The record inflows into US municipals – or fondly referred to as munis – have earned the asset class several mentions on global news headlines, but that doesn’t mean that Asian investors have fully warmed up to these assets just yet.
While they have proven to be very popular among Korean institutional investors, a Thai insurer told AsianInvestor that the country’s insurance companies don’t typically invest in munis, primarily due to the lack of familiarity.
“Munis have certain tax advantages for US investors. [But] we don’t really look for those,” the executive said, and added that his company prefers US dollar investment grade corporate bonds.
Munis saw a total $18 billion inflow last year, double that of 2018’s $9 billion outflow, according to data from Refintiv. In terms of performance, the S&P Municipal Bond Index has posted 4.51%, 3.46% and 4.45% annualised returns over a three-year, five-year and ten-year period respectively as of January 10.
A nearly $4 trillion market, there are more than 50,000 different issuers but they have a varying degree of credit quality.
“Fundamental credit work is heavily dependent on understanding local economic conditions and dynamics – an area where it can be difficult for new investors to develop expertise,” said John Miller, head of Nuveen municipals. About a quarter of the firm’s $17 billion institutional assets in municipal bonds come from Asia.
In addition, disclosure is often made on an annual basis, making it less timely than it is for corporate issuers, which publish quarterly results, Miller said, adding that munis are largely done over the counter. The accounting method municipal issuers use is also different from that of corporate issuers.
“It can be difficult for new entrants with limited resources to try to suddenly gain access to the market with confidence,” he said.
Given that obligations of Asian asset owners are generally denominated in local currency, currency risks are bound to arise when making allocations overseas. If investors opt for a hedged exposure, the costs can “erode the potential income benefits,” said Cynthia Clemson, co-director at Eaton Vance municipal bond investments. Though she added that some investors are willing to take on the exposure without a hedge.
According to Merrill Lynch estimates of cross-country equivalent yields as of December 9, the yield for a five-year triple-A taxable municipal bond was -0.216% for a Japan-based institution. It would, however, increase to 0.244% and 2.166% for a 10-year and 30-year muni of the same credit quality.
“Because many [Asian investors] are new to what has historically been a market for mostly US investors, greater due diligence and understanding of the return and risk profile is required,” said Jeffrey Burger, senior portfolio manager at Mellon. Risks don't just include financial vulnerability of borrowers; investors also need to consider the vulnerability of muni borrowers to less easily considered areas, including the impact of climate change and even hacker extortion.
It could also be difficult for investors to justify the efforts required to invest in munis when corporate bonds or local government bonds can provide higher yields. The S&P 500 Bond Index provided a 13.54% one-year annualised return.
And given that munis tend to trade as a spread product to US treasuries, some volatilities in the munis market are expected as the country approaches the upcoming presidential election, said Clemson.
2020 INFRASTRUCTURE SUPPORT
But the situation is likely to change as the taxable segment of the asset class has grown further, cheapening the price of these assets versus corporate bonds.
Supporting local infrastructure development has formed part of the objective of this year’s budget, including $200 billion towards improving infrastructure in the US. The majority of public infrastructure there is funded by municipal bonds.
Recent changes in US tax law and the low-rate environment have also prompted municipal issuers to refinance outstanding tax-free municipal bonds with taxable municipal bonds, Miller said. Most Asian muni investors allocate to taxable bonds.
“The supply of taxable municipal bonds was significantly higher in the fourth quarter of 2019 than it has been at any time since 2010,” he added.
“Depending on the results of the election, the Federal government may serve an enhanced role in funding infrastructure which may impact the supply of municipal bonds,” said Mellon’s Burger.
It previously saw a surge in taxable municipal issuance on the back of the Build America Bonds initiative in 2009 – more than $235 billion worth of these assets were issued in two years, Clemson said.
“Throughout most of 2018 and 2019, the taxable muni to corporate ratio rested below 100%. However, as taxable municipals cheapened during the fourth quarter, this ratio increased to 107% and ended December at its cheapest level in two years,” she added.
This can potentially provide an opportunity for investors looking to access US infrastructure assets at attractive valuations.