The taxable municipal market is not exactly a backwater, but you won’t see many tourists there. The sector has existed for many years, but got a huge boost in 2009 with the Build America Bonds (BABs) Program when $181 billion were issued between February 2009 to December 2010. After the Great Financial Crisis, the program was designed to reduce the cost of issuance for traditional tax-exempt issuers. Since then, taxable munis are issued for pension funding, advance refunding of outstanding tax-exempts, refundings of refunding issues, and for projects that don’t qualify for tax-exempt status (generally those that do not benefit the general public, such as a financing of sports facilities).
Taxable munis are interesting as they are a diverse, growing universe totaling about $800 billion, including those that carry corporate CUSIPS, though this represents only about 1.5% of the US fixed income universe. Advance refundings have added an average of $140 billion per year to the universe over the past 3 years. The buyer base is very different from that of tax-exempt munis, with about 70% institutional ownership (versus tax-exempts at about 30%) – life insurance companies, foreign investors, mutual funds, and property and casualty insurance companies (P&C) are the top 4 holders.
Taxable munis provide an attractive yield for their generally high credit quality and can act as an excellent diversifier to corporates in a portfolio. More than two-thirds of the outstanding taxable muni bonds are rated AA or AAA (chart 1 below). Sectors that issue include general obligation (GO)/tax backed (state and local) pension obligations, health and higher education organizations, and utilities (chart 2 below).
Chart 1: Taxable munis by rating category
Chart 2: Taxable munis by sector
Bloomberg Taxable Municipal Index Not Fully Representative of the Muni Universe
The $177 billion Bloomberg Taxable Muni Index is not perfectly representative of the universe, as many deals don’t meet index rules, and most of the health and education bonds are considered “Industrial – Other” or “Healthcare” and lie within the credit indices. This segment has been one of the fastest growing within the entire taxable muni universe as shown below.
Chart 3: Universities and hospital systems have been the largest source of taxable new issuance over the last 5 years
Despite the small universe representation of the Bloomberg Index, we can look at spreads versus the entire Bloomberg US Aggregative Credit Index (Credit Index) and clearly see the lower volatility within munis. This is due to the higher quality, as well as the lower liquidity such that investors generally won’t try to sell them in distressed markets.
Chart 4: Most corporate CUSIP municipals are rated in the AA category
Although the lack of volatility could be argued is due to the lack of trading, taxable munis exhibit a relatively low correlation to corporates The outperformance of taxable munis during the financial crisis emphasizes their lower beta – taxable munis widened by 290bps versus 525bps for investment grade corporates; in 2020 they were 150bps wider versus 275bps for corporates.
Chart 5: Rolling 12-month Correlation – Taxable Munis and IG Corps (Excess Returns)
Given the lower correlation, taxable munis can provide excellent opportunities for diversification. With the high-quality backdrop, investors can hold them for the long haul, as it is very unlikely there will be defaults as might be expected for some corporate issuers in distressed environments. The relatively low correlations can reduce systematic risk as well as provide downside performance versus the standard benchmarks. Taxable munis exhibit strong Sharpe ratios relative to corporate.
Chart 6: Based on the Sharpe ratio metric, taxable municipals have far outperformed corporates since 2015
With their high quality, attractive relative yield, and an average maturity of 14 years, taxable munis may make an attractive allocation for pension plans looking for diversification (much like the use of long Collateralized Mortgage Obligations (CMOs) by pension plans looking for corporate alternatives as we discuss here). For pension plans in need of long paper, there are numerous 30-year and century bonds (centuries) in the taxable muni universe, in fact, about 60% of the $22 billion of centuries outstanding are taxable munis. Centuries provide significant additional yield given the modest extension in duration versus a 30-year issue, as well as much higher convexity.
Many investors are suspect of the liquidity of taxable munis, though a lot depends on deal size, issuer, and term. Liquidity is lower than that of corporates, but there are pockets that trade well, and those that trade infrequently may offer attractive opportunities for value. According to Citicorp, taxable munis average about 20% of the average daily trading volume of munis overall, which average about 25-30% of corporate volume. In addition, not all Wall Street firms trade them the same way – some shops trade them on their muni desk, others on their corporate desk, and there are several active regional dealers.
Chart 7: Average daily trading volume in $ billions – taxable municipals account for less than 20% of overall municipal trading volumes
Lastly, the municipal market (both taxable or tax-exempt) is a haven for positively-tilted ESG issues. In particular, health and education issues comprise nearly 30% of the universe. Housing -related issuers provide an improved opportunity for broader home ownership. Public power deals can be laggards if they have coal exposure, but those that support hydro or are for pollution control stand out as leaders, and of course, water and sewer issues are obviously for the public good. Finally, there are some issues for sports facilities or a student center run by a for-profit national chain that may be considered neutral or even laggard from an ESG point of view.
Taxable munis are an easily overlooked sector of the bond market, whether due to lack of knowledge of the issuers, structure, or fear of illiquidity. A strategic allocation may make sense for those investors looking for a high quality diversifier with a reasonably attractive yield and low volatility. Alternatively, a tactical allocation may make sense when spreads are tight and investors look to rotate into higher quality paper to protect capital in a spread widening environment. These features, along with potential ESG considerations, may make taxable munis an attractive idea for pension plans, insurance companies, and other investors in need of diversification.
Sources: Bloomberg as of 3/31/22 unless stated otherwise. Chart 1 and Chart 2 sourced from J.P. Morgan as of March 2022. Charts 3-4 and 6-7 sourced from Citi as of 3/28/22. Chart 5: Historical correlation based on 12-month trailing returns of the Bloomberg IG Corporate Index and the Bloomberg Taxable Municipal Index. The views contained in this report are those of Income Research & Management (“IR+M”) and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. 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. This is not a recommendation to purchase or sell any of the securities listed above. Investing in securities involves risk of loss that clients should be prepared to bear. More specifically, investing in the bond market is subject to certain risks including but not limited to market, interest rate, credit, call or prepayment, extension, issuer, and inflation risk. It should not be assumed that the yields or any other data presented exist today or will in the future. Past performance is not a guarantee of future results and current and future holdings are subject to risk. It should not be assumed that recommendations made will be profitable in the future. Actual results may vary. 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®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.