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Industry Voices

Commentary: The role of U.S. municipal debt in institutional portfolios

The municipal bond market historically has been retail-oriented, as high-net-worth individuals, particularly those in the highest tax bracket, benefit from the interest income tax-exemption. However, institutional investors, such as banks and insurance companies, have been some of the biggest buyers of municipals over the past several years and now represent approximately 30% of the market. Municipal bonds are issued as tax-exempt and taxable and, while both offer different attributes, each offers a role in institutional portfolios.

An important distinction between tax-exempt and taxable municipals is the traditional buyer base. Tax-exempt municipals traditionally are retail-led while taxable municipals offer attributes compelling to institutional buyers. In our view, recent structural changes have made taxable municipals an attractive strategic option for institutional investors while potentially offering a tactical opportunity in tax-exempt municipals.

Taxable municipals offer compelling attributes to institutional investors

The yield advantage taxable municipals offer relative to tax-exempt counterparts also extends to other fixed-income sectors (Figure 1). The municipal yield profile is attractive and comparable to investment-grade corporate bonds, however municipals maintain a higher quality standing: 92% of U.S. taxable municipals are rated A or better compared to 90% of the U.S. investment-grade corporate market, which is rated A or below (Figure 2). The sector historically exhibits a lower probability of default than U.S. corporates due to the higher quality nature of the taxable municipal market. This is of greater importance, particularly this late in the credit cycle and elevated corporate leverage metrics. Municipals are not guaranteed by the full faith and credit of the U.S. government, however, according to Moody's Investors Service, the 1970-2016 cumulative 10-year average default rate for all rated muni bonds was 0.15% compared to all rated global corporate bonds at 10.29%. Finally, municipals offer the ability to add diversity to a broader portfolio as the volatility is traditionally lower than other components of the market. The 10-year correlations of municipals to other broad U.S. fixed-income and equity sectors exemplify the substantial diversification benefit municipals offer (Figure 3).

Figure 3 10-year correlation matrix
IndexU.S. Taxable MunicipalU.S. AggregateU.S. TreasuryU.S. MBSU.S. CorporatesS&P 500
Bloomberg Barclays U.S. Taxable Municipal1.00
Bloomberg Barclays U.S. Aggregate0.751.00
Bloomberg Barclays U.S. Treasury0.650.851.00
Bloomberg Barclays U.S. MBS0.640.870.801.00
Bloomberg Barclays U.S. Corporate0.610.820.440.561.00
S&P 5000.010.05-0.28-0.100.351.00
Source: Bloomberg LP; as of March 31, 2018

Tactical allocations to tax-exempt municipals can provide substantial total returns

There have been periods in history of extreme illiquidity in the tax-exempt municipal market, predominantly due to the ownership structure, which is dominated by retail investors. The market psychology of individual investors is often a returns-chasing behavior that, as a result, produces a highly cyclical demand pattern (Figure 4). These market dynamics and periods of investor sentiment, as opposed to fundamentals, drive municipal valuations and create market dislocations. Yet it is these periods that create an opportunity for investors with a long-term horizon to be liquidity providers and achieve superior total returns.

While the ownership structure continues to be dominated by retail investors, banks and insurance companies have been some of the biggest buyers of tax-exempt municipals since the peak of the global financial crisis. The old tax regime of 35% corporate tax rates resulted in an attractive relative value opportunity between tax-exempt municipals and taxable bonds for institutional investors. As a result, bank and insurance company ownership increased markedly during this period. Corporate investors, including banks and insurance companies, experienced a dramatic decline in tax rates under the Tax Cuts and Jobs Act, lowering the corporate tax rate to 21% from 35%.

Municipal bonds are now less attractive relative to other spread sectors, which could prompt extensive municipal selling. We are cognizant that there are continued benefits to having tax-exempt municipals as part of an asset allocation, (particularly for tax-paying investors) however, if banks and insurance companies are no longer the marginal buyer, or become aggressive sellers, this could result in a period of illiquidity and create an opportunity for substantial total returns for those investors who can act as liquidity providers.

Conclusion

Municipals often have been viewed as the asset class for the retail investor. However, we believe both taxable and tax-exempt municipals can play an important role in an institutional portfolio. Taxable municipals offer compelling attribute: high quality, low default rates, comparable yields and low correlations to other asset classes. Tax-exempt municipals, while being a non-traditional asset class for institutional investors, can opportunistically provide attractive total returns. By overlooking the U.S. municipal market, investors will miss out on opportunities to diversify overall portfolios and achieve attractive total returns.

Julio Bonilla is a New York-based fixed-income portfolio manager at Schroders. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.