxable muni
High yield
Equities
0.71
0.76
0.33
-0.11
-0.24
correlation to other fixed income
1
0.88
0.37
-0.06
-0.19
sectors and equities. This low
1
0.38
-0.17
-0.37
correlation allows you to diversify
1
0.71
0.46
while increasing the overall
1
0.72
stability of your portfolio.
Treasury
Corporate
Taxable high yield
Equities
Five years
Municipal bonds offer low
1
Municipals Taxable muni Treasury Corporate
Municipals
1
Taxable muni
High yield
Equities
0.82
0.73
0.65
0.08
-0.17
1
0.84
0.73
0.04
-0.28
1
0.60
-0.19
-0.48
1
0.55
0.15
1
0.76
Treasury
Corporate
Taxable high yield
Equities
1
Source: Barclays Indices, POINT ©2016 Barclays Capital Inc. Used with permission. Barclays and POINT are registered trademarks of
Barclays Capital Inc. or its affiliates. All data is local currency unhedged and based on total return percentage.
Calculated with monthly frequency for all time periods. Data shown is as of 30 June 2016.
Making an allocation to taxable
U.S. municipals
Now that you know the benefits of investing in U.S.
municipal bonds, your next question might be, “How do
I gain access to the U.S. muni market?” As a whole,
the U.S. municipal bond market is sizeable, with
approximately US$3.7 trillion outstanding, an annual
issuance of about US$400 billion, and an average trading
volume of around US$10 billion per day, according to the
MSRB. And while taxable U.S. municipal bond issuance
represents a smaller portion of the holistic municipal
bond market and averages approximately US$30 billion
in annual issuance as shown in Exhibit 2, taxable muni
bonds boast higher yields, longer-dated maturities, and
larger average issue size with the same high credit quality
of tax exempt municipal bonds as shown in Exhibit 6.
Pairing larger average issue size with a robust secondary
trading market allows an experienced muni credit team
to aggregate a well-diversified portfolio of municipal
bonds in a relatively short time frame. The key takeaway?
U.S. taxable municipal bonds make sense for investors
who are seeking to harvest yield from a well-diversified
portfolio of stable, long-duration, and high credit
quality cash flows with the help of an experienced
muni credit team.
Exhibit 6: Taxable municipal bonds provide a better value proposition than tax exempt munis
Yield to worst
Modifed duration to worst (years)
Average credit rating
Maturity (years)
Average issue size
Barclays Taxable
Municipal Index
Barclays
Municipal Index
3.10%
1.80%
9.2
5.0
AA2/AA3
AA2/AA3
18.3
13.1
59.5 million
25.8 million
Taxable municipal bonds
provide investors higher yields,
longer-dated maturities,
and larger issue sizes when
compared to tax-exempt munis.
Source: Barclays Indices, POINT ©2016 Barclays Capital Inc. Used with permission. Barclays and POINT are registered
trademarks of Barclays Capital Inc. or its affiliates. Data shown is as of 30 September 2016.
Taxable U.S. municipal bonds make sense for non-U.S. investors 4
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Taxable U.S. municipal bonds make sense for non-U.S. investors 5