skip navigation

Infrastructure Investment Under Solvency II: Application to US Municipal Bonds

Alan M. Nadel, PhD
Portfolio Risk Manager
Thea Okin
Research Analyst


Executive Summary

  • Solvency II is a regulatory framework concerning the amount of capital that insurers in Europe must hold to reduce the risk of insolvency.
  • To further promote European infrastructure investment while prudently calibrating risks, the European Commission made additional proposals to relax solvency capital requirements.
  • This paper provides a summary of a subset of taxable municipal bonds that we believe would mostly be considered Solvency II infrastructure investments and how they each fare against the eligibility criteria.
  • The favorable capital-relief treatment available to eligible munis that meet the infrastructure criteria under Solvency II increases their investor base by improving their attractiveness to European insurers.
  • US municipal bonds that qualify as infrastructure investments under Solvency II provide benefits to both European insurers and the residents in those communities that can now more easily and cheaply finance crucial infrastructure projects.

Introduction

Global financial regulation continues to evolve and shape the behavior of investors. For the insurance industry in Europe, the impact of Solvency II—which sets forth guidelines concerning the amount of capital that insurers must hold to reduce the risk of insolvency—continues to permeate. Recently, in an effort to further promote European infrastructure investment while prudently calibrating risks, the European Commission made additional proposals to relax solvency capital requirements.1

In this short note, we consider the criteria that municipal bonds would need to satisfy to qualify as infrastructure investments under Solvency II, and to be eligible for favorable capital treatment under the regulation. We provide specific examples of obligors that would and would not satisfy these criteria.

Overview

In the US, a significant portion of infrastructure investment is financed through the municipal bond market. Moody’s reports that there is $800 billion of rated municipal infrastructure debt currently outstanding. Much of this issuance will likely qualify for capital-charge relief under Solvency II, which covers infrastructure located in Europe and also Organization for Economic Cooperation and Development (OECD) countries such as the US.2,3

Investors should generally consider the three primary components of US municipal bonds:

  1. The bond issue: What is the purpose of the bond? Is it for a specific project, for general system-wide or governmental needs, or to refinance existing debt?
  2. The obligor: This is the entity responsible for paying back the debt, which may be issued by a general governmental entity and/or a department of the entity (such as a city or state), a separate authority or agency charged with operating a system such as a transit agency, or perhaps a limited liability entity (LLC) engaged in a specific project.
  3. The security features that govern debt repayment: This may be a general obligation or the appropriation of a government unrelated to use of the asset(s), a pledge of revenue derived either from a system or a specific asset, or an availability payment related to a specific project.

What Is Eligible for Favorable Relief?

Favorable treatment may be realized if the investment conforms to the following criteria:

  • The Project Entity’s Revenues Derive from Infrastructure Assets
  • The Solvency II definition of “Infrastructure Project Entity” excludes debt issued by general governments or their departments since the substantial majority of revenues does not necessarily derive from owning and operating infrastructure assets. Debt issued by agencies, authorities or LLCs, however, whether for an infrastructure system or for a stand-alone project, may qualify. Recently, the scope of infrastructure investments under Solvency II has been extended from projects to corporate groups.1

  • Cashflows Are Strong and Predictable
  • In general, municipal infrastructure cashflows are robust. The essential nature of the assets allows for flexible tariff raising that supports cashflow. Most municipal cashflows are not subject to rate regulation; instead, control is vested in the obligor (infrastructure entity), providing significant debt protection. Typically, there are a large number of end users.
  • Investments Have Regulatory and/or Contractual Protections
  • The legal framework governing debt issuance—typically in the form of a trust agreement/indenture— specifies covenants, events of default and remedies. A trust indenture is viewed as a contractual obligation within the US. Specific project-related debt generally allows for a security interest in the physical asset being financed, but debt that is issued by an agency or authority and is backed by system-wide cashflows usually does not. Other security features can include a lien over accounts, the right to force a rate increase to meet contractual obligations including debt repayment and step-in rights, which meet the regulatory and contractual protections requirements for a “Qualifying Infrastructure Investment” under Solvency II.
  • The Holding Period Is Long-Dated
  • Infrastructure debt is long-dated, typically matching the useful life of the assets or system being financed, which should be attractive to buy-and-hold investors looking for solid long-dated fixed-income investments.
  • Credit Ratings Are Investment-Grade
  • Public ratings are available on most securities, and they carry a strong rating. At the end of 2016, Moody’s reported that 99% of its universe of US municipal infrastructure debt was rated at least investment-grade.

  • Examples:
  • In Exhibit 1, we summarize a small subset of taxable municipal bonds that we believe would mostly be considered Solvency II infrastructure investments and how they each fare against the eligibility criteria. In Exhibit 2, we examine Solvency II requirements as applied to municipal infrastructure sectors.

Exhibit 1
Sample of US Taxable Municipal Infrastructure Debt: Do They Qualify Under the Solvency II Infrastructure Requirements?
Source: Western Asset, based on candidates’ programs and Western Asset's application of the requirements
Exhibit 2
Basic Requirements for Solvency II for Municipal Infrastructure Sectors
Source: Western Asset. As of 07 Sep 17

Investment Conclusions

In this brief note we have highlighted the eligibility of portions of the US muni universe under the requirements of Solvency II. The favorable capital-relief treatment available to those munis that meet the infrastructure criteria increases their investor base by improving their attractiveness to European insurers. This should also promote issuance in the sector and enhance the overall liquidity of the asset class.

In summary, US municipal bonds that qualify as infrastructure investments under Solvency II provide benefits to both European insurers and the residents in those communities that can now more easily and cheaply finance crucial infrastructure projects.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.