Download the Schwab app from iTunes®Get the AppClose

  • Find a branch
To expand the menu panel use the down arrow key. Use Tab to navigate through submenu items.

Is Your State-Specific Muni-Bond Fund Investing Across State Lines?

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).

Altered states

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).

Credit crunch

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.

3. Diversification

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.
Too Much of a Good Thing: What Happens When an ETF Outgrows Its Underlying Index?
Taming Taxes: Strategies for Minimizing Your Bill

Important Disclosures

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal or investment-planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

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.

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.

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

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.

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.

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 Bloomberg Barclays Municipal Bond Index is a broad-based benchmark that measures the investment-grade, U.S.-dollar-denominated, fixed-rate tax-exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

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

(1117-77JK)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.