When you buy a municipal bond, you’re making a loan to a state or local government, for which it promises to pay you back an amount at some date in the future—potentially as long as 30 years in the future. How do you know if the municipality will be able to make good on its promise by then?
At the most basic level, the credit quality of a municipal bond issuer is largely influenced by the economics of the region in which it’s located. Issuers in thriving economic regions with stable or growing populations generally have greater financial flexibility and can meet their debt payments more easily. Knowing which areas are prospering and expanding today, and what to watch for in the future, can help muni bond investors avoid potential credit problems down the road.
Detroit is an illustration of why muni investors should pay attention to regional trends
Once a beacon of American industrial prosperity, Detroit filed for bankruptcy protection in 2013. At the time it was the largest-ever municipal bankruptcy in U.S. history. However, it was not surprising to municipal bond analysts, given the city’s previous demographic and economic trends. For many years the city suffered from myriad issues, including:
- a shrinking population
- a large share of residents living below the poverty line
- a workforce whose average education level was lower than the national average
- real estate values, which are the bedrock of local government finances, that greatly lagged the rest of the country
- a heavy reliance on a single industry: the auto industry
Detroit’s poor demographic and economic trends helped contribute to its financial demise
Sources: 1990 and 2010 U.S. Census, data obtained on 7/9/2019. S&P CoreLogic Case-Shiller U.S. National Home Price and Detroit Home Price indices for change in home prices.
The demographic and economic problems resulted in a declining tax base and ultimately contributed to Detroit having to file for bankruptcy protection. In the end, bondholders recovered between 12 cents and 73 cents on the dollar of what was originally promised to them. Detroit issued bonds backed by different security pledges. Those with weaker pledges—certificates of participation—received 12 cents on the dollar, whereas those with stronger pledges—unlimited tax general obligation bonds—received 73 cents on the dollar.
Vibrant, growing areas tend to have more stable finances
Municipal bonds are usually backed by a specific revenue pledge, like a claim on sales tax revenue; by the revenue generated by the enterprise, like an airport, or water and sewer system; or by the taxing authority of the local government. Areas with strong and stable economic growth typically are better able to weather economic downturns and have greater flexibility to meet debt service. Cities and local governments that had higher-than-average economic output, measured by gross domestic product, over the past five years all tended to have these elements in common:
- steadily increasing populations
- relatively skilled workforces
- diverse economies
For example, areas such as Seattle, San Francisco, Dallas and Denver all had above-average economic output over the past five years. These areas all tended to have a skilled and diverse workforce that was increasing at a faster rate than other metropolitan areas. For example, the Seattle metropolitan area is home to many major corporations in different industries, such as Amazon, Costco, Microsoft, Starbucks and Nordstrom. Partly due to the economic diversity, Seattle’s economic output grew at one of the fastest rates in the country during the past five years.1
The favorable economic and demographic trends helped boost property values in those areas at a faster rate than the rest of the nation, as illustrated in the chart below. This generally benefited revenues for local governments in those areas, because property taxes tend to make up the largest share of revenue for local governments.
Increasing property values tend to benefit local government revenues
Source: S&P CoreLogic Case-Shiller Indices, as of 4/30/2019.
Which areas suggest caution?
We would suggest caution toward issuers in areas that:
- are highly dependent on one industry
- have an aging population
- are rural
Areas that are highly reliant on one industry tend to have less financial flexibility if there’s an economic downturn. For example, one factor that lead to Detroit’s demise was its reliance on the auto industry—when the automotive industry was in trouble following the 2008 credit crisis, it took Detroit down with it.
We also suggest caution toward areas with aging populations, as younger populations tend to increase economic activity. On average, older populations tend to consume less, leading to lower tax revenues for the issuer. An older population also can negatively affect muni issuers in different ways. For example, older populations tend to travel and commute less, which can lead to lower revenues for issuers like airports, transportation systems and toll roads.
Finally, we’re generally cautious on more-rural areas. These areas tend to have a high reliance on one industry, and their smaller populations make them more susceptible to population declines.
Municipal bond defaults and impairments historically have tended to be clustered in counties and metropolitan areas that are smaller (measured by population) and poorer (measured by gross domestic product, housing values and income levels), according to Municipal Market Analytics. Large metropolitan areas also tend to have more diverse economies, and are therefore generally better suited to weather an economic downturn.
Cities with aging manufacturing industries, many in the Rust Belt, are notable exceptions. Rust Belt cities today generally have declining populations and a higher-than-average number of residents who are unemployed. That usually results in lower tax revenues for the municipality and therefore less financial flexibility to meet debt service. This is a negative for bondholders.
Many cities in the Rust Belt are struggling with demographic and economic declines
* Unemployment rate is a 2017 estimate.
Sources: U.S. Census Bureau using the 2000 and 2010 census for population change. For all other statistics, American Fact Finder at census.gov, which uses the U.S. Census Bureau’s 2013-2017 American Community Survey Five-Year Estimates. Data obtained on 7/9/2019.
Don’t take demographic trends too far
The underlying economics of a region are important to the revenue generating ability of a bond issuer but we would caution against taking it too far. For example, a growing population can lead to greater revenues, but it can also put increased strain on the resources of an issuer. Growth is often a good thing, but not when it’s unsustainable. Be cautious of areas that are growing too fast and causing financial strain for the municipality.
What to consider now:
When considering potential municipal bond investments, we suggest you:
- Start with the credit rating. Areas with stable or steadily increasing populations that are not dominated by one industry will usually have greater financial flexibility, but demographics are only one piece of the puzzle. A bond’s credit rating takes into account other factors, such as amount of debt outstanding and the quality of management, and provides an opinion on the issuer’s ability to meet payments on their debt.
- Diversify. It can be tempting to focus most of your investments in a select number of areas with favorable demographic trends, but we would caution against that strategy. If investing in individual bonds, we suggest diversifying your exposure among at least 10 different issuers with differing factors. For a greater selection of municipalities to choose from, consider diversifying with issuers outside of your home state. We generally suggest a portfolio of bonds for investors in most states (with the exception of New York and California, two high-tax states whose residents may benefit from sticking to in-state munis).
- Consider professional management. If you don’t want to spend your time focusing on demographic trends or reviewing bond documents, you’re not alone. Consider investing in munis via a fund or separately managed account. These choices usually have a team of professionals to help monitor the portfolio and credit quality.
For help in determining which options are appropriate for you, contact a Schwab fixed income specialist.
1 Source: U.S. Bureau of Economic Analysis, as of 4/9/2019.
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