Municipal bonds are issued by state, city and local governments, generally to fund daily operations or to build specific projects such as roads, bridges or hospitals. To thoroughly analyze them, you can delve into the issuer’s budgetary practices, unfunded liabilities, tax collection record, the viability of the project, and so on.
Reviewing the elements above is important, but at the simplest level, consider where the bond issuer is located. You’ve probably heard the real estate agent’s mantra: “location, location, location.” As with real estate investing, understanding the economics of a region is important to investing in muni bonds. Knowing which cities and states are expanding or contracting, and why, can help you make smarter investment decisions.
Look for areas that are growing
Cities and states with strong, expanding economies are often in healthy fiscal shape, which supports their ability to make debt payments. Their muni bonds may be good prospects for investors. The cities whose economies have grown the fastest in recent years all had these characteristics:
- Steadily increasing populations
- Relatively skilled workforces
- Diverse industries
For example, Dallas-Fort Worth, Austin, San Francisco, Denver and Seattle were among the cities with the fastest growth in inflation-adjusted gross domestic product (GDP) in 2014, according to the latest metro-area data published by the U.S. Bureau of Economic Analysis.1 Population growth in those cities also was relatively strong: Austin’s population grew by 3% in 2014, followed by Denver (2%), Dallas-Fort Worth (1.9%), Seattle (1.6%) and San Francisco (1.4%).2
An area’s growth trajectory should be more important for muni investors than its total size. For example, Austin had the fastest population growth (13.2%) of any major U.S. metro area from 2010 to 2014,3 even though it ranked just 35th in size. Meanwhile, Austin’s real GDP grew by 6.1% in 2014—more than twice the 2.3% average for all U.S. major metropolitan areas.4 By comparison, GDP for the New York-Newark metropolitan area, easily the nation’s largest, grew just 2.4% in 2014.5
The areas with the fastest GDP growth also tend to have diverse economies. For example, Seattle is home to many major corporations in different industries, such as Boeing, Amazon, Microsoft, Starbucks and Nordstrom—giving it footholds in the aerospace, e-commerce, technology, restaurant and consumer retailing industries.
In general, cities and states with strong, stable economic and population growth and a diverse business base are better able to weather economic downturns and have greater flexibility to meet their debt service—a plus for muni investors.
Invest cautiously in riskier areas
Investors should exercise caution when investing in areas with slowing or negative growth. We are also cautious about areas that have a high reliance on one industry with little economic diversity.
Detroit, for example, has long been highly dependent on the automotive industry. When the automotive industry was in trouble, it took Detroit down with it. From 1990 to 2004, Detroit’s population declined nearly 34%, even as the U.S. population grew by 28%.6 The slump left Detroit unable to cover its expenses, and the city filed for bankruptcy protection in 2013.
More recently, we’ve seen areas highly dependent on oil and gas—Alaska, Oklahoma, North Dakota and West Virginia—suffer as the price of oil has plunged more than 65% since mid-2014.7 Texas, which has a large oil and gas industry but also a diverse economy, has fared better. Severance taxes—or taxes on the extraction of nonrenewable resources—account for only 11% of the state’s taxes, compared to 54% of North Dakota’s and 72% of Alaska’s.8
The Philadelphia Federal Reserve Bank’s state coincident indexes—a summary of state-level economic indicators, such as the unemployment rate and average hours worked in manufacturing—provide a sense of which state economies are improving and which are worsening. As of November 2015, economic conditions were worse than in the previous three months for Wyoming, North Dakota and Alaska, states whose economies rely heavily on oil and gas revenue.
Cities with aging manufacturing industries, most of which are in the Rust Belt, also carry more risks. These cities generally have declining populations and a higher-than-average number of residents living below the poverty line, which usually results in lower tax revenues for the municipality. This can mean the municipality has less flexibility to meet its debt service—a red flag for bondholders.
We would also caution against boom-and-bust areas. Growth is a good thing, but only if it’s steady and sustainable. We believe you should be careful of cities that grew quickly during the housing boom, for example. Some cities added many new homes without a corresponding expansion in the job base or local economy. Those municipalities tended to be among the most exposed to the drop in home construction and property values. Although the housing market has bounced back from the lows of 2008, some of these areas have not fully recovered. For example, the unemployment rate for Stockton, California, was 8.6% in November 2015,9 well above the national average of 5%.10
Favorable demographics and a strong, diverse economic base can support an issuer’s ability to make coupon payments and eventually repay investors’ principal. That’s important for investors who are using municipal bonds as part of a diversified portfolio, where muni’s benefits include potential tax savings (their interest is usually exempt from federal—and often state and local—income tax) and sometimes higher yields than other comparable taxable investment-grade fixed income investments.
1 U.S. Bureau of Economic Analysis, Real Gross Domestic Product by Metropolitan Area (2014 change from 2013), as of 9/23/2015.
2 U.S. Census Bureau, Estimates of Resident Population Change and Rankings: July 1, 2013 to July 1, 2014. Data as of 5/21/2015.
3 U.S. Census Bureau, Cumulative Estimates of Resident Population Change and Rankings: April 1, 2010 to July 1, 2014. Data as of 5/21/2015.
4 U.S. Bureau of Economic Analysis, Real Gross Domestic Product by Metropolitan Area (2014 change from 2013), as of 9/23/2015.
6 U.S. Census Bureau. Data as of 8/31/2015 for 2014 estimates and as of 5/21/2012 for 1990 population estimates.
7 Bloomberg, change in price for West Texas Intermediate (WTI) crude oil futures contracts from 7/1/2014 to 1/5/2016.
8 U.S Census Bureau, 2014 Annual Survey of State Government Tax Collections, as of 4/16/2015.
9 U.S. Bureau of Labor Statistics, Metropolitan Area Employment and Unemployment, November 2015. Data as of 12/30/2015.
10 U.S. Bureau of Labor Statistics, Employment Situation, November 2015. Data as of 12/4/2015.
Where to start?
When you evaluate potential muni investments, you’ll want to do the following:
- Start with the credit rating. We suggest a rating of A (Standard & Poor's) / A2 (Moody's) or better.
- Stick with areas that have stable or steadily increasing populations. Those close to diverse and growing employment centers are also more attractive.
- Consider investing in areas not dominated by one industry. This is a little tricky, as it requires knowledge of the area. Areas with diversified economies are generally less vulnerable to economic shocks. Plus, they tend to recover more quickly from economic declines.
- Seek portfolio diversification. We suggest avoiding concentration in any particular region or security.
- Consider the tax implications. If you live in a state or city with high income taxes, then you may want to stick with muni bonds from that state to retain the tax benefits.