European insurers looking to U.S. munis

Updated with clarification

European insurers are turning their attention to the U.S. market to make their infrastructure investment plays, with the municipal bond market a particular focus.

Capital charges in the new Solvency II rules, a continued low-interest-rate environment, and the European Central Bank's decision to expand its asset purchase program to European corporate bonds are pushing insurers in Europe to cast their nets wider for returns.

“We have seen significant interest by European insurance companies in infrastructure,” said Kathleen Hughes, London-based head of European institutional sales at Goldman Sachs Asset Management. These investors are looking at taxable municipal bonds — which non-domestic players are able to access — the majority of which finance infrastructure projects in the U.S., such as toll roads, water facilities, hospitals and schools, she said.

Taxable municipal bonds make up $300 billion — about 20% — of the overall $1.4 trillion municipal bonds market, sources said.

In terms of performance, the attraction is clear. In 2015, the non-tax-adjusted S&P Municipal Bond Total Return index gained 3.3%, outperforming the S&P Treasury index's 0.8% gain; the Barclays U.S. Aggregate Corporate Total Return Value index at -0.7%; the Bank of America Merrill Lynch U.S. High Yield index's -4.6% performance; and the S&P 500 Total Return index's 1.4% gain.

But, sources said, there are additional reasons for U.S. municipal bonds' attractiveness: treatment under Solvency II - which came into effect Jan. 1; diversification of insurers' investments; and the macro environment.

Solvency II was designed to improve insurers' financial stability and protect policyholders — the ultimate buyers of their products.

Moves to reduce risk charges on infrastructure investments will enable insurers to better match long-term liabilities with long-term assets, experts say. And this is where municipal bonds come into play.

Last month, tweaks to Solvency II came into force that reduce the risk charges imposed on insurers' equity and debt investments in infrastructure. These changes regarding infrastructure treatment “were very much welcomed by the (insurance) industry,” said Cristina Mihai, head of international affairs and investments at Insurance Europe, the Brussels-based body that represents insurers and reinsurers in Europe.

“The previous capital approach was not tailored to infrastructure investments, as there was no recognition as infrastructure as a separate asset class,” she said. “This made the capital requirements unnecessarily high and extremely penalizing, and so it disincentivized insurers from investing in this asset class,” she explained.

More needs to be done, however, according to Ms. Mihai. She said Insurance Europe supports current efforts to include infrastructure corporate bonds in the scope of Solvency II's tailored treatment as well as the Juncker Investment Plan, which aims to remove obstacles to certain types of investment.

“Conceptually, it is very sensible to support the idea that those with long-term liabilities invest in long-term assets,” said Stuart Shipperlee, managing director at Litmus Analysis Ltd. in London.

This year, German insurer Allianz SE said it is aiming to double investment in infrastructure and renewable energy projects within the next two to three years but did not provide additional details.

Fitch Ratings Ltd. said this signals a trend — notably among life insurers — to invest in these types assets following changes to Solvency II.

Insurers' appetite to increase infrastructure investment reflects the fact that the assets can be a good match for their long-term liabilities, and can offer relatively high yields amid the current low-interest-rate environment, said David Prowse, senior director at Fitch Ratings in London.

Solvency II “includes a complex risk-based capital calculation that has been the subject of much scrutiny and discussion,” said Peter A. Wirtala, insurance strategist at Asset Allocation & Management Co. LLC in Chicago. “Unfortunately, for the time being there are relatively few investment opportunities in the (European Union) that meet the criteria for this treatment, so insurers have turned their eyes to the U.S., which has a much more developed market for infrastructure finance instruments,” said Mr. Wirtala. The U.S. market includes municipal bonds, “a significant percentage of which supports infrastructure construction maintenance, and upgrades,” he said. “These bonds may qualify for capital charges 30% to 40% lower than similar non-infrastructure investments under Solvency II regulations, making them very attractive on a returns-per-capital-charge basis.”

Noted Ms. Hughes: “Their treatment under Solvency II is seen by many European insurers as attractive relative to other fixed-income alternatives.”

The ECB's decision to expand its asset purchase program to include European corporate bonds has investors searching elsewhere for yield. Couple the lower yields that these assets are now attracting with the capital charges that Solvency II places on these investments, and investors have low or negative capital-adjusted returns, said Gilles Drukier, London-based client portfolio manager for European fixed-income insurance solutions at J.P. Morgan Asset Management.

“In that environment, investing into European investment grade becomes a very challenging decision. (U.S. investment grade) meets a lot of criteria that insurance companies will look for in asset-liability management. It is (equivalent) from a cost of capital perspective, (can be longer)-dated, and gives good yield even when you swap back into euros,” Mr. Drukier said.

J.P. Morgan Asset Management's global insurance solutions assets under management is $90 billion.

Paul Forshaw, London-based head of insurance asset management at Schroders PLC, said he has seen global interest — particularly from Japan — for some time in U.S. municipal bonds, but that interest in specific municipal bond allocations has occurred more recently.

He said European insurers are looking for high-yield, creditworthy bonds “at a time when the credit markets may be facing some headwinds. The municipal bond market in the U.S. offers you quite a deep pool of fixed-income assets which have strong credit fundamental behind them - if you are looking to diversify sources of risk in portfolios away from negative-yielding government bonds, municipals are a reasonable opportunity,” he said.

At the end of March, Schroders managed more than $2 billion in municipal assets on behalf of its clients.

However, there is one caveat: the size of the market. There is a great interest among insurers in increasing investment in infrastructure but one constraint is a lack of supply, said Fitch's Mr. Prowse. Insurers typically would be looking for investments with 20 or 30 years' duration, but would prefer midrange quality investments — typically in the BBB range — in order to derive more yield, he said.

In addition, insurers want to avoid concentration risk, so would be looking for a spread of midsize investments in order to avoid carrying too much credit risk in any one investment, he said.

Lack of capacity “could present an issue, as taxable munis will be the most attractive part of the market to European investors and this sector is only a fraction of the size of the tax-exempt muni market,” warned Mr. Wirtala.

U.S. cities and states prefer to issue tax-exempt debt because it reduces the nominal interest paid relative to taxable debt, he said. “Taxable issuance has been especially light in recent years as the Build America Bond program of 2009-2010 pulled forward several years' worth of issuance into that timeframe by offering federal subsidies for the interest payments on qualifying infrastructure-backed bonds,” he said.

However, Mr. Wirtala said increased demand for taxable bonds from European investors could encourage issuance by driving down spreads.

“The fact that the U.S. muni market is already large and well-established means it can respond quickly to fluctuations in supply and demand. For the moment both sides of the equation are uncertain, so we can only speculate.” n

Sarah Veysey is senior editor at Business Insurance, a sister publication of Pensions & Investments.