The persistent low interest rate environment continues to pressure insurance company CIO’s to search for yield-enhancing opportunities. Complicating matters further, many investors believe we are in the late stages of the credit cycle, making them wary of taking on additional credit risk. For high yield corporate bond investors sharing this concern, high yield municipal bonds may be an attractive alternative.
Before discussing the details of high yield municipal bonds, it is important to remember the backdrop for most insurance company investment portfolios. Since the financial crisis, low government bond rates and relatively tight credit spreads have resulted in low insurance portfolio book yields. For the overall life industry, year-end 2017 book yield stood at about 4.5%, while the P&C industry saw a book yield of about 3.0%.1 Some institutional investors have the ability to shift more of their fixed income allocation into high yield corporates; however, risk-based capital requirements in the U.S. significantly constrain insurers’ ability to meaningfully allocate to high yield. That said, insurers do often maintain modest high yield corporate allocations within fixed income portfolios – on average 5.7% for Life and 4.4% for P&C as of year-end 20171 – and swapping out a portion of that high yield corporate allocation for high yield municipals can potentially improve portfolio diversification while maintaining above average risk-adjusted yields.
To estimate risk-adjusted yields for high yield corporate bonds, which are taxable, and high yield municipals, which are tax-exempt, one must first adjust for taxation to formulate a consistent comparison. As of January 31, 2019, taxable-equivalent yields on the Bloomberg Barclays High Yield Corporate and the S&P High Yield Municipal Bond Indexes were 6.9% and 5.68%2, respectively. Before concluding which asset class has the more attractive yield, the impact of expected defaults should also be incorporated as we discuss next.
According to Moody’s annual default analysis through year-end 2017, 10-year cumulative defaults for below-investment-grade corporates were 29.3% vs. 7.6% for below-investment-grade municipals. According to Moody’s, the average recovery rate for municipal bonds was 68%, significantly higher than the average 47.9% ultimate recovery rate for senior unsecured US corporate bonds.3 Assuming these recoveries in default, this means average annual default losses were 1.53% and 0.24% for corporates and municipals, respectively. A natural question is why would high yield corporates and municipals experience such disparate rates of default if they have similar credit ratings? The answer is essentially one of flexibility – corporate issuers have a greater ability to restructure debt and access capital markets again over time, whereas municipal issuers are faced with political and practical constraints that make a bond default very difficult to overcome. Using these estimates for expected default losses, and the previously-discussed taxable-equivalent yields, we can see that default-adjusted yields for high yield corporates and high yield municipals are quite similar: 6.9% – 1.53% = 5.37% for corporates and 5.68% – 0.24% = 5.44% for municipals, see chart 1. With these yields being so similar, investors may ask what is the benefit of allocating to high yield municipals? The answer is diversification.
Chart 1: High Yield Bond Comparisons: Corporate vs. Municipals
Source: Bloomberg Barclays High Yield Corporate Index and S&P High Yield Municipal Bond Index. Data as of January 31, 2019. The taxable-equivalent yield is from the perspective of a Life insurer using a 1.186 adjustment factor (reflecting 21% corporate tax rate and 30% proration). Expected default losses are sourced by Moody’s Investors Service “US Municipal Bond Defaults and Recoveries, 1970-2017”. Performance data quoted represents past performance, which is not a guarantee of future results.
The diversification potential of high yield municipals can be estimated via realized correlations with other asset classes. It is often noted that high yield corporate bonds behave similarly to equities, particularly in risk-off market environments. Over the past 10 years this has been the case, with realized correlation between high yield corporates and U.S. equities of 0.72. Contrast this high correlation with that of high yield municipals and equities, which has nearly been 0 over the past 10 years (0.05 as of January 31 2019). It’s also worth noting that the correlation between high yield municipals and high yield corporates has been low (0.32) over the past 10 years.4 Thus, by incorporating high yield municipal bonds into a multi-asset portfolio, overall portfolio volatility can be reduced, which can be particularly important for investors concerned about a turn in the credit cycle and a shift to a risk-off environment.
While there can be meaningful diversification benefits from high yield municipal bonds, it is also important to consider their risks. For investors already comfortable with high yield credit exposure, arguably the most important risk factor to consider with high yield municipals is liquidity. The high yield municipal market is smaller and more fragmented than the high yield corporate market, meaning investors should carefully consider their expected holding period and transaction costs prior to implementation. Furthermore, in practice, the high yield municipal market consists of both unrated bonds and bonds rated below-investment-grade, so it is important for investors to define the universe of bonds that is appropriate for their return objectives and risk tolerance. As such, an allocation to high yield municipals may be best suited to buy-and-hold investors with long expected holding periods and investors with access to deep credit research expertise.
The high yield municipal market is an often-overlooked part of the market. Like any asset class, there are certain risks that should be carefully considered before investing – but it should not be dismissed as an opportunity before considering its diversification benefits. Default-adjusted yields are comparable to high yield corporates, and for investors with the ability to forgo liquidity – insurance companies being the prime example – high yield municipals can act as a portfolio diversifier relative to equities and other high-risk assets that may suffer in the next market downturn.
Peter Miller, CFA, FSA, Insurance Research Strategist, Invesco Investment Solutions