Out of (state) bondage
linkages between bond issuers, investors can
BY RICHARD SAPERSTEIN AND KATHLEEN BRAMLAGE
Tax advisors often recommend that investors purchase municipal bonds issued in the state
where they reside to avoid state and local taxes on the interest income. However compelling this
strategy may appear, it also results in increased risk.
Exploring the benefits of out-of-state municipal bonds
The 2008 crisis and the weak economy has
led to increased financial stress on state and
local governments, reduced tax collections,
and budget gaps. As a consequence of these
risks, we are proponents of geographic diversification within municipal bond portfolios.
The benefits of geographic diversification in
portfolios are identified below.
economies, declining tax revenues and budget shortfalls may not be able to rely on state
aid if the state is experiencing similar problems. New York State, New York City and the
state’s school districts illlustrate this. The 2008
meltdown in the financial markets resulted in
massive job losses, and greatly reduced sales
and income tax receipts. As a result, the state
is experiencing fiscal stress. Investors that
own bonds issued by the state, New York City
and certain school districts are now highly
exposed to concentrated risk.
Political risk can also be a factor. In a num-
ber of states, particularly California, Colora-
do, Oregon and Florida, voters have initiated
legislation imposing tax limitations and/or
reductions. Voters in California passed Prop-
osition 13 in 1978, tying real estate taxes to
1975 assessed values and, except when a
house was sold, capping annual increases in
assessed values at 2 percent. Consequently,
cities and counties became increasingly re-
liant on investment income. This led to in-
creased risk-taking and, in one especially
notable instance, Orange County defaulted
on its debt in December 1994. Investors can
reduce exposure to the unintended conse-
quences of voter initiatives by diversifying
outside those states where state constitutions
make such initiatives more likely to evolve.
INDUSTRIAL REVENUE BONDS
A little known segment of the municipal bond
market is industrial revenue bonds, which are
tax-free, subject to the Alternative Minimum
Tax, and typically guaranteed by a corporate
issuer. In essence, investors can adjust the
credit risk to that of the corporate guarantor,
although IRBs are only issued in those states
that benefit from the corporate project being
funded. For example, following the BP spill, a
trading opportunity in BP-backed IRBs arose.
However, these bonds were issued in only a
handful of states, including Texas, California,
and Indiana. Investors should consider the
benefits of these types of securities, even if
they are out of their home state.
When a state or region is impacted by a natural or man-made disaster, the ability of that
state or region to pay bondholders may be
compromised. The economic impact of Hurricane Katrina and the BP oil spill on Louisiana is a prime example. Louisiana’s current
revenues are approximately 14 percent lower
than in 2009, and all agencies and authorities
have been directed to prepare budget cuts.
Investors concentrated in Louisiana municipals will be adversely affected.
Municipalities suffering from weakened
Richard Saperstein is managing part-ner/principal/senior portfolio manager,
and Kathleen A. Bramlage is a director, at
Treasury Partners, a Chicago-based independent advisory platform registered with
High Tower Securities.
Some state authorities rely on annual appropriations that must be approved by state
legislators. States in fiscal distress may reduce
these appropriations in order to achieve a balanced budget. The State of Illinois recently reduced its annual appropriation to the Illinois
Regional Transit Authority. As a result, the
RTA is facing a budget deficit and the Chicago
Transit Authority, which is a beneficiary of
these appropriations, has been forced to cut
services by 18 percent. Bonds issued by both
of these agencies have declined in value.
However, not all state appropriations are
created equal, and in fact the process in
some states is stronger. In New Jersey, the
N.J. Transportation Trust Fund Authority also
relies on the state for annual appropriations.
The revenues that are used for the appropriations include gasoline taxes, motor vehicle
fees and sales taxes on new vehicles. Unlike
Illinois, these revenues are constitutionally
dedicated for transportation purposes only,
and it is therefore highly unlikely that the
state will use them for other purposes.
By understanding the tiered effects of state
appropriations, and avoiding the financial
Investors should note that bonds issued from
states with high income tax rates that offer
state tax exemption for in-state bonds tend
to trade at lower yields than those of states
that do not have a state income tax, like Texas.
This additional yield could potentially offset
the added state and local income tax required
from holding out-of-state bonds.
One of the casualties of the crisis in the
financial markets was the demise of municipal bond insurance. With bond insurance,
many investors were less concerned about
diversification because principal and interest
payments were “guaranteed” by the insurer.
Now, investors must have a better understanding of the underlying credit quality of
the municipal bonds they own.
Increased scrutiny of issuers and geograph-
ic diversification are the hallmarks of a prop-
erly executed municipal bond strategy. AT
business in the financial world. Other coun-
tries, however, have not declared transpar-
ency as their way of doing business. Not only
is transparency important with respect to
costs, but it is an issue with financial report-
ing, insider trading, management experience,
mergers and acquisitions, trade secrets, and
corporate business plans in general. Sea-
soned foreign investors spend millions in
additional diligence to enhance their deci-
understand is that inflation rates published by
different countries cannot be compared simply. Beyond developed nations, double-digit
or triple-digit inflation happens every year
somewhere in the world, and it can change
fast. You do not want to get washed away in
another country’s tsunami of inflation.
Hopefully, these risks haven’t overshadowed the opportunities available by investing globally. And if you’re still game, the only
questions left are what countries, what asset
classes and how much.
When I started as an investment advisor in
the 1980s, it was common to hear investment
consultants speak in terms of a 5-percent-to-
10-percent position in foreign equities. For-
eign holdings were viewed as non-correlating
assets. Today, it appears to be a bit more cor-
related than it was 30 years ago, and many
economists have stated a case for holding as
much as 40 percent of one’s portfolio in for-
eign investments. Some economists, perhaps
a bit more extreme or radical, have made even
bolder predictions and suggest a majority of
your portfolio in foreign investments.