If you invest in municipal bonds, it’s probably for their tax benefits. Interest payments are often exempt from federal income taxes, and munis from your home state may also be exempt from state and local income taxes. What investors in state-specific bond funds might not be aware of, however, is that fund managers can—and often do—invest in munis from other states or U.S. territories (see “Altered states,” below).
Of the 23 funds on the Schwab OneSource State Tax-Free Bond Fund List, 12 have allocations to states other than their home state—and 16 have allocations to Guam, Puerto Rico and/or the U.S. Virgin Islands.
Source: Schwab.com and Bloomberg L.P., as of 08/03/2017. A fund’s exposure to sub-investment-grade bonds must be less than 10% to be eligible for the Schwab OneSource State Tax-Free Bond Fund List. Reporting dates of mutual funds may differ and actual current exposure to bonds may vary. All funds and market data shown are for illustrative purposes only and are not a recommendation, offer to sell or a solicitation of an offer to buy any security.
Most fund managers opt for investment-grade bonds when crossing state lines. However, that’s not always the case when investing in munis from U.S. territories, particularly general-obligation bonds from Guam and Puerto Rico and the senior-most bonds issued by the U.S. Virgin Islands Public Finance Authority—all three of which have lower credit ratings than their lowest-rated mainland counterparts (see “Credit crunch,” below).
Bonds from Guam, Puerto Rico and the U.S. Virgin Islands are all sub-investment grade—unlike their lowest-rated mainland counterparts.
Source: Moody’s and Standard & Poor’s, as of 09/19/2017. Ratings listed are for Connecticut’s, Guam’s, Illinois’, New Jersey’s and Puerto Rico’s general-obligation bonds and the U.S. Virgin Islands Public Finance Authority’s senior-most bonds. For illustrative purposes only. Not a recommendation.
Puerto Rico has had a particularly troubled recent history. On May 3, the Financial Oversight and Management Board for Puerto Rico filed a petition to put the central government into bankruptcy-like protection—a byzantine process further complicated by September's hurricanes—which is why Schwab now classifies Puerto Rico’s bonds as speculative investments.
So why might fund managers invest in bonds from sub-investment-grade territories?
1. Tax-free income
As with many munis, bonds from U.S. territories offer interest income that’s exempt from federal, state and local taxes—regardless of where you reside.
2. Potentially higher yields
Many munis from Puerto Rico and the U.S. Virgin Islands, for example, currently offer yields of 4% or more, compared with roughly 2.3% for a broad municipal bond index.1 Of course, higher yields generally reflect a greater risk of default. This may not be an issue if a fund has a relatively low exposure to such bonds, but not all fund managers are so restrained.
Some states have so few munis outstanding that they must cross state lines to maintain adequate diversification.
What to do
Don’t avoid state-specific muni-bond funds merely because they include out-of-state bonds—but do look under the hood. Those with relatively high exposures to sub-investment-grade U.S. territories, for example, may increase a fund’s risk profile beyond what you’re comfortable with.
Cooper Howard, CFA®, is a senior research analyst at the Schwab Center for Financial Research.
1As represented by yield to worst on the Bloomberg Barclays Municipal Bond Index, as of 06/30/2017.
What you can do next
- Call a Schwab fixed income specialist at 877-566-7982 for help assessing your muni-bond portfolio.