Finding Relative Value in Infrastructure Financing | Case Studies

US infrastructure has immense investment needs and higher funding in this area is one of the key policy projects of both political parties. We see attractive relative value opportunities in smaller bond issues that finance strategic/essential infrastructure and often are overlooked by investors. They have been gaining interest from institutional pension funds and life insurers looking for a highly rated investment opportunity that can provide a yield pickup over their traditional fixed income allocation as well as portfolio diversification.

Historically, the $3.6 trillion municipal bond market has been the primary source of funding for American infrastructure.1 US infrastructure earned a D+ grade2 from the American Society of Civil Engineers. Bringing it to a state of good repair would cost $4 trillion, with only 55% of funding in place.3 Municipalities and public-private partnerships are expected to fund the remaining $2 trillion.3 MacKay Municipal ManagersTM (MMM) believes that taxable municipal bonds will provide the majority of the new financing (Figure 1).

Market Characteristics

State, county and local governments and agencies issue these municipal bonds to build highways, airports, water and sewer plants, and other structures that provide essential services to the public. With nearly $3.9 trillion in outstanding bonds, municipal bonds make up nearly 10% of the value of the $40.8 trillion U.S. bond market. (Source: SIFMA, Outstanding US Bond Market Debt, data as of 6/30/2019)

The municipal bond market is complex and inefficient with more than 54,000 issuers and no national exchange.4 Particularly smaller issues that often get overlooked offer access to essential infrastructure bonds at attractive relative value (Figure 2).

Interest income from most municipal bonds is not subject to federal income tax, so individual US investors have long dominated the market; today, individuals own about two-thirds of the municipal bonds outstanding. Some taxable US institutions, such as nuclear decommissioning trusts, have also invested in the asset class for decades. Tax exempt US entities and non-US investors that aren’t subject to US taxation have generally stayed away, because the yields on tax-exempt municipal are generally lower than yields on other bonds with similar duration.

Not All Muni Bonds Are Tax-Exempt

Historically, taxable municipal bonds have represented approximately 10 - 15 percent of total municipal bond borrowings by state and local governments, with the balance being tax-exempt (Source: SIFMA, Municipal Bond Credit Report, 4Q 2018). The U.S. tax code strictly limits the volume of tax-exempt municipal bonds for each of the thousands of issuers, and restricts the eligible purposes for issuing them. Issuers that need to issue more debt than allowed, or to fund a non-permitted purpose, tap the taxable municipal bond market (Figure 3). Institutional investors’ recent increased appetite for municipal bonds is focused on the taxable category, which generally offers higher yields because their interest payments are not tax exempt. At the end of the second quarter, 6/30/2018, $480 billion in taxable municipal bonds were outstanding. (Source: SIFMA, Municipal Bond Credit Report August 2018).

Taxable municipal bonds, by their very nature, exist because the federal government will not subsidize certain kinds of financing in the tax-exempt market, i.e. corporate-lead hospital networks, stadium financings, private education/charter schools, university endowments, to name a few. As a result, these sub-sectors of the municipal market are more concentrated with taxable issuance vs. the broader tax-exempt market. In addition, when certain states exceed their annual threshold of tax-exempt bond issuance for private activity purposes (airports, sewage, intercity rails, mass transit), they must issue in the taxable market. Depending on the nature of a state's infrastructure needs, taxable issuance can be very geographically concentrated vs the broader tax-exempt municipal market.

Capturing Relative Value in an Inefficient Market

MMM employs a relative value investment approach across all of their municipal strategies, predicated on fundamental research on each security MMM contemplates for inclusion in client portfolios. A client portfolio may include U.S. Taxable and/or Tax Exempt municipal bonds, including general obligation and revenue bonds (across all states and sectors), industrial development bonds, pollution control bonds, and zero-coupon bonds.

MMM believes that specialised managers like us will continue to be able to exploit strong relative value opportunities in U.S. infrastructure investments through credit research and security selection. The characteristics of the municipal taxable marketplace present opportunities to diversify for investors. These inefficiencies may help generate consistent outperformance for managers while taking advantage of these mis-pricings on a daily basis by applying an active, relative value approach.

1Source: SIFMA, September 2019, Federal Reserve Data.

2The American Society of Civil Engineers (ASCE)’s 2017 Infrastructure Report Card.

3 The American Society of Civil Engineers.

4 Bloomberg Barclays. Data as of March 31, 2018.