US municipal bonds
Taxable US municipal (muni) bonds have become one of the fastest-growing fixed income asset classes currently available in the market, and are a compelling strategic fixed income option for global investors. These bonds are issued by state and local governments to finance essential services projects that have historically exhibited strong credit strength and offer relatively attractive yields. The asset class offers diversification benefits to an insurer’s portfolio as, historically, it has shown low volatility and correlation to other fixed income segments. Non-US insurance companies can benefit from exposure to US municipal issuers that qualify as infrastructure under Solvency II rules. The broad spectrum of issuance across the duration spectrum creates broad appeal to both life and property insurers.
The number of municipalities addressing critical initiatives has increased, and the opportunities within this space offer not only positive change, but also potentially lucrative financial opportunities.
With infrastructure improvements tied to green and other ESG initiatives, President Biden’s ‘Build Back Better’ programme could drive greater opportunity, as these projects can be funded by municipal bonds. Municipal bonds’ use of proceeds are aligned with social impact and responsible investing. Muni bonds can be considered the ‘original impact investment’ and still dominate the ESG landscape. According to the rules governing the federal tax-exemption of municipal bonds, muni issuances must have a public purpose and earnings cannot be used to benefit private people. In essence, muni bonds have been conceived for society’s greater good and are focused on improving areas such as education, public transportation, and city and state infrastructure. Beyond the broad scope of public utility, certain projects have an even greater and more targeted positive impact. In our view, this is where investors should focus:
Municipal issuers with potentially high social impact:
- Tuition-free public district and charter schools, focusing on socio-economic equality;
- Affordable housing projects, focusing on safe and healthy retirement living; and
- Not-for-profit healthcare facilities, focusing on quality medical care for all.
Municipal issuers with potentially high environmental impact:
- Water and sewer authorities, focusing on clean delivery and removal;
- Public transit systems, focusing on electric renewable energy and solar technology; and
- Waste disposal and recycling projects, focusing on pollution mitigation.
The number of municipalities addressing these critical initiatives has increased, and the opportunities within this space offer not only positive change, but also potentially lucrative financial opportunities.
US IG corporate debt
In terms of market value, the dollar IG credit market is twice the size of the European one and accounts for over 700 US-domiciled issuers, of which about 600 have never issued in euro. Therefore, investing in the dollar corporate bond market would allow European investors to get exposure to completely new companies. This is also true at the sector level, as underlying sector dynamics (e.g., the size and growth dynamic, consumer culture, regulatory framework) can be completely different in the United States from Europe.
Muni bonds can be considered the ‘original impact investment’ and still dominate the ESG landscape.
In addition, the dollar IG credit market offers a diversified set of exposures to longer maturities for European investors with ‘buy and maintain’ portfolios. Longer-dated bonds (ten years and above) account for 39% of the dollar universe, compared with only 10% in the euro universe. Credit curves of US domestic issuers are steep compared to euro ones, offering an attractive spread pick-up on intermediate and long-dated maturities. Such steepness is observable within every rating category (see figure 1). This is good news for those investors seeking to add credit exposure on longer maturities for yield or ALM reasons.
Investing in the dollar corporate bond market would allow European investor to get exposure to completely new companies.
Emerging HC IG corporate debt
With $800bn of market value, the EM IG corporate debt market offers significant diversification opportunities for euro-based investors, as the majority of issuers (about 400 companies) have never issued in euro. The emerging hard-currency (HC) debt remains dollar-centred.
Insurers tend to embrace a cautious approach when it comes to emerging corporate debt because of country risk, even if the issuer is rated as investment grade. However, the EM IG corporate debt universe is diverse in its composition and some selected issuers could be considered even for those with a ‘buy and maintain’ conservative approach. Global players with good revenue diversification and low exposure to a specific emerging country are the best example of low-risk issuers to be considered. However, some issuers with high exposure to a single economy could be considered by selecting national champions, for example, from the communications or utilities sectors. According to our estimates, some 80-120 issuers within the EM corporate investment universe could be good candidates for a ‘buy and maintain’ portfolio.
EM IG corporate debt market offers significant diversification opportunities for eurobased investors, as the majority of issuers (about 400 companies) have never issued in euros.
A strict credit selection framework is key when dealing with EM issuers. Being well equipped with strong credit analysis resources should enable detecting those issuers with a sound credit profile that could add value to insurers’ fixed income portfolios. The EM IG corporate market offers some attractive spread pick-up over euro credit. This is true across every rating category and maturity bucket (see figure 2).
A strict credit selection framework is key when dealing with EM issuers. Being well equipped with strong credit analysis resources could allow to detect those issuers with a sound credit profile that could add value to insurers fixed income portfolio.
The introduction of non-euro investments into insurers fixed income portfolios requires the hedging of currency risk in order to ensure their eligibility under the insurers regulatory framework (e.g., Solvency II). Two types of hedging strategies could be considered:
- Hedging via short-term forwards
Under this approach, the currency risk of dollar-denominated investments is hedged by selling dollars on a forward basis. Short-term forward contracts (one-twelve months) have to be rolled until the bond maturity. This implies uncertainty about the overall hedging costs over the life of the bond. For example, in 2014, while investing in ten-year dollar-denominated corporate bonds, hedging with short-term forwards was attractive, as hedging costs were very low. However, the latter increased afterwards and exceeded 3% in late 2018, offsetting a significant part of this long-term investment return. Since March 2020, short-term hedging costs have decreased significantly following the emergency Fed rate cuts in the context of the Covid-19 outbreak. Since then, short-term hedging costs have stabilised at around 75bp. For now, FOMC members still see the Fed funds rates at zero through end-2023. However, at its March meeting, the Fed upgraded its growth and inflation forecasts for 2021-23. If such a positive scenario materialises quickly, this could put upward pressure on US short-term rates and increase short-term hedging costs.
It is worth noticing that hedging via short-term forwards hedges only the currency risk and investors keep their exposure to dollar long-term interest rates. If investors want to hedge both risks, they should opt for the cross-currency swap strategy.
- Hedging via cross-currency swaps at maturity
On the other hand, hedging via cross-currency swaps allows for both currency and interest rate risk hedging. Investors will gain yield in euros until bond maturity, as if it was a euro-denominated bond. Long-term hedging costs have increased significantly over the past few months, following the increase in US long-term yields. Despite their penalising level today – around 155 bp annualised for ten-year euro-dollar cross-currency swap – we still see some opportunities on a name-by-name basis to implement this strategy into insurers’ fixed income portfolios. In particular, EM IG issuers offer attractive yields in euros after cross-currency swaps thanks to their relatively large credit spreads.