[IMGCAP(1)]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 financial crisis resulted in a deterioration of the fiscal condition of many state and local governments. The weak economy, coupled with rising unemployment and the collapse of the housing market, has led to increased financial stress, reduced tax collections and budget gaps.

As a consequence of these associated risks, geographic diversification within municipal bond portfolios has many benefits, especially when disaster strikes in one area of the country.

Disastrous Events

When a state or region is hit 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 are two prime examples.

Louisiana has a 4 percent state sales tax, and the parishes and a number of cities also levy sales taxes. Tourism was negatively affected by the oil spill, which resulted in reduced levels of sales taxes. In addition, the state’s economic health is heavily reliant on the petroleum and chemical industries, both of which have suffered from the consequences of the oil spill.

As a result, Louisiana’s current revenues are approximately 14 percent lower than in 2009, and all agencies and authorities have been directed to prepare budget cuts in order to finance the state’s Budget Stabilization Fund.

Investors concentrated in Louisiana municipals will be adversely affected.

Local Financial Issues

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 illustrate this risk factor.

New York City income and sales taxes represent a significant source of state revenues. The 2008 meltdown in the financial markets resulted in massive job losses, and greatly reduced tax receipts. As a result of the reduced tax revenue, the state of New York is experiencing fiscal stress. It became necessary for the state to make expenditure cuts in many departments in an effort to balance its budget.

Seemingly unrelated to the financial sector woes is the financial condition of school districts throughout the state. Since the state provides aid payments to all New York school districts, school budget deficits are now widespread. Many of these districts may not have been directly affected by the financial crisis, but were forced to make expenditure cuts in their budgets in response to decreased amounts of state aid.

Investors that own bonds issued by the state, New York City and certain school districts are now highly exposed to concentrated risk.

Political Forces

In a number of states, particularly California, Colorado, Oregon and Florida, voters have taken advantage of their constitutional rights to initiate legislation imposing tax limitations or reductions.

Voters in California passed Proposition 13 in 1978. As a result, real estate taxes were tied to 1975 assessed values and, except when a house was sold, annual increases in assessed values were capped at 2 percent.

Consequently, cities and counties became increasingly reliant on investment income to balance their budgets. This led to increased risk taking in the investment process and, in one especially notable instance, Orange County defaulted on its debt in December 1994.
Investors can reduce their 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, which are 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 service 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 appropriation 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 motor vehicles. Unlike Illinois, these revenues are constitutionally dedicated to transportation purposes only and, therefore, it is highly unlikely that the state will use these revenues for other purposes.

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

Out-of-State 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. However, 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 originate outside their home state.

Regulatory Protection

The SEC recognizes the risks inherent in the lack of geographic diversification.

Since single-state municipal bond mutual funds concentrate investments in one state, or in issuers located within that state, making diversification difficult to achieve, the SEC requires the investment advisors of these funds to disclose the lack of diversification in the fund prospectus.

Investors should note that bonds issued from states with high income tax rates that offer a state tax exemption for in-state bonds often tend to trade at lower yields than 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 the 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, and senior portfolio manager at Treasury Partners in New York.

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