BlackRock: munis vs corporate bonds - a gradual shift

BlackRock: munis vs corporate bonds - a gradual shift

Anticipating political change in business is usually risky, and as much of an art as a science. However, asset manager BlackRock has turned its unparalleled resources in market data and analysis to do much of the work for its insurance sector clients.

The political shift in question is President Donald Trump’s promise of US corporate tax reform. Specifics – as with so many nascent policies of the Trump Administration – are still elusive, but the market’s so-called “Trump rally” is evidence of the market’s confidence that opportunities await. The biggest question, which BlackRock has sought to answer, is perhaps how best to take advantage of them.

Corporate bonds make up a very large proportion of many insurers’ investment portfolios. Tax reform will affect the performance of US companies and consequently the creditworthiness of corporate debt (and equities), the yields produced, and the volumes of fresh bond issuance that can be expected to be brought to market. 

Reform will also affect the relative attractiveness of tax-sheltered US municipal bonds, which have proven popular investments for property and casualty (P&C) insurers. According to Federal Reserve flow of funds data, for example, by the end of 2016 approximately $345bn of US munis were held by P&C insurers.

“It’s a sensitive topic for the market, because public finance is a political topic. In other words, it’s the level of investment by financial institutions that determines the success of public works projects,” says James Pruskowski, managing director, head portfolio manager on BlackRock’s municipal institutional portfolio team. “There are broad implications for the US economy, as well as the yields that are on offer.” 

The degree to which corporate tax will be cut is up for debate – between White House, Congressional and potential compromise scenarios (see box). Much will also depend on whether the participants decide to repeal or alter the alternative minimum tax (AMT) rules, as well as changing the broader corporate tax rate.  

“Tax reform creates a rich debate between market valuations and core asset allocators to this sector,” says Pruskowski. “The bear versus bull scenario is that with lower corporate rates, lower individual tax rates, and the loss of the healthcare savings charge, the lesser the tax rate the lesser the need to shelter from taxes.”

Pruskowski draws the comparison with President Reagan’s 1986 US tax reforms, which lowered the corporate tax rate and also instituted a 15% proration on P&C companies, which worked as a form of deduction cap.

“The difficulty here is there are a wide range of outcomes for insurers. It took Reagan years, and a lot more detailed work,” says Pruskowski. “If the Trump administration drops the corporate rate to 25% the market can deal with that, but if they change the proration to something more onerous, then obviously the benefits to insurers would be even less.”

A trade-off looms – but with the corporate tax and AMT specifics as yet undefined – between the relative attractiveness of munis and corporates for P&C insurers’ investment portfolios. “It’s going to come down to those supply and demand dynamics of those two major components of reform. The devil is definitely going to be in the details with respect to the magnitude and direction of corporate tax and AMT,” says Anne Marie Schultz, director of BlackRock’s financial institutions group.

“Both of those proposals on the table work opposite of each other in terms of their net impact on muni demand. Driving down corporate tax rates would drive down demand for munis. On the flipside, if AMT is repealed, which keeps a portion of muni demand in check today, it would drive up demand for tax exempt assets, because the constant need to offset taxable income is no longer there,” she says.

“Added to that, if the net interest deductibility feature ends up being enacted – which has been toyed with – this would equalize the corporate tax benefit for issuing debt versus issuing equity, causing lower debt supply which would be a headwind for insurance companies,” Schultz adds.

Asking Aladdin

BlackRock has been using its vast Aladdin platform for tracking market data to assess the likely behaviour of insurers towards their holdings of municipal bonds and corporate debt, across the different scenarios that may arise through US tax reform over the coming years.

Schultz explains the work undertaken by the asset management firm. “We’ve tried to isolate some of the levers in tax reform that are under discussion: corporate tax reform; AMT; and the proration element,” she says. “We did all this analysis to look at how sensitive insurers demand for munis would be, relative to tax reform scenarios and insurer’s profitability,” notes Schultz.

Pruskowski continues: “The bull case scenario revolves around grandfathering the asset class, which is similar to what happened in 1986, when those bonds were moved to hold to maturity because they got grandfathered under the old corporate rate and had preferential treatment. We did not see much of a change, albeit over time, reinvestment shifted to other asset classes. 

“What’s interesting in the post US election market reaction is that, as the industry has been profitable for many years, valuations got richer that didn’t warrant new exposure to the asset class, so when the market cheapened up earlier this year we saw new entrants and very little selling. The little selling revolved around book yields in this space being pretty onerous, but those that had core allocations were looking at where to shift dollars elsewhere slowly over time,” he adds.

Across the broad reaches of the US insurance industry, different investment reactions to US tax reform can be expected along the spectrum of individual auto insurers, life and health, and P&C firms. However, according to Schultz, a sudden switch away from munis is not anticipated.

“While insurers may have a new strategic target based on the final outcomes of tax reform, it should take time for that new target state to be realized, because nobody is going to want to give up the high book yields that they have in their existing muni bond portfolios. So we would say let it roll off, and then reinvest in new allocations,” Schultz suggests.

Analysis from Aladdin – after loading insurers’ statutory holdings data onto the system – backs up this advice, she suggests, by allowing greater insight into yields and over what timeframe investments are likely to be rolled off, she suggests. The analysis takes into account high embedded book yields within insurers’ muni portfolios, likely soft implementation of reforms as well as grandfathering effects, combining to still support the asset class.

“That’s when we came to the realization that most insurers are unlikely to flip the switch by making a strategic allocation merely on the back of the announcement of tax reform. We realize that insurers are looking at more than just tax efficiency, and that’s reflected in their portfolio allocations. That said, the magnitude of the changes being proposed demands that this gets reviewed.”

Pruskowski agrees on a cautious and steady approach rather than any sudden moves to sell. He notes that the Trump administration will want to show some tax reform progress by the end of this year, and certainly before the 2018 midterm congressional elections.

But while the details do not yet exist, firms can already plan for likely scenarios to meet their projected targets rather than simply wait out political events, suggests Schultz.

“While you might not be able to make decisions yet, you can certainly plan for scenarios and have agreement on different paths forward depending on how reform decisions unfold,” she says. “If you wait until everything’s settled you might find yourself disadvantaged. If you don’t have plans in place, you’re not going to be able to take advantage of opportunities that arise from the changes.”

Munis vs corporate bonds

Based on BlackRock’s December 31 2016 security-level analysis of $1.4trn in cash and investments from US statutory filings by property and casualty (P&C) insurance, the industry average book yield of the tax exempt municipal bonds held by these insurers, unadjusted for tax benefit, is circa 3.4%. Adjusting for the tax exempt income benefit at various corporate tax rates, the industry average book yields are / would be as follows:

Compared against 

1) the market yield of the Barclays Credit index, as a taxable fixed income alternative, of 3.38% OR

2) the market yield of the taxable investment grade corporate bond holdings of these same insurers of 2.9% (both as of 12/31/16, not adjusted for duration or quality differences), 

The adjusted tax exempt bond yields, even at lower corporate tax rates, still look more attractive than their taxable fixed income alternatives.

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