Tax advisors often recommend that investors purchase municipal bonds issued in the state where they reside to avoid state and local taxes on the interest income. However compelling this strategy may appear, it also results in increased risk.

The 2008 crisis and the weak economy has led to increased financial stress on state and local governments, reduced tax collections, and budget gaps. As a consequence of these risks, we are proponents of geographic diversification within municipal bond portfolios. The benefits of geographic diversification in portfolios are identified below.

 

RISK FACTORS

When a state or region is impacted by a natural or man-made disaster, the ability of that state or region to pay bondholders may be compromised. The economic impact of Hurricane Katrina and the BP oil spill on Louisiana is a prime example. Louisiana's current revenues are approximately 14 percent lower than in 2009, and all agencies and authorities have been directed to prepare budget cuts. Investors concentrated in Louisiana municipals will be adversely affected.

Municipalities suffering from weakened economies, declining tax revenues and budget shortfalls may not be able to rely on state aid if the state is experiencing similar problems. New York State, New York City and the state's school districts illlustrate this. The 2008 meltdown in the financial markets resulted in massive job losses, and greatly reduced sales and income tax receipts. As a result, the state is experiencing fiscal stress. Investors that own bonds issued by the state, New York City and certain school districts are now highly exposed to concentrated risk.

Political risk can also be a factor. In a number of states, particularly California, Colorado, Oregon and Florida, voters have initiated legislation imposing tax limitations and/or reductions. Voters in California passed Proposition 13 in 1978, tying real estate taxes to 1975 assessed values and, except when a house was sold, capping annual increases in assessed values at 2 percent. Consequently, cities and counties became increasingly reliant on investment income. This led to increased risk-taking and, in one especially notable instance, Orange County defaulted on its debt in December 1994. Investors can reduce exposure to the unintended consequences of voter initiatives by diversifying outside those states where state constitutions make such initiatives more likely to evolve.

 

STATE APPROPRIATIONS

Some state authorities rely on annual appropriations that must be approved by state legislators. States in fiscal distress may reduce these appropriations in order to achieve a balanced budget. The State of Illinois recently reduced its annual appropriation to the Illinois Regional Transit Authority. As a result, the RTA is facing a budget deficit and the Chicago Transit Authority, which is a beneficiary of these appropriations, has been forced to cut services by 18 percent. Bonds issued by both of these agencies have declined in value.

However, not all state appropriations are created equal, and in fact the process in some states is stronger. In New Jersey, the N.J. Transportation Trust Fund Authority also relies on the state for annual appropriations. The revenues that are used for the appropriations include gasoline taxes, motor vehicle fees and sales taxes on new vehicles. Unlike Illinois, these revenues are constitutionally dedicated for transportation purposes only, and it is therefore highly unlikely that the state will use them for other purposes.

By understanding the tiered effects of state appropriations, and avoiding the financial linkages between bond issuers, investors can reduce risk.

 

INDUSTRIAL REVENUE BONDS

A little known segment of the municipal bond market is industrial revenue bonds, which are tax-free, subject to the Alternative Minimum Tax, and typically guaranteed by a corporate issuer. In essence, investors can adjust the credit risk to that of the corporate guarantor, although IRBs are only issued in those states that benefit from the corporate project being funded. For example, following the BP spill, a trading opportunity in BP-backed IRBs arose. However, these bonds were issued in only a handful of states, including Texas, California, and Indiana. Investors should consider the benefits of these types of securities, even if they are out of their home state.

 

CONCLUSION

Investors should note that bonds issued from states with high income tax rates that offer state tax exemption for in-state bonds tend to trade at lower yields than those of states that do not have a state income tax, like Texas. This additional yield could potentially offset the added state and local income tax required from holding out-of-state bonds.

One of the casualties of the crisis in the financial markets was the demise of municipal bond insurance. With bond insurance, many investors were less concerned about diversification because principal and interest payments were "guaranteed" by the insurer. Now, investors must have a better understanding of the underlying credit quality of the municipal bonds they own.

Increased scrutiny of issuers and geographic diversification are the hallmarks of a properly executed municipal bond strategy.

 

Richard Saperstein is managing partner/principal/senior portfolio manager, and Kathleen A. Bramlage is a director, at Treasury Partners, a Chicago-based independent advisory platform registered with HighTower Securities.

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