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Is Now the Time to Buy State Municipal Bonds?

Is now the time to add bonds issued by states to your municipal portfolio? Certain states may be poised to benefit from recent developments such as higher oil prices, legalized sports gambling, and potentially new sources of revenue. Meanwhile, yields on an index of state municipal bonds have increased by 130 basis points since last summer.1

We have a favorable view of municipal bonds issued by most states, but believe that investors should be selective about which states they choose and the maturities they select. Here are some things you should know.

State municipal bonds are bonds that are issued by the state government and are most often backed by the state’s general fund including tax revenue. Like other municipal bonds, interest paid is generally exempt from federal income taxes as well as state income taxes if purchased from your home state.

1. Recent developments could help some states, but the impact is likely to be small.

Higher oil prices, legalized sports gambling and marijuana revenues are all recent developments that could help boost states’ financial revenues. However, their impact is likely to be small, in our view, or it’s still too early to predict what effect they will have on a states’ credit quality.

  • Most state revenues will be unaffected by higher oil prices. Crude oil prices have risen by approximately 70% 2 since last summer, which could modestly boost revenues for a few states that have a large oil and gas industry. However, because states tend to have diverse revenue streams with little to no reliance on the oil and gas industry, credit quality for most will not change due to higher oil prices. Oil and gas production in the U.S. is concentrated in a few states. Just three—Texas, North Dakota and California—account for nearly two-thirds of total U.S. oil production. Many states 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. For some states where this tax based on value, tax revenues in theory should increase, as oil prices have risen.
  • Marijuana revenues likely won’t have a meaningful impact on state revenues. California legalized the sale of recreational marijuana on January 1, 2018 making it the ninth and largest state to legalize the use of recreational marijuana. Twenty-nine other states allow marijuana use in some form, according to Moody’s. Recreational marijuana use is heavily taxed by the states that allow it, creating  a new source of revenue. However, according to Moody’s, it’s only marginally a credit positive for the states that allow it. For example, Colorado, the first state to legalize recreational marijuana, taxes recreational marijuana sales at 30% while also receiving marijuana application and licensing fees. In 2017, total revenue was $223.5 million, and the state projects total state marijuana revenue will to grow to $258.6 million in fiscal year 2018.3 However, it’s unlikely to have a large impact on the state’s credit quality because just 5% of the revenues went to the state’s general fund—the fund used to pay bonds.
  • It’s too early to tell how legalized sports gambling will affect state revenues.On May 14 the U.S. Supreme Court struck down a 1992 statute that prohibited legalized sports gambling. The state of New Jersey brought the suit and is likely to become the second state, after Nevada, to allow legalized sports gambling. This creates a new potential source of revenues for the state, but the impact to the state’s financial position will likely be limited. Using a study by Oxford Economics that was commissioned by the Gaming Association, Municipal Market Advisors calculated that direct tax revenues from sports betting will only account for between an estimated 0.1% and 0.3% of the state’s fiscal year 2018 budgets.

2. Credit quality for state municipal bonds is generally high and relatively stable already.

Most states have large and diverse economies and usually are not heavily reliant on one source of revenue. For example, if California were a country, its economy would be the fifth largest in the world—larger than the United Kingdom’s, but smaller than Germany’s.4 Diverse revenues and generally broad leeway to raise revenues are factors that have tended to result in high and usually stable credit ratings. As shown in the map below, 45 states have either AAA or AA ratings, the top two possible rungs. However, some states are struggling with outsized pension obligations and declining populations, issues that could weigh on their credit quality in the future. States have also had a strong track record of paying timely interest and principal payments on their bonds. The last time a state defaulted on one of its bonds was Arkansas in the 1930s, during the Great Depression.5

Forty-five states have AAA or AA credit ratings from Moody’s

Forty-five states have AAA or AA credit ratings from Moody’s. Only five—Connecticut, Kentucky, Illinois, New Jersey and Pennsylvania—have credit ratings lower than AA.

Source: Standard and Poor’s as of 5/18/2018 and Moody’s as of 5/22/2018

3. We’re getting late in the economic cycle, and an economic downturn could hurt some states’ credit quality.

Although the current economic landscape for states is generally favorable, we believe that we are in the later stages of the U.S. economic cycle, as evidenced by different factors such as slowing state revenues and slowing growth in state employment. Since September 2017 the annual change in state employment has been negative, as shown in the chart below. States, unlike the federal government, have to balance their annual budgets, and one way to do this is to reduce expenditures, including state employment, if revenues fall.

Year-over-year growth in state employment has been negative since fall 2017

Year-over-year growth in state employment has been negative since September 2017.

Source: Bureau of Labor Statistics, as of 6/1/18

4. Moody’s Analytics believes 15 states are unprepared to weather the next economic downturn.

We don’t believe that there is a risk of a recession in the near term, but it has been nearly nine years since the last recession. A moderate recession likely would result in a decline in state revenues, which could be offset by spending from the state’s financial reserves—if available—or cutting expenditures. Moody’s Analytics recently found that 15 states lacked the financial reserves to weather a moderate recession, in their view, without budget cuts. Lacking adequate reserves reduces the state’s financial flexibility and could lead to downgrades on their bond ratings. When a bond is downgraded its price generally falls.

The table below shows the financial preparedness for the 15 states that account for the greatest portion of the Bloomberg Municipal Bond Index, a broad-based index often used to represent the total municipal bond market. For example, in the table below, Texas has 21.7% of its projected fiscal 2017 revenue in cash reserves. Based on Moody’s analysis, it would need 11.7% of its projected fiscal 2017 revenues in reserves to weather a moderate recession. Texas is prepared for a moderate recession, in Moody’s view, because it has 10 percentage points more in actual reserves than necessary reserves. Illinois, on the other hand, is not prepared for a moderate recession, in Moody’s view, because it only has 0.4% of projected revenues in reserves, whereas Moody’s projects a need of 11.1% of projected revenues—a difference of 10.7 percentage points.

State preparedness for a moderate recession

 

State

Actual reserves as a % of FY2017 projected revenues

 Necessary reserves as a % of FY2017 projected revenues

Difference between actual and necessary reserves (in percentage points)

Texas

21.7%

11.7%

10.0

Washington

10.1%

9.2%

1.0

New York

10.0%

11.0%

-0.9

Ohio

7.9%

9.2%

-1.4

Georgia

8.8%

10.4%

-1.6

Florida

9.5%

12.2%

-2.7

Maryland

5.5%

9.0%

-3.5

Massachusetts

3.1%

6.9%

-3.8

Michigan

9.8%

13.9%

-4.2

California

5.9%

10.7%

-4.8

Arizona

5.7%

12.4%

-6.7

Virginia

3.4%

10.9%

-7.5

Pennsylvania

-1.8%

6.9%

-8.8

New Jersey

1.4%

11.0%

-9.6

Illinois

0.4%

11.1%

-10.7

Source: Moody’s Analytics, as of October 2017. Assumes a “moderate recession” as defined by Moody’s Analytics. States selected represent the top 15 largest states in the Bloomberg Barclays Municipal Bond Index as of 5/18/2018. Difference between actual and necessary reserves may be off due to rounding.

Lack of preparedness and reserves, as defined by Moody’s, is more predictive of changes to a state’s credit rating, in our view, not necessarily default.  But investors looking for stronger state issuers with more flexibility should look for states with higher preparedness and reserves.

Be selective about where on the yield curve you invest

Investing in your home states municipal bonds can be beneficial, if you live in a state with state income taxes. Interest paid on municipal bonds from your home state is not subject to state income tax.  But where you invest on the yield curve is important, as well. The chart below shows the difference in yield between an index of state general obligation (GO) bonds and a AAA-rated benchmark index for select states and maturities. Using California, the light blue bar, as an example, a one-year California GO yields about 15 basis points less than the AAA-rated benchmark index.

Because California is rated lower than AAA, at AA3/AA-, investors considering a one-year California GO may be taking on more credit risk but earning less in yield. In this case, investors considering one-year California GOs may want to consider other options for the one-year portion of their muni portfolio, depending on other investments in your bond portfolio and tax rate.

By comparison, other than the four-year index, the indices of Texas GOs currently yield more than the AAA-rated index, so it may be possible for investors considering Texas GOs to achieve higher yields than the AAA-rated index.

Source: Bloomberg, as of 6/1/2018

The chart shows the difference in yield for an index of state general obligation bonds compared to the Bloomberg BVAL Muni Benchmark curve for selected maturities. The example is provided for illustrative purposes only. It is not intended to represent a specific investment product. The example does not reflect the effects of taxes or fees.

 What to do now

Overall, most states have a strong ability to pay their debts, in our view, and their financial positions, on average, have improved since the end of the Great Recession. We generally have a favorable view of state credit quality and believe they can often serve a purpose in a well-diversified muni portfolio. But if you’re worried about credit risk, avoid the lower-rated states—or diversify your portfolio.

 

1 Source: As represented by the change in the yields to worst on the Bloomberg Barclays Municipal Bond: State GO Index from 7/29/2016 to 5/16/2018

2 Source: Bloomberg, as represented by the percentage change in crude oil futures from 6/21/17 to 5/21/2018

3 Source: Moody’s Investor Services, as of 5/8/2018

4 Source: The Bond Buyer, as of 5/7/2018

5 Source: The Bond Buyer, as of 11/2/2015

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures

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.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic 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.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

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.

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.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Bloomberg Barclays U.S. Municipal Bond Index (“Investment grade munis”) 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 Bloomberg 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.

The BVAL Muni Benchmark Curve is the baseline curve for BVAL tax-exempt munis. It is populated with high quality US municipal bonds with an average rating of AAA from Moody's and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues calendars, and other proprietary contributed prices. Represents 5% couponing.

The US California Muni BVAL Curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of California.

The US New York Muni BVAL Curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of New York.

The US Texas Muni BVAL Curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of Texas.

The US Florida Muni BVAL Curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of Florida.

The US Ohio Muni BVAL Curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of Ohio.

 Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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