The Muni Pit: Tax Reform and the Municipal Market

With all the news surrounding recent tax reform and the municipal market, we wanted to get a better understanding of how those changes affected our clients. We sat down with Peter Wirtala, CFA, AAM’s Insurance Strategist, to discuss how tax reform has reshaped the investment landscape for insurers.

Q: We’ve all heard that the new tax regime is making insurers rethink their strategy towards tax-exempt municipal bonds. Can you sum up what has changed and what it means?

A: Big changes are definitely taking place. Historically, P&C insurers have been major buyers of tax-exempts, with about two-thirds of them owning at least a few, and typical allocations ranging from 30-40% of investment grade bond holdings. But with the lower corporate tax rate in place, taxable bonds are now much more attractive relative to tax-exempt bonds. Insurers typically “gross up” the yield on a tax-exempt bond to compare it to taxable yields, and the magnitude of that gross-up just got a lot smaller.

A simple example: previously a tax-exempt bond yielding 2.50% and a taxable bond yielding 3.64% produced the same after-tax income. Now, the tax-exempt bond would need to yield 3.00% to compete. Unfortunately, muni spreads haven’t widened 50 bps to compensate, so a large swath of the market has ceased to be appealing to insurance investors.

Q: Can you further quantify what you mean when you say tax-exempt munis are less appealing now?

A: Another quick illustration should help: at this writing, a representative 10yr AA-rated municipal bond yields about 2.63%, or 3.15% after the gross-up factor is applied. That’s a spread of 28 bps over the 10yr US Treasury. At the old tax rate, this bond would’ve had a grossed-up yield of 3.83%, or a spread of 96 bps.

The Bloomberg Barclays Corporate Index currently shows a spread of about 65 bps on 10yr AA-rated corporate bonds. You can see that at the old tax rate, the muni bond would’ve looked appealing by comparison, but at the new one it does not.

Q: I take it thus far you’ve been talking about P&C insurers, but what about the Life industry?

A: That’s right, the comments above apply to P&C companies. However, the situation for Life insurers has changed dramatically as well. These companies mostly avoided tax-exempt munis in the past (though they bought plenty of taxable munis). Historically, only around 10% of Life companies reported any tax-exempt bond income, and usually just small amounts. This is because under the previous law, the degree of tax exemption Life insurers could get on these bonds was both complicated to calculate, and frequently too small to be worthwhile.

That’s now changed. Life insurer treatment of tax-exempt income has been greatly simplified, the uncertainty about being able to use the tax exemption has been removed, and overall their rules are now very similar to P&C insurers’.

At first glance this would suggest Life companies could now start adding muni allocations, but they face the same issue mentioned above: yields on most tax-exempts can no longer compete with taxable alternatives.

Q: How about Health insurers, where do they fit in?

A: They’re probably the ones least affected here. Their tax rules have traditionally worked similarly to P&C insurers’, but they’ve mostly avoided the sector. To put a number to it, in 2016 only about 5% of health insurers reported more than a negligible amount of tax-exempt bond income. The main reason has to do with asset-liability matching. Health insurers usually have short liabilities that turn over very quickly, so their assets mostly need to be invested in shorter-duration securities; for example, at 12/31/16 the industry reported less than 10% of their bond holdings had maturities of over 10 years. But munis have always been most attractive at longer maturities, from around 7 year maturities and out. Health companies don’t have much appetite for that part of the yield curve, and that is unlikely to change in the foreseeable future.

Q: So are insurers just going to stop buying munis, unless spreads widen?

A: Not necessarily. It’s true that most tax-exempt muni bonds’ spreads are no longer attractive to insurers, and this appears unlikely to change in the near future since top individual tax rates didn’t change nearly as much as corporate rates, and retail investors make up the bulk of muni buyers. Still, there are pockets of value, at least relatively speaking.

The key is to break the market out by maturity and quality buckets. Broadly speaking, muni bonds rated AA and above, and/or maturing in 10yrs or less, have experienced the largest relative decline in attractiveness. Munis rated A or BBB, or maturing in >20yrs, have spreads significantly closer to those on comparable taxable bonds.

The table below compares representative spreads to Treasuries on some selected quality/maturity buckets:

Source: Bloomberg Barclays indexes. Values are indicative. As of 2/8/2018

This suggests that insurers should consider investing in longer and lower-quality munis than they have in the past. Complicating this is the fact that A and BBB rated munis are much rarer than higher-rated bonds, making up only 24% and 8% respectively of the overall Bloomberg Barclays Municipal index by market value.

By contrast, A and BBB bonds make up 42% and 48% of the Corporate index (which is also over 3x larger than the Municipal index). This could make bonds difficult to source for larger insurance companies, and creates a risk that a large-scale shift into these ratings buckets by insurers could drive down spreads, defeating the point of the exercise.

In any case, insurers with large legacy allocations to tax-exempt municipals should now consider reducing those exposures in favor of taxable alternatives, which now offer superior tax-adjusted spreads for most maturities and ratings buckets.

While corporate and muni spreads will fluctuate relative to each other as time goes by, with both offering value at certain points in the cycle, it is likely that insurers will need to consider longer, lower-rated munis if they want to obtain the best tax-adjusted yields available from the sector.

Written by: Peter Wirtala, CFA

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees.  This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.