In the current low yield environment, the search for higher-yielding fixed income instruments remains strong in Europe, with a rising number of insurance companies exploring infrastructure debt as an attractive investment opportunity.
However, as the European infrastructure debt market is only in the early stages of development, investment opportunities are rare.
According to the latest white paper from Invesco, European-based insurers are starting to consider US municipal bonds as a way to deliver risk-adjusted returns and improve diversification.
Municipal bonds have played a vital role in building the framework of America’s modern infrastructure since the 1800s. Today, the proceeds from municipal debt continue to fund a wide range of state and local projects.
Alexandre Mincier (pictured), Global Head of Insurance Client Solutions, Invesco, says: “When an investor purchases a municipal bond, he or she is lending money to finance myriad public projects. The current offering in Europe is limited, so insurers are looking across the Atlantic for attractive infrastructure debt opportunities. This instrument has many features that make them worthy of consideration for matching insurers’ long-term liabilities.”
One major benefit of municipal bonds that the white paper highlights is that the majority of state and local governments are highly rated, whereas corporate credits tend to have lower average ratings. While up to 93 per cent of US municipal issuers are currently rated single-A or higher, only 25 per cent of corporate bonds meet this standard.
It comes as no surprise therefore that the default rates for municipal bonds are very low, particularly when compared to corporate bonds. This is especially evident in the investment-grade universe wherein corporate investment-grade bonds have a default rate 27 times higher than the municipal investment-grade rate.
Another key factor that makes municipal bonds attractive to insurers is the low capital requirement. Since January 2016 European-based insurers have been subject to Solvency II, which calculates the capital requirement of a bond or loan by interest rate, spread, concentration and currency modules. The lower the risk factor, the lower the capital requirement. The high-quality profile of US municipal bonds is one important reason why they are very attractive for insurers regulated under Solvency II, particularly those looking for “cheap” sources of duration to match longer-dated liabilities.
Steffen Hahn, Senior Insurance Specialist, Invesco, says: “With above 80 per cent of the market rated investment-grade and maturities typically exceeding 20 years, municipal bonds represent a potential instrument to manage long-duration life insurance liabilities. In the context of relatively low yields, municipal bonds can offer better yield than investments in high-grade corporate bonds for lower capital requirements and lower economic risk in the context of buy-and-hold strategies.”