The Importance of Geographic Diversification in Today s Municipal Bond Market

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1 The Importance of Geographic Diversification in Today s Municipal Bond Market August 2014 OVERVIEW In the municipal bond market, a state-specific investment focus will reduce tax liability in most circumstances. However, this tax objective can run counter to portfolio management practices established to maximize risk-adjusted after-tax total return. Adam Mackey Managing Director Municipal Fixed Income State-specific investment policies subject an investor to a number of risks from which a geographically diversified portfolio could shield investors, including 1) a limited investment grade opportunity set, 2) inordinate exposure to state- or regional-specific events, and 3) a portfolio of bonds with highly correlated returns. Evaluation of a state-specific investment must include assessment of both the depth and breadth of the state market; state issuer diversity by sector type, rating level, and pledged cash flows; and general credit quality, in addition to tax implications. DIVERSIFICATION IN A MUNICIPAL BOND PORTFOLIO William Bonawitz, CFA Director of Municipal Research The PNC Capital Advisors Municipal Fixed Income team has long expressed the benefits of building purpose-driven municipal bond portfolios consisting of assets that provide layers of diversification. Asset diversification across state, sector, obligor, pledge type, and rating categories mitigates different risks and insulates the portfolio from idiosyncratic risks associated with greater returns volatility. A municipal bond portfolio can be constructed with broad diversification across risk factors with a higher after-tax total return or a lower level of risk than a state-concentrated portfolio. Historically, municipal bond investors have favored state-specific investing to minimize income tax obligations to the investor s state of primary residence. While we recognize the lure of a lower in-state tax bill arising from state-specific investing, the tax advantages can be over emphasized and come with potentially dire consequences for the after-tax total return of a bond portfolio. Throughout history, unforeseen events have compromised state, regional, and local municipal credit quality. Credit stress can emerge from natural disasters, like an earthquake or hurricane, man-made strife, economic turmoil, political malfeasance, or an energy crisis. Events like these often lead to credit downgrades and associated price degradation across many issuers located near or correlated with the geographic area in which events unfold. By limiting investment to a single state, investors expose themselves to concentrated risk that can be avoided in a geographically diverse national portfolio. pnccapitaladvisors.com

2 CONSTRUCTING A MUNICIPAL BOND PORTFOLIO Bond selection is the final step in a long process. Proper portfolio construction requires assessment of supply and demand for an obligor s bond offerings. The portfolio manager must understand federal, state, and local income tax treatment of a bond s coupon interest and potential gains/losses subsequent to purchase. As well, the manager must evaluate the obligor-specific risks associated with a given credit under consideration for portfolio selection. Supply The municipal market is a large and diverse market from an issuer perspective. There are thousands of potential issuers with approximately $3.4 trillion 1 in debt outstanding across the United States and three U.S. territories. We include U.S. territory debt because tax advantages afforded to such debt have historically made these securities suitable investment options for state-specific and general market municipal bond portfolios. Income from bonds issued in all U.S. territories is exempt from federal, state, and local income tax. The portfolio investment opportunity set is diminished significantly when investments are limited to a primary state residence, but the degree to which the opportunities are limited may not be understood without a few numbers. There are only 13 states or territories that individually comprise over 2% of the total outstanding municipal debt, and those 13 states/territories comprise close to 69% of that total debt (Table 1). When we exclude noninvestment grade, nonrated, taxable municipal bonds and bonds subject to the alternative minimum tax (AMT), the opportunity set is further diminished. 2 Consider Pennsylvania. It makes up only 3.86% of the national opportunity set, which would equate to investors disqualifying 96% of all municipal bonds outstanding from their Pennsylvania-only portfolios. Table 1: Taxable and Tax Exempt Municipal Debt Outstanding. States % > 2 Total % of Tax Investment Noninvestment Max Tax State Outstanding Total Issuance Exempt % Taxable % Grade % Grade % AMT% Rate Municipal Total 3,340, % 75.52% 24.48% 86.12% 13.88% 5.03% NA California 541, % 78.72% 21.28% 83.89% 16.11% 3.64% 13.30% New York 370, % 80.41% 19.59% 90.15% 9.85% 5.68% 8.82% Texas 304, % 76.04% 23.96% 89.45% 10.55% 5.24% Illinois 156, % 64.56% 35.44% 94.37% 5.63% 4.29% 5.00% Florida 147, % 83.17% 16.83% 87.88% 12.12% 8.38% Pennsylvania 128, % 72.06% 27.94% 92.70% 7.30% 4.55% 3.07% New Jersey 117, % 73.65% 26.35% 89.23% 10.77% 5.90% 8.97% Puerto Rico 107, % 81.12% 18.88% 39.60% 60.40% 0.43% Ohio 104, % 71.00% 29.00% 76.44% 23.56% 3.02% 5.42% Massachusetts 93, % 83.19% 16.81% 93.33% 6.67% 4.43% 5.20% Washington 77, % 76.37% 23.63% 96.49% 3.51% 5.31% Michigan 76, % 74.53% 25.47% 73.66% 26.34% 5.25% 4.25% Georgia 69, % 78.87% 21.13% 87.80% 12.20% 5.86% 6.00% >2% State Total 2,295, % Source: Sifma.org, PNC Capital Advisors 1 Municipal Bond Credit Report 1Q 2014, Sifma.org 2 Recent economic and fiscal stress in Puerto Rico has moved most credits on the island to noninvestment grade, shrinking the state-specific investment universe further. 2 The Importance of Geographic Diversification in Today s Municipal Bond Market

3 Demand Graph 1: Holders of Municipal Bonds The U.S. municipal market is primarily a closed market that appeals to U.S.-domiciled investors drawn to the market for the inherent tax advantages and relative credit quality of the asset class. Unlike other fixed income asset classes, municipal securities have U.S. households as the largest holder (Graph 1). The market is primarily supported by retail demand that can create a fragmented and opaque market, which at times lacks depth, velocity, and institutional sponsorship. Mutual Funds 16.97% Ins Co % Household Sector 43.81% For portfolios restricted to a state with high income tax rates, investors domiciled in that state provide liquidity via their demand for the tax exemption. This state-specific demand drives up the value of all bonds issued in that state, which, in turn, drives down the potential total return to investors. This built-in demand may concentrate most of the in-state float in a few investors hands all with the same objectives. Liquidity suffers accordingly. Tax Treatment MM 8.10% Other 6.51% Commercial Banking 11.61% Source: Federal Reserve System, PNC Capital Advisors, U.S. Department of Treasury Income tax code and tax rates vary considerably from state to state and are subject to change at any time. It is our belief that in-state tax advantages are often overemphasized and not fully vetted relative to the municipal bond investment opportunity set. While we recognize the value of the tax exemption, statespecific investors unnecessarily restrict themselves from most of the opportunity set. Often the result is a portfolio burdened with concentrated price and credit risk in exchange for a few extra basis points of return in the form of lower taxes. Again we use Pennsylvania as an example to calculate where resident investors would be indifferent to owning a Pennsylvania exempt bond relative to a non-pennsylvania exempt bond. Table 2 outlines at various yield levels the investor tax indifference curve. A Pennsylvania resident would be indifferent to purchasing a Pennsylvania-exempt bond that yields 3.00% or a non- Pennsylvania exempt bond at 3.06%. The higher the state tax rate the higher the benefit from the tax exemption, but even with California (the highest income tax state with a marginal rate of 13.30%), the benefit is only 26 basis points relative to a 3.00% in state bond. Table 2: Tax Indifference Curve Pennsylvania Aa3 / AA- PA State Rate 3.07% Total Effective Rate * 45.25% Ohio Aa1/AA+ OH State Rate 5.42% Total Effective Rate * 46.67% New Jersey A1/A+ NJ State Rate 8.97% Total Effective Rate * 48.82% California A1 / A CA State Rate 13.30% Total Effective Rate * 51.43% 1.00% 1.02% 1.50% 1.53% 2.00% 2.04% 2.50% 2.55% 3.00% 3.06% 3.50% 3.57% 4.00% 4.08% 4.50% 4.59% 5.00% 5.09% 1.00% 1.03% 1.50% 1.55% 2.00% 2.07% 2.50% 2.58% 3.00% 3.10% 3.50% 3.62% 4.00% 4.14% 4.50% 4.65% 5.00% 5.17% 1.00% 1.06% 1.50% 1.59% 2.00% 2.11% 2.50% 2.64% 3.00% 3.17% 3.50% 3.70% 4.00% 4.23% 4.50% 4.76% 5.00% 5.29% 1.00% 1.09% 1.50% 1.63% 2.00% 2.17% 2.50% 2.72% 3.00% 3.26% 3.50% 3.81% 4.00% 4.35% 4.50% 4.89% 5.00% 5.44% * Reflects deduction of state income tax on federal tax return. Includes the 3.8% Net Investment Tax. 1 Not subject to state or federal income tax. 2 Subject to state income tax; exempt from federal tax. Source: PNC Capital Advisors, IRS.Gov 3 The Importance of Geographic Diversification in Today s Municipal Bond Market

4 We assert that investors could construct a portfolio that offers higher yield, broader sector diversification, and stronger credit quality than nearly all state-restricted alternatives. Take, for example, the case of a New Jersey investor. Using the S&P municipal bond index to define the set of available securities, we can identify a subset of the index with taxadjusted return to which a New Jersey investor would be Table 3: S&P Municipal Bond Index 7/30/2014 Security Breakdown NJ Non-NJ indifferent (Table 3). First, we scan the opportunity set for A-rated bonds in order to match credit risk. Next, the data are grouped by yield, 3% or greater for New Jersey and 3.17% Total # Securities Total # A Category Cusips 2, ,993 6,253 or greater for non-new Jersey bonds. We find more than Total # A Category > 3% Yield 242 2,100 out-of-state municipal securities that could potentially Total # A Category > 3.17% Yield 2,133 be used to enhance after-tax total return and insulate the portfolio from state-specific risk. Source: S&P, PNC Capital Advisors, Investortools Correlated Credit Risk State-specific portfolios are fundamentally more exposed to the relationships formed among different levels of state and local governments. It is natural for a state and its localities to depend on each other for revenue collection, service provision, and other basic functions of government. It follows that statespecific municipal bond investors would be subject to correlated risks. In our view, these risks present themselves in four forms. Shared Risk Factors: Issuers that share a geographic region are susceptible to certain types of risks that can affect bond valuations. Economic, political, and catastrophic risks have been witnessed throughout history, and we find their effects can be magnified on an in-state portfolio. Examples of such risks would include a declining local housing market, significant government corruption, and force majeure. Also, some states have certain cultural or legal factors that can impact credit quality. Culturally, there are states that are more aggressive users of leverage, and state legal frameworks can inhibit or encourage the use of debt at the margins. Finally, governments, and in some cases tax-exempt enterprises, can share risks tied to financial obligations. Pension obligations serve as an example. An underfunded pension system can have deleterious effects on multiple issuers within a state, including cities, school districts, and universities. Financial Interdependence: The financial relationship of a state and its local governments can vary, but some states employ heavily centralized funding schemes. In this case, investors who have concerns about their state government may not be sufficiently insulated from what they perceive by owning local government bonds within that state. Further, in-state investors are more likely to experience a credit contagion if one or more large issuers in their state finds itself in severe financial trouble, municipal bankruptcy, or simply in default. The contagion would result in reduced liquidity and potential repricing of a large swath of bonds within that state. The most important type of financial interdependence involves states that provide contingent credit support for local obligations, often referred to as intercept programs. Credit Exposure: A close examination of the offering documents is a prerequisite for proper investing in the municipal market. It is important that an investor identify specific repayment source(s) before adding a bond to an investment portfolio. Unlike the corporate or sovereign bond markets, it is all too common for the municipality or authority that is issuing a bond to not be the ultimate obligor. It is appropriate to understand the offered pledge under each document to properly assess the credit and pricing risks that the investor is assuming. State-specific investing greatly increases the odds that a portfolio could unknowingly be concentrated to a specific repayment source. Linked Credit: In many instances, the municipal market views several of the above-mentioned factors as so related that it can create credit linkages, which result in direct or indirect credit correlation. For example, the rating agencies will explicitly apply linkages to ratings per their individual methodologies. These linkages are likely to apply to several categories of bonds, including cities and counties, taxing districts, special tax bonds, and public universities. We demonstrate this 4 The Importance of Geographic Diversification in Today s Municipal Bond Market

5 The Importance of Geographic Diversification in Today s Municipal Bond Market concept using Pennsylvania credits. If the state of Pennsylvania general obligation rating is downgraded, the state school intercept rating also will be downgraded by the equivalent notching as well as the state of Pennsylvania appropriation-backed debt rating. Consequently, if a ratings change for a sponsoring entity results in bond price degradation, then linkages can magnify the impact that ripples through the state-specific portfolio. Price Risk The credit factors mentioned above magnify the impact of ratings transition on state-specific portfolios. Typically, price risk associated with ratings degradation more than offsets any in-state tax advantages that state-concentrated portfolios enjoy. Over the last 10 years, the cost for a ratings category downgrade from AA to the A category, for example, has averaged 48 basis points (bps) and 73bps from A to BBB (Table 4). A 48bps increase in yield for a 10-year bond translates to roughly a 3-4% price decline. The impact is exacerbated by each bond that exhibits some type of correlated risk. Table 4: Credit Spreads to AAA 10 Year Bond 6/30/2004-6/30/2014 Average Category Migration Current Min Max Average Cost AA 10bps 9bps 30bps 17bps 17bps A 33bps 22bps 157bps 65bps 48bps BBB 71bps 34bps 354bps 138bps 73bps Source: Thomson Reuters CONCLUSION While we are not calling for a ban on state-specific portfolio options, in-state tax rates must be set quite high to justify single-state portfolios in light of the risks outlined above. Further, only investors in the highest tax states with a broad issuer base and high supply should consider state-specific bond portfolios. State-specific investors must be aware that the in-state tax exemption may not adequately compensate for the additional fundamental credit risk. The municipal market is a large market with a variety of issuers and security pledge types that afford investors the ability to construct diversified portfolios. We implore investors to examine the in-state tax benefits with a holistic view and recognize that the cost of the tax shelter could be significantly greater than its value. A geographically diversified portfolio can be constructed with greater potential after-tax total return and risk mitigation profile than a state-specific or state-concentrated portfolio. This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities referenced are not representative of all securities, purchased, sold or recommended by the manager, are not necessarily held in the manager s portfolio, and it should not be assumed that any referenced securities were or will prove to be profitable. Indices are unmanaged and not available for direct investment. This publication has been prepared without taking into account your objectives, financial situation or needs. 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