Download The Importance of Geographic Diversification in Today`s Municipal

The Importance of Geographic Diversification
in Today’s Municipal Bond Market
August 2014
OVERVIEW
• In the municipal bond market, a state-specific investment focus will reduce tax liability in
most circumstances. However, this tax objective can run counter to portfolio management
practices established to maximize risk-adjusted after-tax total return.
Adam Mackey
Managing Director
Municipal Fixed
Income
• State-specific investment policies subject an investor to a number of risks from which a
geographically diversified portfolio could shield investors, including 1) a limited investment
grade opportunity set, 2) inordinate exposure to state- or regional-specific events, and
3) a portfolio of bonds with highly correlated returns.
• Evaluation of a state-specific investment must include assessment of both the depth and
breadth of the state market; state issuer diversity by sector type, rating level, and pledged
cash flows; and general credit quality, in addition to tax implications.
DIVERSIFICATION IN A MUNICIPAL BOND PORTFOLIO
William Bonawitz,
CFA
Director of
Municipal Research
The PNC Capital Advisors Municipal Fixed Income team has long expressed the benefits of
building purpose-driven municipal bond portfolios consisting of assets that provide layers
of diversification. Asset diversification across state, sector, obligor, pledge type, and rating
categories mitigates different risks and insulates the portfolio from idiosyncratic risks
associated with greater returns volatility. A municipal bond portfolio can be constructed with
broad diversification across risk factors with a higher after-tax total return – or a lower level
of risk – than a state-concentrated portfolio.
Historically, municipal bond investors have favored state-specific investing to minimize
income tax obligations to the investor’s state of primary residence. While we recognize the
lure of a lower in-state tax bill arising from state-specific investing, the tax advantages can
be over emphasized and come with potentially dire consequences for the after-tax total
return of a bond portfolio. Throughout history, unforeseen events have compromised state,
regional, and local municipal credit quality. Credit stress can emerge from natural disasters,
like an earthquake or hurricane, man-made strife, economic turmoil, political malfeasance,
or an energy crisis. Events like these often lead to credit downgrades and associated price
degradation across many issuers located near or correlated with the geographic area in
which events unfold. By limiting investment to a single state, investors expose themselves
to concentrated risk that can be avoided in a geographically diverse national portfolio.
pnccapitaladvisors.com
CONSTRUCTING A MUNICIPAL BOND PORTFOLIO
Bond selection is the final step in a long process. Proper portfolio construction requires assessment
of supply and demand for an obligor’s bond offerings. The portfolio manager must understand federal,
state, and local income tax treatment of a bond’s coupon interest and potential gains/losses subsequent
to purchase. As well, the manager must evaluate the obligor-specific risks associated with a given credit
under consideration for portfolio selection.
Supply
The municipal market is a large and diverse market from an issuer perspective. There are thousands
of potential issuers with approximately $3.4 trillion1 in debt outstanding across the United States and
three U.S. territories. We include U.S. territory debt because tax advantages afforded to such debt have
historically made these securities suitable investment options for state-specific and general market
municipal bond portfolios. Income from bonds issued in all U.S. territories is exempt from federal, state,
and local income tax.
The portfolio investment opportunity set is diminished significantly when investments are limited to a
primary state residence, but the degree to which the opportunities are limited may not be understood
without a few numbers. There are only 13 states or territories that individually comprise over 2% of the
total outstanding municipal debt, and those 13 states/territories comprise close to 69% of that total debt
(Table 1). When we exclude noninvestment grade, nonrated, taxable municipal bonds and bonds subject
to the alternative minimum tax (AMT), the opportunity set is further diminished.2 Consider Pennsylvania.
It makes up only 3.86% of the national opportunity set, which would equate to investors disqualifying 96%
of all municipal bonds outstanding from their Pennsylvania-only portfolios.
Table 1: Taxable and Tax Exempt Municipal Debt Outstanding. States % > 2
State
Total Outstanding
Municipal Total
3,340,276.6
California
% of Total Issuance
100.00%
Tax
Exempt % Taxable %
75.52%
24.48%
Investment
Grade %
Noninvestment
Grade %
AMT%
86.12%
541,121.0 16.20% 78.72%21.28% 83.89%
New York
370,668.1
11.10%
80.41%
19.59%
90.15%
Texas
304,110.6 9.10% 76.04%23.96% 89.45%
Illinois
156,055.8 4.67% 64.56%35.44% 94.37%
Florida
147,702.9 4.42% 83.17%16.83%87.88%
Pennsylvania128,869.83.86% 72.06%27.94% 92.70%
13.88%
Max Tax
Rate
5.03%
NA
16.11% 3.64%13.30%
9.85%
5.68%
10.55% 5.24%
8.82%
—
5.63% 4.29% 5.00%
12.12% 8.38% —
7.30% 4.55% 3.07%
New Jersey
117,601.7
3.52%
73.65%
26.35%
89.23%
10.77%
5.90%
8.97%
Puerto Rico
107,103.3
3.21%
81.12%
18.88%
39.60%
60.40%
0.43%
—
Ohio
104,605.3 3.13% 71.00%29.00% 76.44%
23.56% 3.02% 5.42%
Massachusetts 93,850.0 2.81% 83.19%16.81%93.33%
6.67% 4.43% 5.20%
Washington
77,992.0 2.33% 76.37%23.63% 96.49%
3.51% 5.31%
Michigan
76,661.1 2.30% 74.53%25.47% 73.66%
26.34% 5.25% 4.25%
Georgia
69,019.3 2.07% 78.87%21.13% 87.80%
12.20% 5.86% 6.00%
>2% State Total
2,295,360.9
—
68.72%
Source: Sifma.org, PNC Capital Advisors
Municipal Bond Credit Report 1Q 2014, Sifma.org
1
2
Recent economic and fiscal stress in Puerto Rico has moved most credits on the island to noninvestment grade, shrinking the state-specific investment universe further.
2 The Importance of Geographic Diversification in Today’s Municipal Bond Market
Demand
Graph 1: Holders of Municipal Bonds
The U.S. municipal market is primarily a closed market that appeals
to U.S.-domiciled investors drawn to the market for the inherent tax
advantages and relative credit quality of the asset class. Unlike other
fixed income asset classes, municipal securities have U.S. households
as the largest holder (Graph 1). The market is primarily supported by
retail demand that can create a fragmented and opaque market, which
at times lacks depth, velocity, and institutional sponsorship.
Mutual Funds
16.97%
Household Sector
43.81%
Ins Co.
12.78%
For portfolios restricted to a state with high income tax rates, investors
domiciled in that state provide liquidity via their demand for the tax
exemption. This state-specific demand drives up the value of all bonds
issued in that state, which, in turn, drives down the potential total return
to investors. This built-in demand may concentrate most of the in-state
float in a few investors’ hands all with the same objectives. Liquidity
suffers accordingly.
MM
8.10%
Other
6.51%
Commercial Banking
11.61%
Source: F
ederal Reserve System, PNC Capital Advisors,
U.S. Department of Treasury
Tax Treatment
Income tax code and tax rates vary considerably from state to state and are subject to change at any time.
It is our belief that in-state tax advantages are often overemphasized and not fully vetted relative to the
municipal bond investment opportunity set. While we recognize the value of the tax exemption, statespecific investors unnecessarily restrict themselves from most of the opportunity set. Often the result
is a portfolio burdened with concentrated price and credit risk in exchange for a few extra basis points of
return in the form of lower taxes. Again we use Pennsylvania as an example to calculate where resident
investors would be indifferent to owning a Pennsylvania exempt bond relative to a non-Pennsylvania
exempt bond. Table 2 outlines at various yield levels the investor tax indifference curve. A Pennsylvania
resident would be indifferent to purchasing a Pennsylvania-exempt bond that yields 3.00% or a nonPennsylvania exempt bond at 3.06%. The higher the state tax rate the higher the benefit from the tax
exemption, but even with California (the highest income tax state with a marginal rate of 13.30%), the
benefit is only 26 basis points relative to a 3.00% in state bond.
Table 2: Tax Indifference Curve
Pennsylvania
Ohio
Aa3 / AAFederal Tax Rate PA State Rate New Jersey
Aa1/AA+
39.60% Federal Tax Rate 3.07% OH State Rate California
A1/A+
39.60% Federal Tax Rate 5.42% NJ State Rate A1 / A
39.60% Federal Tax Rate 8.97% CA State Rate 39.60%
13.30%
Total Effective Rate*†45.25% Total Effective Rate*†46.67% Total Effective Rate*†48.82% Total Effective Rate*†51.43%
In-State
Municipal
Return1
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
Equivalent
In-State
Out-of-State
Municipal
Municipal Return2 Return1
1.02%
1.53%
2.04%
2.55%
3.06%
3.57%
4.08%
4.59%
5.09%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
Equivalent
In-State
Out-of-State
Municipal
Municipal Return2 Return1
1.03%
1.55%
2.07%
2.58%
3.10%
3.62%
4.14%
4.65%
5.17%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
*Reflects deduction of state income tax on federal tax return.
†
Includes the 3.8% Net Investment Tax.
1
Not subject to state or federal income tax.
2
Subject to state income tax; exempt from federal tax.
Source: PNC Capital Advisors, IRS.Gov
3 The Importance of Geographic Diversification in Today’s Municipal Bond Market
Equivalent
In-State
Out-of-State
Municipal
Municipal Return2 Return1
1.06%
1.59%
2.11%
2.64%
3.17%
3.70%
4.23%
4.76%
5.29%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
Equivalent
Out-of-State
Municipal Return2
1.09%
1.63%
2.17%
2.72%
3.26%
3.81%
4.35%
4.89%
5.44%
We assert that investors could construct a portfolio that offers higher yield, broader sector
diversification, and stronger credit quality than nearly all state-restricted alternatives. Take, for example,
the case of a New Jersey investor. Using the S&P municipal bond index to define the set of available
securities, we can identify a subset of the index with taxTable 3: S&P Municipal Bond Index 7/30/2014
adjusted return to which a New Jersey investor would be
Security Breakdown
NJ Non-NJ
indifferent (Table 3). First, we scan the opportunity set for
Total # Securities
2,269
72,993
A-rated bonds in order to match credit risk. Next, the data
are grouped by yield, 3% or greater for New Jersey and 3.17%
Total # A Category Cusips
622
6,253
or greater for non-New Jersey bonds. We find more than
Total # A Category > 3% Yield
242
2,100 out-of-state municipal securities that could potentially
Total # A Category > 3.17% Yield
2,133
be used to enhance after-tax total return and insulate the
Source: S&P, PNC Capital Advisors, Investortools
portfolio from state-specific risk.
Correlated Credit Risk
State-specific portfolios are fundamentally more exposed to the relationships formed among different
levels of state and local governments. It is natural for a state and its localities to depend on each other
for revenue collection, service provision, and other basic functions of government. It follows that statespecific municipal bond investors would be subject to correlated risks. In our view, these risks present
themselves in four forms.
• Shared Risk Factors: Issuers that share a geographic region are susceptible to certain types of risks
that can affect bond valuations. Economic, political, and catastrophic risks have been witnessed
throughout history, and we find their effects can be magnified on an in-state portfolio. Examples of
such risks would include a declining local housing market, significant government corruption, and
force majeure. Also, some states have certain cultural or legal factors that can impact credit quality.
Culturally, there are states that are more aggressive users of leverage, and state legal frameworks
can inhibit or encourage the use of debt at the margins. Finally, governments, and in some cases
tax-exempt enterprises, can share risks tied to financial obligations. Pension obligations serve as an
example. An underfunded pension system can have deleterious effects on multiple issuers within a
state, including cities, school districts, and universities.
• Financial Interdependence: The financial relationship of a state and its local governments can
vary, but some states employ heavily centralized funding schemes. In this case, investors who have
concerns about their state government may not be sufficiently insulated from what they perceive
by owning local government bonds within that state. Further, in-state investors are more likely to
experience a credit contagion if one or more large issuers in their state finds itself in severe financial
trouble, municipal bankruptcy, or simply in default. The contagion would result in reduced liquidity
and potential repricing of a large swath of bonds within that state. The most important type of
financial interdependence involves states that provide contingent credit support for local obligations,
often referred to as intercept programs.
• Credit Exposure: A close examination of the offering documents is a prerequisite for proper investing
in the municipal market. It is important that an investor identify specific repayment source(s) before
adding a bond to an investment portfolio. Unlike the corporate or sovereign bond markets, it is all
too common for the municipality or authority that is issuing a bond to not be the ultimate obligor. It is
appropriate to understand the offered pledge under each document to properly assess the credit and
pricing risks that the investor is assuming. State-specific investing greatly increases the odds that a
portfolio could unknowingly be concentrated to a specific repayment source.
• Linked Credit: In many instances, the municipal market views several of the above-mentioned
factors as so related that it can create credit “linkages,” which result in direct or indirect credit
correlation. For example, the rating agencies will explicitly apply linkages to ratings per their
individual methodologies. These linkages are likely to apply to several categories of bonds, including
cities and counties, taxing districts, special tax bonds, and public universities. We demonstrate this
4 The Importance of Geographic Diversification in Today’s Municipal Bond Market
The Importance of Geographic Diversification
in Today’s Municipal Bond Market
concept using Pennsylvania credits. If the state of Pennsylvania general obligation rating is downgraded, the state
school intercept rating also will be downgraded by the equivalent notching as well as the state of Pennsylvania
appropriation-backed debt rating. Consequently, if a ratings change for a sponsoring entity results in bond price
degradation, then linkages can magnify the impact that ripples through the state-specific portfolio.
Price Risk
The credit factors mentioned above magnify the impact of
ratings transition on state-specific portfolios. Typically, price
risk associated with ratings degradation more than offsets
any in-state tax advantages that state-concentrated portfolios
enjoy. Over the last 10 years, the cost for a ratings category
downgrade from AA to the A category, for example, has
averaged 48 basis points (bps) and 73bps from A to BBB
(Table 4). A 48bps increase in yield for a 10-year bond
translates to roughly a 3-4% price decline. The impact
is exacerbated by each bond that exhibits some type of
correlated risk.
Table 4: Credit Spreads to AAA 10 Year Bond
6/30/2004 - 6/30/2014
Average
Category
Migration
CurrentMin MaxAverage Cost
AA 10bps 9bps30bps17bps 17bps
A
33bps 22bps157bps 65bps
48bps
BBB 71bps 34bps354bps138bps
73bps
Source: Thomson Reuters
CONCLUSION
While we are not calling for a ban on state-specific portfolio options, in-state tax rates must be set quite high to justify
single-state portfolios in light of the risks outlined above. Further, only investors in the highest tax states with a broad
issuer base and high supply should consider state-specific bond portfolios. State-specific investors must be aware that
the in-state tax exemption may not adequately compensate for the additional fundamental credit risk.
The municipal market is a large market with a variety of issuers and security pledge types that afford investors the
ability to construct diversified portfolios. We implore investors to examine the in-state tax benefits with a holistic view
and recognize that the cost of the tax shelter could be significantly greater than its value. A geographically diversified
portfolio can be constructed with greater potential after-tax total return and risk mitigation profile than a state-specific
or state-concentrated portfolio.
This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but has not
been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change
without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced
herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about
such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities referenced are not representative of all
securities, purchased, sold or recommended by the manager, are not necessarily held in the manager’s portfolio, and it should not be assumed that any referenced securities were
or will prove to be profitable. Indices are unmanaged and not available for direct investment. This publication has been prepared without taking into account your objectives, financial
situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Past performance is no
guarantee of future results.
PNC Capital Advisors, LLC does not provide legal, tax or accounting advice and does not provide services in any jurisdiction in which it is not authorized to conduct business.
The material contained herein, including any provisions pertaining to issues regarding federal and state taxation, is for informational purposes only and is not intended, nor should
it be used, as tax advice. This material is not intended to replace the advice of a qualified tax advisor, attorney,or accountant and all decisions regarding the tax implications of your
investments should be made in consultation with your independent tax advisor, attorney or accountant.
This publication is the property of PNC Capital Advisors and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other
person. Contents herein should be treated as proprietary information. This material may not be reproduced or used in any form or medium without express written permission.
PNC Capital Advisors, LLC is an SEC-registered investment adviser, offering an array of investment strategies. PNC Capital Advisors, LLC is an indirect subsidiary of The PNC Financial Services Group, Inc.
IN V E S T MEN T S: NOT F DIC IN S URED - NO B A NK OR F EDER A L G O V ERNMEN T GUA R A N T EE - M AY LO SE VA LUE
pnccapitaladvisors.com