Is Your State Muni Bond Fund Investing Elsewhere? Why It Matters
- Many state-specific municipal bond mutual funds invest in states and U.S. territories outside of their home state.
- While out-of-state investing isn’t necessarily a problem, funds with large allocations to lower-rated U.S. territories—such as Guam, Puerto Rico and the U.S. Virgin Islands—could be negatively affected if the credit conditions of those territories continue to deteriorate.
- Investors shouldn’t avoid mutual funds that invest in out-of-state bonds, but should review fund holdings and be careful of funds with especially large allocations to lower-rated U.S. territories.
Managers of state-specific municipal bond funds often look elsewhere for their investments, purchasing bonds issued by other states and U.S. territories.
The tax and diversification benefits, and potential increase in yield for the funds, could make them more attractive to investors. But at the same time, the amount of out-of-state investments in some portfolios could surprise–and be worrisome.
Specifically, we’re concerned about funds with large allocations to U.S. territories such as the U.S. Virgin Islands, Guam, and Puerto Rico that have declining credit conditions and may struggle to meet debt obligations.
Attraction of muni bonds
Municipal bonds’ main attraction is that they generally provide tax-advantaged income. Interest payments on most munis are exempt from federal income taxes, and those from your home state may also be exempt from state income taxes (assuming your state has such a tax).
Investors in states with high state income tax rates, like California or New York, may choose to invest in munis solely from their state to reduce their state tax liability, and some may invest via a state-specific bond mutual fund.
However, many state-specific bond funds can invest in other states or U.S. territories. The interest income from bonds issued by U.S. territories is generally exempt from federal, state and local income taxes in all 50 states, so fund managers can invest in these bonds without generating a state income tax bill for their investors. Occasionally, a surprising percentage of the portfolio is invested in bonds issued by U.S. territories with sub-investment-grade credit quality, which could result in unpleasant surprises for investors in these funds if credit conditions in these territories continues to deteriorate.
Higher yields, higher risks
A fund manager can potentially increase the overall yield on a portfolio by investing in other states or U.S. territories, making the fund more attractive to new investors. This is especially true if they are investing in U.S. territories such as the U.S. Virgin Islands or Puerto Rico, where yields can be higher than 4%, compared with 2.5% for a broad municipal bond index.1
However, investing in these bonds increases the risk of the mutual fund portfolio, due to the lower ratings of bonds from many U.S. territories. This may not be an issue if the fund is only investing small amounts in these riskier bonds but could be a concern if the fund has large allocations to these lower rated territories.
We are most concerned about funds with large allocations to U.S. territories
From a risk perspective, we are generally less concerned about funds investing in bonds issued by municipalities in other states. Investing in other states can offer diversification benefits, and most fund managers will choose investment-grade-rated issuers when crossing state boundaries.
However, some funds may invest a large amount of their portfolio in bonds issued by U.S. territories–specifically Guam, Puerto Rico and the U.S. Virgin Islands. The credit ratings of these territories are often lower than ratings on mainland issuers, and their economies can be shallower and more exposed to credit risk. This reduces the municipality’s flexibility to levy taxes to help pay for the bonds they issue.
Standard & Poor’s currently rates the general obligation bonds of Guam and Puerto Rico below investment grade, as shown in the chart below. Moody’s Investors Service also rates Puerto Rico’s GO bonds below investment grade. Moody’s has no current rating on Guam’s GO bonds. Issuers with below-investment grade ratings have a higher chance, in the rating agencies opinion, of not being able to make timely interest or principal payments. Both S&P and Moody’s have recently downgraded the U.S. Virgin Islands’ senior bonds to B and Caa1, respectively. The territory currently “holds approximately two days' cash on hand and may not have sufficient cash to meet obligations including pay-roll obligations,” according to S&P.
Ratings for three U.S. territories are all below investment grade
Source: Moody’s and S&P, ratings obtained on 3/3/17. *Ratings listed in the chart for U.S. Virgin Islands are for senior bonds, whereas ratings for Puerto Rico and Guam are for general obligation bonds.
The performance of funds with investments in bonds issued by these U.S. territories could be negatively affected if their credit quality worsens and their bonds fail to make timely interest or principal payments.
A state with limited munis outstanding may be more likely to invest out of state
Adequate diversification may be more difficult to achieve for states with a limited number of issuers, like Wyoming, which only has eight obligors that are rated by Moody’s. This isn’t a problem for states that have a large inventory of bonds from issuers with different credit characteristics, like California, which has nearly 1,000 obligors. However, fund managers of state-specific funds in states with a limited number of issuers may be more likely to invest in bonds outside of their home state.
Many funds invest outside their home states
This map shows Moody’s-rated obligors by state.
Source: Moody’s Investors Service, as of 2/8/2016.
The practice of investing in bonds outside of the fund’s home state is common. Of the 16 different funds on the Schwab OneSource State Tax-Free Bond Fund List, 10 have allocations to states other than their home state and nine of those have allocations to Guam, U.S. Virgin Islands or Puerto Rico.
However, the exposure for most funds on the Schwab OneSource State Tax-Free Bond List is limited. The largest allocation is 6.2% in a Nuveen Connecticut fund, as of the last statement dated Jan. 31, 2017.
Not all state-specific funds have limited exposure, though. For example, a Wisconsin mutual fund that isn’t on the OneSource State Tax-Free Bond Fund List had 29% of the fund allocated to Guam, Puerto Rico, or the U.S. Virgin Islands.2 Some of these bonds may be investment-grade or carry credit enhancements such as additional collateral, insurance or third-party guarantees. These credit enhancements may increase the rating on the bond, or ensure timely interest or principal payments if the municipality is unable to make the payment. As such, we don’t believe investors should sell their mutual fund solely because of holdings in U.S. territories. But it’s important to know what the fund owns.
Funds’ approach to out-of-state investing varies widely
Source: Bloomberg; data obtained on 3/1/2017.
Note: Reporting date of each mutual fund may differ and actual current exposure to bonds may vary. Funds selected are the 16 funds on the OneSource State Tax-Free Bond Fund List.
What to do
We don’t believe investors should avoid state specific-mutual funds merely because they own out-of-state bonds. Investors in high state-tax brackets can reduce their state tax liability by investing in a state-specific fund, and investing in mutual funds is often an appropriate way to gain diversified exposure to the municipal bond market, as the funds provide professional monitoring and greater diversification for each dollar invested (compared with investing in individual bonds).
However, investors should be aware that state-specific funds may not invest 100% in their home state and may hold outsized positions in other states or U.S. territories. We would suggestion caution for funds that are investing more than 10% of their holdings in bonds from territories with below investment grade ratings.
Investors can review the holdings of their mutual funds in the fund’s semi-annual or annual report,3 which generally includes a breakdown of the amount of investments by state or U.S. territory. For assistance in reviewing a fund’s holdings, consider reaching out to a Schwab Fixed Income Specialist.
1As represented by the yield to worst on the Bloomberg Barclays Municipal Bond Index.
2As of their most recent reporting date, Jan. 31, 2017.
3Note that a fund’s investments may have changed since the most recent semi-annual or annual report.
Investors should consider carefully information contained in the prospectus, or if available, the summary prospectus, including investment objectives, risks, charges and expenses. Please read it carefully before investing.
Past performance does not guarantee future performance. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost. If an expense waiver was in place during the period, the net expense ratio was used to calculate fund performance
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions.. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly
Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
All fund names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
The Bloomberg Barclays Municipal Bond Index (“Municipals”) is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.