What's Good Enough for the Gherkin Should Be Good Enough for Americans

The most sophisticated risk managers in the world invest in state and local governments. So why are Americans so hesitant?
August 2017
London's Gherkin building (Shutterstock)
By Justin Marlowe  |  Columnist
Endowed Professor of Public Finance and Civic Engagement at the Daniel J. Evans School of Public Policy & Governance at the University of Washington

London’s iconic skyline features an enormous, cigar-shaped glass building lovingly known as the “Gherkin.” Tourists from around the world stop to take in its bold, environmentally friendly design and spectacular views. The Gherkin is also becoming a destination for U.S. public finance -- but more on that in a bit.

First, let’s look at the wild ride municipal bond investors have been on since the 2016 elections. Back in July 2016 the interest rate on a 30-year muni bond was just over 2 percent, according to a Bloomberg index. That was its lowest rate in years. By that December, it had jumped to 3.3 percent, its highest in years. More recently, it has hovered closer to 2.75 percent, and market experts agree there’s more volatility to come.

Some of those wide swings are due to a Trump effect. President Trump has promised a peculiar combination of spending and tax cuts, which in most scenarios will lead to increases in inflation. Higher inflation, in turn, generally means higher interest rates.

The Trump factor aside, many muni investors think they have good reason to expect higher interest rates. They’ve heard relentless chatter about a housing bubble, big potential cuts to Medicaid, late state budgets, unfunded pensions, the unfolding fiscal debacle in Puerto Rico, and other bad news for states and localities. According to J.P. Morgan, investors pulled more than $3 billion from municipal bond funds in the week following the election. Since then, they’ve put some of that money back in, but overall fund levels have not returned to their pre-election levels.

More than half the money invested in the muni market is from mom-and-pop investors who have traditionally seen munis as a safe place to save for retirement, college or other long-term investment goals. And indeed, munis are a great vehicle to achieve those long-term goals -- despite the muni market’s recent swings.

Which brings us back to the Gherkin.

The Gherkin is the U.K. headquarters of Swiss Re, a global insurance and financial services company. Swiss Re is a major player in the “reinsurance” market -- that is, they sell insurance to insurance companies. They’re some of the most sophisticated risk managers in the world.

Swiss Re and entities like it have become major players in public-private partnerships for state and local infrastructure. P3s come in a variety of forms, but in this case we’re talking about an arrangement where a private entity enters into a long-term deal with a government to finance, design, build, operate and maintain a piece of infrastructure. In exchange, the government pays the private partner a predetermined amount, usually as a lease or “availability payment.” Many of the major airports, convention centers, civic centers and other big public projects in the U.S. today are happening through this model.

Swiss Re and entities like it get involved in P3s in several ways. For one, they insure the contractors that perform the construction work. Or they manage money on behalf of global investment funds that front the capital for many P3s. Or sometimes they invest in P3s directly. For example, last year the city of Long Beach, Calif., finalized an innovative, 30-year P3 for a new civic center. Nearly half the upfront investment came from the German insurer Allianz, one of Swiss Re’s key competitors. The interest rates on the Allianz loan were just above comparable, taxable rates on munis, so unsurprisingly Allianz was eager to get in on the action.

This is quite a contrast to traditional muni investors who seem anything but confident in munis. What do Swiss Re and Allianz know that traditional muni bond investors don’t? They know how to evaluate muni risks with cold, dispassionate logic, and their evaluations have shown again and again that state and local governments are a good long-term risk.

If loans backing U.S. state and local infrastructure are a good enough bet for the most sophisticated risk managers in the world, then they should be a good enough bet for the average person’s retirement fund. States and municipalities should tell their investors: If it’s good enough for the Gherkin, it’s good enough for you.