Over the past decade, institutional investors have enthusiastically embraced investments in private equity funds dedicated to infrastructure projects, but until recently they’ve overlooked an attractive liquid version of infrastructure: U.S. public revenue bonds.
Key benefits of this asset class are diversification (the unique features of this market translate into low or negative correlations with other asset classes), long-dated cash flows (a significant part of the market is long duration), and a measure of inflation protection (these bonds are supported by usage fees that rise with inflation due to the monopoly nature of the projects, such as airports, toll roads and bridges).
This $3.7-trillion market provides enough depth for institutional investors to access it, yet is incredibly fragmented. For instance, there are over 46,000 issuers, over a million Committee on Uniform Securities Identification Procedures (CUSIPS) and over 2,000 dealers. An experienced research team can generate significant alpha for tax-neutral, long-term-focused clients. It is also worth noting that the default rate in the U.S. municipal market is significantly lower than other sectors of the credit markets and foreign government bonds.
Muni bonds in Canada
How can a Canadian plan sponsor use the U.S. public revenue asset class? There are three main ways:
As part of an infrastructure exposure. A portfolio of municipal bonds can provide immediate access to an infrastructure exposure, reducing the J-curve effect of the overall allocation. The portfolio can then be used as a funding portfolio for future infrastructure private-equity capital calls.
As part of a hedge fund portfolio. From a strategic point of view, a portfolio of municipal bonds can provide a very attractive return profile over a variety of market cycles by capitalizing on market inefficiencies and hedging out interest-rate risk if desired.
As part of a liability-driven investment (LDI) framework. Roughly $1.3 trillion of this market has maturities in excess of 20 years. These long-dated bonds can be an excellent complement to domestic bond allocations, as well as provide a measure of inflation protection.
There are many long-term strategic arguments for including infrastructure bonds in an asset allocation. In addition, this year’s liquidity crisis provides an extraordinarily compelling entry point from a tactical point of view based on spread levels across credit quality and maturity versus other fixed-income asset classes.
Robert DiMella is executive managing director, MacKay Shields LLC