Schwab Bond Insights: Munis and Oil Prices, Bonds With "Survivor's Benefits"
- With the drop in yields, long-term Treasury bonds have been the best performer of the year, with Treasuries maturing in more than 10 years generating double-digit returns.
- We don't believe falling oil prices will have a significant impact on the municipal market as a whole, but investors should consider the risks of owning bonds issued by smaller local governments in areas where the oil and gas industry is a major source of revenues.
- Bonds with "survivor's options" can help protect the value of assets to be passed on to beneficiaries.
As 2014 draws to a close, long-term Treasury bonds continue to defy most expectations. With yields marching higher at the end of 2013, consensus expectations were for the upward trend to continue. But those expectations did not play out. Long-term Treasury yields are lower now than where they began the year, and are still close to their 2014 lows.
Due to the drop in yields, long-term Treasury bonds have been the best performer of the year, with Treasuries maturing in more than 10 years generating double-digit returns. However, most short-term Treasury yields are either flat or up slightly for the year, leading to underperformance relative to long-term bonds. Other underperformers include some of the riskier segments of the market, like high-yield bonds, international bonds, and emerging market bonds.
Year-to-date total returns
Source: Barclays, as of November 28, 2014. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.
What does this mean for 2015? As we get closer to the first Fed rate hike, which we anticipate will take place some time in the middle of next year, we think short- and intermediate-term Treasury bonds will likely begin to move even higher.
However, there are still factors that can keep long-term Treasury yields low. Long-term Treasury yields are influenced more by growth and inflation expectations than by monetary policies. Inflation continues to run below the Fed’s target. And the yield advantage Treasuries offer relative to most other developed-market government bonds should prevent long-term yields from spiking much higher. Therefore, we think the yield curve is likely to flatten in 2015, with short-term yields increasing more than long-term yields.
Will Falling Oil Prices Hurt Municipal Bonds?
Falling oil prices can be a welcome sight at the gas pump. The spot price of crude oil has fallen nearly 30% since the summer, and the impact has already been felt in other parts of the markets. But what impact might falling oil prices have on municipalities and what, if anything, should muni investors do about it?
Falling oil prices may be a negative for some municipal issuers because of a potential decline in employment and revenues. In our opinion, a decline in oil prices will have a different impact on states as compared to local governments where oil and gas extraction is a major part of the local economy. States should be less affected, while local governments may suffer due to a potential decline in employment and the lost revenues associated with oil and gas production. This can affect bondholders because shrinking revenue leaves less financial flexibility to meet debt payments.
Oil and gas revenues vary substantially from state to state
States tend to receive revenues from various sources that are tied to the production of oil and gas. Many charge a severance tax—a tax on the removal of non-renewable natural resources—on the extraction, production, and sale of oil. At least 36 states impose some sort of severance tax, and 31 states specifically levy taxes on the extraction of oil and gas, according to the National Conference of State Legislatures. States tend to tax the volume, value, or a combination of both of produced oil and gas. So for some states that tax the volume, tax revenues in theory shouldn't decline so long as production doesn't slow.
States and the local governments may also charge other fees or taxes to generate additional revenues from oil and gas extraction. As can be seen in the chart below, the production of crude oil in the U.S. is highly concentrated in only a few states, and the reliance on severance taxes as a portion of total state tax collections varies.
States with a higher reliance on severance taxes may feel the impact of falling oil prices more than those states with a more diverse revenue stream. For example, California is the third-largest producer of crude oil, but severance taxes account for less than one-tenth of one percent of its total tax revenues, so it's unlikely Californians will feel the impact of falling oil prices as a result of reduced severance taxes. Alaska, on the other hand, might feel the pinch to a greater degree, as severance taxes account for nearly 80% of total tax collections.
States' reliance on severance taxes
Source: United States Census Bureau, as of 2013 and U.S. Energy Information Administration, as of October 30, 2014.
Note: Chart shows only the top 15 domestic producers of crude oil.
Though severance taxes are generally collected at the state level, they are sometimes passed down to the local governments within that state. This distribution of severance taxes to cities and counties varies from state to state and even within states. Some states—Colorado, Montana, and North Dakota for example—distribute a large portion of state severance taxes to counties and local governments. Other states, like Texas and Wyoming, distribute very little in severance taxes to their counties or local governments.
Oil and gas producing areas have other revenue sources
The majority of municipalities with high oil and gas production that don’t receive substantial revenue from severance taxes rely on sales taxes as a major source of revenue, according to a study by Duke University. Sales taxes tend to rise as the economy grows and employment increases.
Recently, employment for areas where oil shale production is economically feasible has been booming. For example, North Dakota—the state with the second-largest oil production—saw employment climb by more than 350%1 and sales tax revenues rise by almost 150% from 2007 to 2013.2
What’s the impact if production is scaled back?
As a result of the recent sharp decline in oil prices, the level of production may decrease, depending on location-specific extraction costs and other factors. At lower oil prices, the economics of extracting some types of oil and other fuels, such as natural gas, are more marginal.
The impact likely won't be equally felt. Only five states account for nearly 75% of U.S. domestic oil production.3 The table below illustrates which states are the most reliant on the mining industry as a percentage of total state GDP. Note that the mining industry includes all forms of mining, not just oil and gas extraction. There may be areas within each state that are not heavily reliant on the mining industry and therefore may not be affected by a decline in oil prices.
States heavily reliant on mining may be more affected if oil production slows
Top 10 States
Mining Industry as a % of Total State GDP
State GO Bond Rating (Moody's)
State GO Bond Rating (S&P)
Sources: U.S. Department of Commerce / Bureau of Economic Analysis / Regional Product Division, as of June 11, 2014 and Bloomberg, as of November 26, 2014.
Note: Wyoming, North Dakota, and Colorado do not have state general obligation bonds outstanding.
The biggest risk in the oil and gas boom
For some states and local governments, growth in the oil and gas industry has increased the economic concentration in a single industry. If producers do cut back, local governments may be stuck holding the bill to pay for the services associated with a growing population, such as increased law enforcement, emergency services, and administrative staff.
We saw a similar situation play out in Stockton, CA, for example, and other areas—but with real estate. When the real estate market was booming, the city of Stockton promised rich benefits for its employees. But when the housing market collapsed and revenues fell, the city was stuck having to pay for these rich benefits and ultimately defaulted on paying their bonds. A boom in revenues could be a good thing, so long as it's not associated with a boom in expenses.
What's a muni investor to do about falling oil prices?
In our opinion, most states should not be negatively affected by a decline in oil prices. States generally have diverse revenue streams which in the past have been a source of financial strength. However, local governments where oil and gas production is the primary source of revenues may be impacted by a decline in oil prices.
These areas generally tend to be sparsely populated and do not have highly diverse revenue streams. As a result, they tend to not issue much debt and are already lower rated. We don't believe falling oil prices will have a significant impact on the municipal market as a whole, but investors should consider the risks of owning bonds issued by smaller local governments where the oil and gas industry is a major revenue source.
For additional help, consider the benefits of professional management or reach out to your local Schwab fixed income specialist.
Why Buy Bonds With "Survivor's Options?"
Bonds with "survivor's options" are not always familiar to investors, but they can help protect the value of assets to be passed on to beneficiaries. A survivor's option is a feature that allows the bond to be "put back," or sold back, to the issuer at its par value before its scheduled maturity date if the bond holder passes away. If interest rates are expected to rise, this feature can help protect the value of assets, whose prices would then fall, since bond prices and yields move in opposite directions.
There are a few types of bonds that may offer a survivor’s option, like brokered certificates of deposit (CDs), agency bonds, and certain corporate bonds. For this article, we will focus on corporate bonds. Of course, there are certain restrictions to the survivor's option feature, so it's important to know the basics first and check the details for each individual security.
Two key requirements must be met for these types of bonds to be put back to the issuer. First, the bond holder must have passed away, and second, the bond must still be held in the account of the deceased bond holder. If the bond gets transferred out of the account—for example, bequeathed to a beneficiary—before being put back to the issuer, the option is no longer valid.
Corporate bonds that have the survivor's option are generally part of a "retail note" program, which is a little different from traditional corporate bonds. Retail notes are issued by some companies on a regular basis—it could be as often as once a week.
Retail notes have some additional risks, like liquidity risk, since the market for them may not be very active.
Retail note issues tend to be smaller in size, unlike large benchmark issues from most corporations. Large investment-grade issuers prefer to issue bonds with large deal sizes—think $250 million or more per issue. In contrast, retail note issues can be less than $10 million per issue. As a result, retail notes tend to be less liquid than large benchmark-sized corporate bonds. While that might not matter for buy-and-hold investors, if you’re looking to sell before maturity the price may be lower than for bonds that have larger deal sizes and tend to be more liquid.
There's also the risk of being over-concentrated in a single issuer or sector. Only a handful of companies participate in retail note programs, making it difficult to get a truly diversified portfolio with a variety of issuers. Of the handful of firms that issue these bonds, many are financial institutions. If you're looking at buying individual bonds in the retail note program, make sure you understand the risks with each issuer.
Retail notes can be bought in both the primary market and secondary market. While retail notes are issued in the primary market at their par value of $1,000, notes trading in the secondary market can trade above or below their par values, depending on the level of interest rates. While most retail notes pay interest on a semi-annual basis, some pay quarterly or even monthly.
The fine print
There are some limitations surrounding bonds with survivor's options, so it's best to know all of the details before you dive in. Each bond may have different terms but they share some of the broad characteristics below.
Holding period. In addition to the requirement that the bond holder must have passed away and the bond still needs to be in the bondholder's account, there is also a holding period that generally needs to be met before a bond can be put back to the issuer. Often, the holding period is six months. That means the bond needs to be held in the account for at least six months before it can be put back to the issuer, even if the bond holder passes away before six months has elapsed. The holding period can vary by issuer. The bond's prospectus can provide the exact details.
Redemption limits. Most issuers also cap how much an account can put back each year, usually $250,000 per account holder. For example, if an account owns $500,000 worth of a single bond with a survivor's option, and the account holder passes away, the account would only be able to redeem $250,000 that year. It would need to wait until the next calendar year to redeem the remainder. Also, most issuers have an overall limit on how much they will redeem in a given year, regardless of who the account holder is. For example, some issuers will only redeem the greater of $2 million or an amount equal to 2% of the principal amount of all outstanding bonds with survivor's options. This will vary by issuer as well.
When do they make sense?
Retail notes with survivor's options can help protect the value of assets to be passed on to beneficiaries. With bond yields so low, any rise in yields can have a negative effect on bond prices.
Under normal circumstances, investors are left with two options when interest rates rise: Hold the bond until maturity, missing out on higher yields that newer bonds offer, or sell the bond—at a lower price—to take advantage of the opportunity to invest in higher yielding bonds. Barring a default by the issuer, bonds with survivor's options can allow an estate to redeem a bond at its par value, even if higher rates have pushed the price in the secondary market below its par value.
Of course, this makes the most sense when a bond is trading at a discount to par value in the secondary market and you think interest rates will rise. If a bond with a survivor's option is trading at a premium, it would make more sense to just sell it at its higher price rather than putting it back to the issuer at par. If the bond was purchased at a premium, and the price remains above the par value, you won't benefit from the ability to put it back at its par value. Given the low interest rate environment, many bonds are priced at a premium these days.
While we generally don't recommend investing in bonds with very long maturities, long-term bonds with survivor's options may make sense for investors who expect to leave assets to their heirs. Although you'll generally earn a higher yield by investing in bonds with longer maturities, many people have avoided them, concerned that the bonds might decline in value. A survivor's option can help mitigate that risk for the account's heirs.
All bonds with survivor's options are different, so it's important to know the details of each issue. And while these bonds can play a part in the planning process, they should never fully encompass your investing strategy; rather, they can help complement other investments in the estate planning process. As with most investments, it's best to speak with an investment specialist to see if these bonds make sense for you.
I hope this enhanced your understanding of Treasury bonds, the impact of oil prices on municipal bonds, and bonds with survivor's benefits. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 Bureau of Labor Statistics, as of April 4, 2014.
2 Rockefeller Institute, as of 2nd quarter, 2014.
3 U.S. Energy Information Administration, as of August 2014.
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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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