Municipal bonds have become an attractive asset class over the past several years. With their unique tax advantages, the bonds provide higher after-tax yields than comparable Treasury or corporate bonds. Muni bonds are also generally regarded as safer than many bonds since they are usually backed by the full faith and credit of a state or local government. However, there are times when lower tax revenue could impact the valuation of these bonds.
In this article, we will take a look at how slowing tax revenues affect state muni bonds, as well as some considerations for investors holding them.
Consider Credit Ratings
Many states depend on tax revenue to balance their budget and pay debt obligations. While an economic downturn can affect this revenue, most states have high credit quality and stable ratings. A June 2016 survey found that only two states had ratings below Aa3 or AA-, with over 80% of states having the three highest ratings possible. The credit issues facing most states are also largely self-inflicted injuries from political stalemates or inaction.
Investors should look at a state’s credit rating when tax revenues are on the decline. If the credit rating is high, the state is likely to weather any economic cycle and come out just fine. If the credit rating is poor, the state could experience issues and investors may want to add a risk premium to the bond’s price. Credit ratings may not be perfect – as evidenced by the ratings on mortgages during the 2008 financial crisis – but they provide a solid starting point for analysis.
Most state economies are well-diversified in terms of their economic activity; but some states rely on specific industries to fuel their growth and fund their taxpayer base. For example, Alaska is highly dependent on crude oil revenue to balance its budget, which means that a downturn in the commodity could adversely affect its state revenue. Similarly, Michigan is dependent on the automotive industry as a key jobs provider – a fact that contributed to Detroit’s issues.
Aside from industry-related risks, some states have limited abilities to tax their residents relative to other states. The most obvious examples are states that don’t have a state-level income tax and rely on sales and property taxes alone. When a downturn occurs, states that have more possible taxation sources may have an easier time raising aggregate taxes and improving revenue to cover any shortfalls in their budgets.
Dealing With a Slowdown
Investors interested in the municipal bond market can deal with these slowdowns in state tax revenue in a few different ways.
The most important strategy for handling a slowdown is to ensure that any individual bond represents less than 10% of a diversified portfolio. By doing so, investors can be sure that a single state’s issue doesn’t have a tremendously negative impact on an entire portfolio. Muni exchange-traded funds are a great way to obtain this kind of diversification without having to purchase tens of thousands of dollars’ worth of individual muni bonds.
Investors purchasing individual muni bonds should stick to highly traded bonds that have a credit rating of A or A2 (or better) before bond insurance factors. Looking deeper, investors should also take a look at demographic trends, jobs creation and other factors that could influence the long-term performance of the bond. The goal is to look for stable tax revenue streams and budget practices that can weather an economic downturn.
The Bottom Line
Municipal bonds have become an attractive asset class over the past several years due to their unique tax advantages. While these bonds are generally safe, state muni bonds often rely on tax revenue in order to balance budgets and pay debt obligations. Investors should carefully analyze state muni bonds for potential problems before adding them to their portfolio, while simultaneously ensuring that their overall portfolio is well-diversified.