U.S. retail investors have long dominated the U.S. municipal bond market, but over the last decade, institutional interest in the sector has soared, particularly outside the U.S. and specifically in taxable municipal bonds.
So far, these non-traditional investors, including pension funds, insurance companies and family offices, have been rewarded. Over the last 10 years, taxable U.S. municipal bond returns have topped all but one major bond sector, U.S. high yield.
For example, the sector's 6.9% annualized total return for the period handily outperformed the 4.6% return on U.S. corporate investment-grade bonds, a staple in most institutional portfolios.
But strong returns are just one of many reasons that institutional investors have ventured into the asset class. Taxable municipal bonds are also garnering interest due to their high-quality ratings, longer durations, and low correlations and diversification to other asset classes.
In addition to these compelling attributes, many institutional investors today say they see taxable municipals as an attractive late-cycle asset class. With the U.S. economic recovery now longer than all but one in history, and the global economy still fragile, many of these investors welcome the higher credit quality and more reliable ratings stability of municipals vs. other fixed-income sectors. The virtues of the asset class were most recently on display during December 2018's market volatility as investment-grade corporate spreads widened sharply while taxable municipal price volatility was muted.
Low correlations and broad diversification
Municipal bonds also provide significant risk-reduction benefits. An allocation to municipal bonds may help reduce fixed-income portfolio volatility as returns generally have a lower correlation to other fixed-income asset classes (Figure 2). Similarly, spread volatility for taxable municipals is also lower with roughly two-thirds the correlation to the Bloomberg Barclays investment-grade corporate market index.
The relative high-quality nature of municipal bonds is also attractive for risk-conscious liability-driven investors and insurers seeking to meet their capital requirements most efficiently. According to Moody's "U.S. Municipal Bond Defaults & Recoveries, 1970-2017," more than 76% of U.S. municipal bonds outstanding are A+ rated or better; only a tiny portion are below investment grade. In contrast, only about 10% of the global corporate bond market are AA rated, and nearly half are below investment grade.
Moreover, municipal default rates have been significantly lower over time, even compared to corporates with higher ratings. Since 1986, as Standard & Poor's has found in its U.S. public finance cumulative average default rates (1986-2017) and U.S. corporate average cumulative default rates (1981-2017) data, the average default rate for municipals that S&P rated BAA was 0.81%, less than the 0.84% default rate for AAA-rated corporates.
By the end of 2018, the share of the investment-grade corporate index (ICE BofAML U.S. Corporate index) with a BBB rating was 50%, up from 33% 10 years earlier. Many investment professionals believe these bonds are vulnerable to being re-rated below investment grade during the next economic downturn. Investors that can't own below-investment-grade debt would therefore be forced to liquidate their holdings at inopportune times, pushing prices down further.
In contrast, municipal bond ratings have, historically, been far more stable than corporate bond ratings, as Figure 3 illustrates. Why? Some corporations are vulnerable to event risks, such as leveraged buyouts, that rarely affect municipal bonds. More generally, corporations have fewer options to cover debt in times of stress and are much more focused on equity performance than maintaining high credit ratings. On the contrary, municipal bond issuers have more latitude. State and local governments can raise taxes, if necessary, to support the general obligation bonds, which are backed by the issuer's full faith and credit. Revenue bonds, on the other hand, are backed by dedicated cash flow streams from tolls or other user fees for essential services. In many cases, these public enterprises are virtual monopolies. An airport or water/sewer system, for example, can often raise prices without losing customers.
Competitive yields and long durations
Institutional appetite for yield has also driven the sector's rapid growth over the last decade. Many investors have sought to enhance book yields by increasing corporate or emerging market credit risk. Taxable municipal bonds provided an alternative source of incremental yield, though spreads varied over time.
Duration is another key driver of growth. While many capital projects financed with taxable municipal bonds generally last for decades, they are typically financed with longer maturing bonds. When comparing the maturity distribution of the Bloomberg Barclays Municipal Bond index – taxable bonds and the Bloomberg Barclays U.S. Corporate Bond index, about 57% of taxable municipals outstanding have maturities of 10 to 25 years; another 16% are even longer dated. Corporate bonds, as evidenced by the Bloomberg Barclays U.S. Corporate Bond index, by contrast, are distributed evenly across the maturity range. Institutions seeking to immunize their long-dated obligations have welcomed this source of long-duration assets to match their long-term liabilities.
For instance, at the end of January, the yield on the ICE BofAML (average AA rating) Taxable Municipal Bond index was 3.83% (+111 option-adjusted spread vs. Treasuries) with an effective duration of 8.59, whereas the ICE BofAML AA U.S. Corporate Bond index yield was 3.3% (+70 OAS vs. Treasuries) with an effective duration of 6.57.
Lastly, while many investors have been focusing on the corporate bond and equity markets for environmental, social and governance investment strategies, we believe that the municipal bond market is a natural fit for strategies with ESG considerations. Municipal bonds are the primary funding source for infrastructure projects in the United States. Many of these projects address environmental and social considerations and are also aligned with the United Nations' Sustainable Development Goals, including conservation projects for water and wastewater systems, wind farms, public education, non-profit hospitals, public transport and affordable housing. Fundamental municipal credit analysis regularly takes ESG considerations into account when determining the underlying strength of a municipal credit.
For all of these reasons, institutional investors are taking a much closer look at the potential role municipal bonds can play in a fixed-income portfolio.
Scott Sprauer and Robert Burke are municipal portfolio managers at MacKay Shields LLC, Princeton, N.J. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.