The Case for Tax-Efficient Crossover Investing

We spoke with Income Research + Management to discuss how the Tax Cuts & Jobs Act has affected insurer portfolio allocations and the current state of municipals within insurer investments. Highlights from the discussion include the expected reduction in municipal allocations by insurers, why municipals continue to play an integral role in insurance portfolios, and where insurers can find potential municipal alternatives.

Rob Lund, CFA
SVP, Client Portfolio Manager
Income Research + Management |

SAA: Following the passage of the Tax Cuts & Jobs Act (TCJA) it was widely expected that insurance companies would reduce municipal allocations, has that been the case?

IR+M: Although the passage of the TCJA preserved the tax exemption for municipal bonds, corporate investors, such as P&C insurance companies, did experience a substantial decline in their tax rate, from 35% to 21%. With the value of the tax exemption reduced, municipal bonds lost some attractiveness at the new, lower tax rate. As a result, insurers were expected to shift allocations away from municipals in favor of other fixed income sectors.

Due to the TCJA, as expected, we saw a reduction in municipal holdings overall for insurance companies. According to S&P Global Market Intelligence, as of 12/31/17, insurance companies held over $545 billion of municipal bonds.

Year-over-year, insurers reduced holdings by almost $39 billion to $508 billion. The reduction was primarily limited to P&C insurers. With P&C insurers being subject to the new, lower effective tax rate, they reduced the municipal weighting of their fixed income allocation by 4% to 27%, or $34 billion to $287 billion.

SAA: Do you think that municipals still have a place in insurance company fixed income portfolios? How should investors think about municipals in the context of their portfolios?

IR+M: Following the reduction of the effective tax rate, municipals lost some of their appeal relative to other fixed income sectors that offered higher after-tax yields. Despite this, we believe that municipals continue to play an integral role within insurance investment portfolios. There are several characteristics of the sector that warrant holding, or the flexibility to hold, a sizeable allocation, such as the diversification benefits and high-quality nature of the sector.

Both in 2019 and historically, municipals have had a low correlation to equities and other fixed income sectors. Heterogeneous characteristics uniquely drive sector performance and as a result, correlations across sectors may occasionally break down and lead to market dislocations. These dislocations allow investors with dynamic portfolios to capitalize on this by over or underweighting the sector.

It also provides an effective hedge to broad market weakness relative to other parts of an insurer’s investment portfolio. For example, during the financial crisis, between October 2008 and June 2009, munis had a negative correlation to stocks and a lower correlation to corporate and securitized bonds than historical averages, potentially providing added stability during periods of market weakness.

The liquidity profile of the municipal sector also adds another important layer of diversification. Although investment-grade fixed income is generally very liquid, relative liquidity varies across markets from time to time. Performance can become uncorrelated during periods of stress, and the same is true for the relative liquidity of each sector.

Looking back at the energy crisis of 2015-2016, we found that liquidity in the corporate market declined sharply. However, the liquidity of the municipal market remained solid, as the sector was insulated from the broader market weakness. The diversification in liquidity profiles allows insurers, if needed, to smoothly sell a portion of their portfolio under different market cycles and events.

The municipal sector is of very high credit quality, evident by the average credit rating of the broad indices. The Bloomberg Barclays Corporate Index has an average rating of A3/A-, while the average credit rating of the Bloomberg Barclays Municipal Index is Aa3/AA-. For those insurance companies looking to reduce exposure to lower rated fixed income, there is also a larger percentage of the muni index that is rated AA and higher. When comparing indices, less than 10%, or $921 billion, of the corporate market is rated AA or higher. Comparatively, over 65% of the municipal market is rated AA or higher, or over $2.3 trillion.

The default rate of municipal bonds has historically been much lower than that of comparable corporate bonds. In fact, from 1970 to 2017, the historical default rate of BBB-rated municipal bonds was equivalent to that of AA corporate bonds.

SAA: Muni/Treasury ratios have recently reached an all-time low. What is driving the recent strength?

IR+M: Muni/Treasury ratios, which are typically used as a broad measure of the relative attractiveness of municipals, fell to the lowest levels in history before bouncing back in the recent rally. The 10-year muni/Treasury ratio reached 72% in late May – well below the five- and ten-year average of 91% and 95%, respectively. We believe there are two main reasons for the current richness in valuations: lower supply and strong demand from retail investors.

The TCJA’s elimination of tax-exempt advance refundings is the primary cause of the lower supply. Prior to the elimination, over $240 billion of issuance per year was from refundings. The new refunding rules caused municipalities to flood the market in the fourth quarter of 2017, which led to record issuance that year of $448 billion.

Year-to-date, municipal issuance has totaled over $132 billion, roughly flat to 2018, but over 18% behind 2017’s pace. Refunding supply has been reduced to roughly $110 billion in 2018 and $21 billion so far this year. We would anticipate that, without legislative action, the pre-re municipal market will continue to decline.

The fall in municipal/Treasury ratios can also be attributed to the strong demand from retail investors, which hold almost 50% of all municipal bonds.

In addition to the TCJA eliminating tax-exempt advance refundings, it also resulted in higher tax liabilities for some high net worth individuals, especially those living in high tax states due to the new maximum SALT deduction. These retail investors have demanded more in-state tax-exempt municipal bonds, which is evident in municipal mutual fund flows of over $39 billion year-to-date.

SAA: As insurers potentially look for alternatives to municipals, are there certain sectors that look more attractive than others?

IR+M: For insurers looking for fixed income ideas away from municipals, at current valuations, we believe that the securitized sector offers an array of opportunities. Securitized bonds can still be looked at as a diversifier to corporate credit, while still potentially offering an after-tax yield spread over municipals and attractive capital treatment.

Additionally, many securitized bonds are not represented within traditional indexes, offering investment managers the opportunity to utilize bottom-up security selection to uncover opportunities. We believe that non-agency mortgage-backed securities (MBS) and asset-backed securities (ABS) are two sectors that currently can add incremental value to an insurer’s investment portfolio.

Non-agency MBS are pools of mortgage loans that do not meet criteria for inclusion in Agency pass-throughs. Investors have the ability to focus on borrowers that have pristine credit, and loans that are backed by full documentation and asset verification. The current deals and underwriting standards are also far superior to pre-crisis deals, and credit enhancements can cover estimated losses by 2-3x.The sector can offer 85 to 125bps of additional yield over Treasuries with approximately a 4 year duration.

ABS are backed by tangible, high-quality collateral that ranges from vehicles and credit cards to franchise royalties. We prefer to invest in senior positions in the capital structure, as we believe this mitigates risks as specified triggers cause cash flows to be rerouted to senior bonds in times of stress.

We believe that investors who haven’t reduced their municipal allocations may benefit from increasing exposure to the securitized sector.

Source: Strategic Asset Alliance, Income Research + Management
The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.

Source: Sources: S&P Global Market Intelligence as of 3/31/19, Bloomberg Barclays as of 5/31/19, BofA Merrill Lynch Global Research, Moody’s as of 7/31/18, SIFMA as of 5/31/19. The size of the AA or higher corporate market was calculated using the ratings distribution of the Bloomberg Barclays Corporate Index and the size of the total municipal market according to SIFMA data. The size of the AA or higher muni market was calculated using the ratings distribution of the Bloomberg Barclays Municipal Index and the size of the total corporate market according to SIFMA data.

The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.