Municipal Bonds

Last Updated 7/6/17

Issue: Municipal securities are issued by states or local governments to fund a variety of government expenditures and investments including transportation and transit, water and sewer, electric and gas utility, higher education, housing and development, school district, and medical facilities. The two major categories of municipal bonds, general obligation and revenue bonds, are distinguished by their sources of repayment. General obligation bonds are secured by the full faith, credit and taxing power of a governmental entity and present the lowest historical default risk and the lowest loss given default. In contrast, the source of repayment of revenue bonds is restricted to a specified revenue stream, which is derived from the operation of a financed project, discretionary appropriations, grants or a dedicated specialized tax.

Overview: The U.S. insurance industry is a major institutional investor in the $3.7 trillion municipal securities market. U.S. insurer holdings of municipal bonds have increased annually at least since 2011, to a book/adjusted carrying value (BACV) of $556 billion at year-end 2015 from $467 billion at year-end 2011. This translates into a combined increase of $89 billion or an aggregate change of 19%.

While municipal bonds are not the largest bond allocation for insurers overall, they are the largest for P/C companies. P/C companies have tended to be more active in the municipal bond market than life companies due to the tax-exempt status of most municipal bonds. P/C companies' municipal holdings, as a percentage of total U.S. insurer municipal bond exposure, have declined year-over-year (YOY), retreating to 62% in 2015 from 71% in 2011. Life companies' exposure, meanwhile, increased to 32% in 2015 from 24% in 2011. The largest YOY increase for life companies, to 29% in 2012 from 24% in 2011, was, in part, due to increased purchases of taxable municipal bonds offered under the Build America Bonds program. Changes amongst the other insurer types were relatively minor.

The industry's predominant municipal bond exposure, or $355 billion (or about 64%), was in revenue and special assessment bonds. Revenue bonds are backed by income from a specific project or resource such as bridge tolls, highway tolls or property lease fees. They are "non-recourse," meaning that if income from the project or resource fails to meet the debt obligations, bondholders cannot seek repayment from the general or taxing resources of the municipality or state.

The vast majority of U.S. insurer's municipal bond exposure at year-end 2015, or 99.6% of total holdings, were investment grade credit quality, evidenced by either NAIC 1 or NAIC 2 designations. This was unchanged from year-end 2014. In 2015, 97.1% of municipal bond investments were designated NAIC 1, down slightly from 97.9% in the prior year, while those designated NAIC 2 increased to 2.4% from 1.7%.

The municipal securities market, which has provided an efficient and low cost means of financing for state and local projects, has historically offered investors high credit quality investments whose income is largely tax-exempt.

According to Moody's research, its 2017 outlook for the U.S. states sector is stable based on expectation of “modest" economic and revenue growth that will,  "…keep most states in a stable credit position, but will not be strong enough to foster broad credit improvement." In their view, some states may experience additional credit deterioration as they continue to face major challenges, including pension underfunding, rising health care costs, and weak oil and gas extraction revenues. S&P research, meanwhile, stated that it expects continued "fiscal strain" for many states due to slow tax revenue growth and added pressures from growing pension contribution requirements and Medicaid expenses. S&P also expects revenue growth, for certain states, to remain below the levels of growth in key expenditures in the coming year.

For the U.S. local government sector, Moody's outlook is listed as stable, supported by its expectations of strong projected property tax revenue growth of 3% to 5% in 2017. It states, however, about 5% to 10% of issuers will be exposed to "compounding pressures and credit challenges." S&P also has a stable outlook for the U.S. local government sector, but it expects some municipalities to face budgetary challenges. Key risks for the sector, per S&P, include possible reductions in state-shared revenues, state-funding cutbacks, pressures from underfunded pension plans and tax reform that could reduce the attractiveness of municipal bonds. S&P, alternatively, lists several opportunities for the sector in its research, including continued economic recovery, potential of a federal infrastructure program and ongoing demand for capital projects.

Bloomberg reported in May 2017 municipal bonds rose to their highest value in about a year compared with Treasuries as demand remains strong against a diminishing supply. The index tracking the benchmark 10-year municipal bond yield as a percentage of U.S. Treasuries sunk to 86.9% (June 2017), the lowest since June 2016, according to Bloomberg data. Analysts expect supply to continue shrinking in the summer months as demand is rising feeding the rally. Citigroup Inc. analysts predicted the market will decrease by $39.5 billion between June and August, while investors will receive $44 billion in interest payments.

Status: Insurance companies are required to file all unrated municipal bonds they purchase with NAIC’s SVO in the Capital Markets & Investment Analysis Office for credit assessment and the appropriate NAIC credit designation.

The NAIC Capital Markets Bureau reports on developments within the municipal bond market as deemed appropriate. A full listing of their reports can be found on the Capital Markets Special Reports archive webpage. The Capital Markets Bureau will continue to monitor trends with Puerto Rico’s debt crisis as it evolves.