Schwab Center for Financial Research
Think Local — Why to Consider General Obligation Bonds A white paper by Cooper Howard, CFA® and Rob Williams, CFP®
We believe now is a good time to consider investing in bonds issued by cities, counties and local school districts. These bonds, known as local government general obligation, or GO bonds, offer attractive yields relative to other municipal bonds. Local GO bonds are generally backed by the municipality’s authority to collect taxes – often property taxes. Despite the well-publicized financial troubles of cities such as Detroit and Chicago, the finances for most local governments are stable or improving in our view. In addition, the top tax rate for interest income is higher than it has been in nearly 20 years. This adds to the attractiveness of investing in municipal bonds. Municipal bonds, including local general obligation bonds, are one of the few investments that pay interest that is exempt from federal, and potentially state, income taxes. Investors who are in high tax brackets and looking for stable fixed income investments might consider local general obligation bonds.
Cooper Howard, CFA® Senior Research Analyst, Fixed Income and Income Planning, Schwab Center for Financial Research Cooper Howard is responsible for providing analysis and investor education on fixed income and income-planning topics, including reserach and perspective on the municipal bond market and income investing.
Robert Williams CFP® Director of Income Planning, Schwab Center for Financial Research Rob Williams, Director of Income Planning for the Schwab Center for Financial Research, focuses on fixed income and income-planning issues, including key topics of interest to individual investors seeking to increase income from their portfolios. Williams also provides analysis of bonds, fixed-income strategies, and other income-oriented issues. This white paper is part of a continuing series of timely and actionable investing ideas provided by the experts at the Schwab Center for Financial Research (SCFR). The guidance provided through investing ideas will be updated over time as market conditions change and as SCFR’s point of view evolves.
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Executive Summary • Within the municipal bond market, we believe that bonds issued by cities, counties, and school districts – known as local general obligation (GO) bonds – are appealing now because they offer relativity attractive yields, on average, and their finances are generally stable or improving. • Stick to local government general obligation bonds that are backed by the either the municipalities full taxing power and pledge to use all necessary resources, the revenues from a specific tax, or both methods to pay the bonds back. • We suggest consulting with a Schwab Fixed Income Specialist or using a professional manager when selecting local government GO bonds
What is the gist of this idea? Bonds issued by cities, counties, and local school districts appear attractive to us now because they often have high credit qualities and may offer attractive yields comparable to other municipal bonds. In the municipal bond market, these are local general obligation (GO) bonds. Usually, the source for repayment of these bonds is the municipality’s full taxing authority – often property taxes – and pledge to use all necessary resources to pay the bonds back. In some instances, the pledge may be a specific tax that is solely used to repay the bonds. In some cases, municipalities may be restricted in the amount they can increase taxes.
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Who would benefit most from this idea? Investors who are looking for after-tax investment income and low credit risk should consider local GO bonds. Municipal bonds – including local GOs – are one of the few investments that pay interest that is exempt from federal and often state income tax1. They are also one of the few investments that pay interest that is exempt from the recently enacted 3.8% Medicare surtax on investment income 2 . Within the municipal market, we believe local GOs are attractive because they have high credit quality, meaning a low chance of the issuer defaulting on the bond, and generally offer attractive yields in comparison with other municipal bonds.
Why is the idea particularly relevant now? First, we believe that municipal bond yields, on average, are attractive relative to other fixed income investments, such as Treasuries and corporate bonds. The yield on a 10-year municipal bond is almost equal to that of a U.S. Treasury 3 . After factoring in the tax benefits for municipal bonds, the yield difference is even more attractive for municipal bonds. Municipal bond interest, unlike Treasury and corporate bond interest, is usually exempt from federal, and potentially state, income taxes 4 .
1
If purchased from your home state
2
Net investment income includes, among other items, “interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer,” according to the IRS 3
Source: Bloomberg, the municipals-over-bonds spread (MOB) was 95.0% as of November 23, 2015
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Interest income from Treasury bonds is not subject to state income taxes
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Within the municipal bond market, we believe that local government general obligation bonds are especially attractive now. Here’s why: 1) Credit conditions for local governments are improving Despite the well-publicized financial troubles of cities such as Detroit and
Local GOs appear
Chicago, the finances for local municipalities are improving. For example,
attractive because
local government employment has increased for 20 consecutive months
they offer attractive
and for 24 out of the past 27 months on a year-to-year basis 5 . In addition,
home values have increased 36% since the lows of 2012 6 . Most cities rely
on property taxes for a large portion of their revenues. The
assessment of properties for tax purposes tends to lag behind market
values. A Federal Reserve study found that it takes an average of three
years for a change in home prices to be reflected in property tax
yields relative to other municipal bonds
revenues 7. Therefore, the improving housing market should soon help
shore up the finances of a large number of local governments. 2) After-tax yields for local general obligation bonds are attractive in
comparison with the yields on other municipal bonds Yields for local general obligation bonds, on average, have historically
been lower than yields on most other municipal bonds. This is not the
case today. From 2010 to 2014, the yield to worst 8 of the Barclays
Municipal Bond Index, a broad-based representation of the entire
municipal bond market, averaged 31 basis points more than the Barclays
Municipal Local GO Index – a broad representation of local government
GO bonds. As of November 17, 2015, the difference in yields is only 4
basis points in favor of the broad-based market. A basis point is one-
hundredth of a percentage point.
5 Source: 6
Bureau of Labor Statistics, as of September 2015
As represented by the S&P Case-Shiller 20-City Composite Home Price Index, as of July 2015
7
Source: Federal Reserve Board, “The Connection Between House Price Appreciation and Property Tax Revenues”, as of September 12, 2008 8
Yield to worst is the lower of the yield to maturity or the yield to call. It’s essentially the lowest potential rate of return, barring default, for a bond
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3) The long-term credit characteristics for local government GO bonds are attractive in comparison with other municipal bonds Local government general obligation bonds have higher credit ratings, on average, than other municipal bonds for these reasons: Local GOs are often backed by a city’s legal pledge to increase taxes 9 to pay its debt. Local GO bonds are often backed by the local government’s ability to tax its residents. In some instances, the bonds are backed by a specific tax. This is generally one of the stronger sources or repayment because the revenues are not mixed in with the municipalities other operations but are instead used solely to repay the bonds. While the legal definition varies by municipality and some local governments may be limited in the amount they can increase taxes, if any, GO bonds generally have a legal priority over other obligations. U.S. cities must balance their budgets each year. Local governments in nearly all states operate under balanced budget requirements. If a municipality faces declining revenues, it must reduce non-legally binding liabilities – like employment – so it can meet its legally binding liabilities — such as GO bonds. In addition, many states oversee the finances of local governments. Therefore, if a U.S. city runs into financial difficulties, the state may step in and provide support. Defaults have been rare for general obligation bonds. While past performance does not guarantee future results, GO bonds have rarely defaulted. Between 1970 and 2014, only eight of the more than 8,600 Moody’s-rated GOs have defaulted10 . While the number of defaults could increase, we believe the historical trend of strong finances among most U.S. cities should continue. Not all local general obligation bonds, however, are of similar or high credit quality in the municipal market. We believe investors should work with a fixed income specialist such as a Schwab Regional Bond Special or consider investing via a professional managed account such as a Separately Managed Account (SMA).
Why are yields for local GOs near the rest of the muni market these days? We believe that local GOs are especially attractive now because a few highprofile cases have caused investors to wrongly paint the entire market with the same negative broad brush. Detroit filed for bankruptcy in the summer of 2013, which we believe caused many investors to question the financial strength of U.S. 9
In some instances, local governments may be limited in the amount, if any, they can increase taxes. Consult the individual bond’s offering statement for additional information. 10
Source: Moody’s, “US Municipal Bond Defaults and Recoveries, 1970 – 2014”, as of July 24, 2015
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cites. This was especially heightened due to the well-publicized difficulties that Chicago is facing. At the time of Detroit’s bankruptcy filing, local GOs, on average, yielded approximately 30 basis points less than the rest of the muni market. Today, that difference is only 4 basis points. In our view, this spread contracted due in part to some of the proposals that came out of the Detroit bankruptcy. These proposals did not actually materialize.
Are there certain areas of the country that investors should focus on? Municipal bonds largely reflect the economics of the region. We believe that investors should focus on areas within your home state11 with these attributes: • Steadily increasing populations and a growing labor force • Unemployment rates below the national average • Relatively skilled work forces • Diversified economies When considering municipal bonds, the demographics and characteristics of the area’s population are more important than its total size. Austin-Round Rock, Texas, for example, had the fastest population growth of any major U.S. metro area from 2010 to 201412 , even though it ranked No. 35 in size. At the same time, its economic output rose 6.1%. This is more than double the 2.3% average for all U.S. major metropolitan areas. 11
Generally, municipal bond interest is exempt from state income taxes if it is issued by a municipality within your home state 12
Source: U.S. Census 2014 Population Estimates, data obtained on 9/29/2015. Excludes metropolitan statistical areas with a population of less than 500,000.
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That made it the third-fastest-growing urban area13 . By comparison, the New York-Newark-Jersey City metropolitan area, the nation’s largest, grew just 2.4% over the same period. The areas with the fastest growth also have relatively diverse economies. Seattle, for example, one of the top 20 fastest growing metropolitan statistical areas and top 20 in terms of economic output for 201414 , is home to many major corporations in different industries. These include Boeing, Amazon, Starbucks, and Nordstrom—giving Seattle footholds in the aerospace, e-commerce, restaurant and consumer retailing industries.
Not all local governments are stable or improving, right? Correct, there are areas that are not stable or improving. Areas that we would
Avoid boom-and-bust areas. Growth is a positive sign but only if it is steady and sustainable.
suggest avoiding are those that rely on a single industry or have unfavorable demographic trends. For example, once the thriving centers of the American industrial revolution, cities in the so-called Rust Belt, such as Detroit, Pittsburgh and Cleveland, today generally have declining populations and a higher-than-average number of residents living in poverty. That usually results in lower tax revenues for the municipality. This can mean the municipality has less flexibility to pay its debt, which is a negative sign for bondholders. Also avoid boom-and-bust areas. Growth is a positive sign but only if it is steady and sustainable. We believe, for example, you should be careful of buying the bonds issued by cities or areas that grew quickly during the housing boom or depend heavily on oil and gas production. A risk to this idea is taking it too far and being overexposed to certain regions or areas. Information related to the financial health of a city or local government can also be difficult to come by or delayed. We would suggest using the help of a bond professional to implement this idea so they can help identify areas that may not be as attractive.
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Source: U.S. Bureau of Economic Analysis, as of 9/23/2015. Excludes metropolitan statistical areas with a population of less than 500,000 14
Source: U.S. Bureau of Economic Analysis, as of 9/23/2015. Excludes metropolitan statistical areas with a population of less than 500,000
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Aren’t pension obligations a risk for local governments? Unfunded pension liabilities are a growing expense for many local governments. We do not believe, however, that pension liabilities will become an immediate burden to most local governments. There may be some that suffer credit downgrades or may be forced to seek legal restructuring of their debts but we believe these will be isolated cases. It appears that most of the largest local governments have the resources to manage their near-term pension costs. According to Moody’s, “pension costs are not a substantial burden for a significant portion of the largest local governments.” Thirty of the nation’s 50 largest local governments have plans that “cost” less than 10% of operating revenues. Among those, 14 have plans that “cost” less than 5% of operating revenues.
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The worst may be over in terms of funded pension levels. Standard & Poor’s believes that funded levels have likely bottomed out15 . In addition, the pension crisis has forced action. For the most part, cities appear to be actively addressing their pension liabilities. More than 3,600 bills related to pension reform were introduced from 2013 through September of 2015, according to the National Conference of State Legislatures (NCSL). We recommend investors purchase local government GO bonds with a rating of A or higher as part of this idea. Therefore, municipalities with severely burdensome pension costs relative to revenues would likely not be part of this investing idea. Some local government general obligation bonds may still have high credit ratings and high pension costs, however. Therefore, we suggest using professional management to help implement this idea so they can do additional analysis.
Do rising interest rates pose a risk to this idea? Rising interest rates affect most fixed income investments. When interest rates rise, bonds prices fall. Yields on most fixed income investments are historically low which has caused some investors to believe that rates are bound to go up and they will be better served by waiting to invest. This is not our view. Holding too much of a portfolio in securities with very low yields – such as cash – can mean missing out on current income and the potential for reinvesting and compounding that income. Returns for most bonds come from two sources – coupons and changes in prices. Coupon returns are always positive and can help to offset any negative price declines. In addition, every day that you hold a bond, you earn the coupon return. Over time, coupon returns generally account for the majority of the total return of a fixed income portfolio. Municipal bond coupons are often exempt from federal, and potentially state, income taxes. For investors in high tax brackets, this can help to increase the after-tax total return. We expect municipal bonds – including local GOs – to move roughly in tandem with Treasury bonds. The forecast for 10-year Treasury yield for the fourth quarter of 2016 is 2.80%, which would be an increase of approximately 50 basis points from the current yield to maturity of 2.26%16 . If yields on 10-year
15
Standard and Poor’s, “U.S. State Pension Funding: Strong Investment Returns Could Lift Funded Ratios, But Longer-Term Challenges Remain,” as of June 24, 2014 16
Source: Bloomberg, as of November 17, 2015
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Treasury bonds rose by 50 basis points and municipal bonds followed suit, we calculate that a portfolio of local general obligation bonds of average maturity and credit quality would generate a positive total return, all things being equal17.
Should a client consider any bond issued by a local government? Local governments tend to issue many different types of debt to help fund projects or operations. The types of long-term debt obligations that local governments issue are based on many factors including the state or local government legal authorization, debt policies, project type, existing debt composition, and other factors. Focus first on unlimited tax general obligation bonds with or without a dedicated tax pledge and limited tax general obligation bonds. Unlimited tax general obligation bonds are generally backed by the issuers’ full taxing authority and they can increase taxes to an unlimited amount to pay the bonds back. A dedicated tax pledge is a tax that can only be used to repay the bonds. With a limited tax GO bond, a municipality is restricted in the amount they can increase taxes.
How can a Schwab client implement this idea?
Clients can purchase individual local GO
To implement the idea, clients can purchase individual local GO bonds with the
bonds with the help of
help of their Regional Bond Specialist (RBS) or use a separately managed
their Regional Bond
account (SMA). We suggest the following considerations for clients who are
Specialist or use a
purchasing individual bonds:
separately managed
• Pick highly rated bonds. Choose bonds with a rating of A (Standard & Poor’s)/A2 (Moody’s) or better, before accounting for bond insurance.
account.
• Diversify. No more than 10% of your portfolio should consist of any single issuer.
• Know the terrain. Focus on areas that have stable or steadily increasing populations. Those close to diverse and growing employment centers are also more attractive.
• Focus on jobs. Invest in areas not dominated by one industry. Areas that have a diverse economy are generally less vulnerable to economic shocks. In addition, they tend to recover more quickly from economic declines.
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Using the Barclays Local GO Bond Index, which has a duration of 6.85 and a coupon of 4.53%, we assumed an increase in interest rates of 50 basis points which resulted in a price loss of -3.42%. After accounting for the positive coupon return of 4.53%, the total return was 1.11%. As of November 10, 2015. For Illustration Only.
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For help, talk with a Schwab Regional Bond Specialist who knows the areas and issuers in the areas where you’d like to invest. You can also use a professional bond portfolio manager such as a separately managed account (SMA). Most managers don’t focus exclusively on local GO bonds, but they generally have knowledge of the areas they are investing in and have done additional credit research. The core of this idea is to invest in high quality municipal bonds backed by issuers with stable or improving credit characteristics. Using a SMA to implement this idea achieves what the core of this idea intends to do.
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Important Disclosures Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies. All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. Indices are unmanaged, do not incur management fees, costs, or expenses; and cannot be invested in directly.
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.
Barclays Municipal Bond: GO Index is the GO component of the Barclays Municipal Bond Index
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security’s taxexempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Taxexempt income may be subject to the Alternative Minimum Tax (AMT). 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.
S&P Case-Shiller 20-City Composite Home Price Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan areas: Atlanta, Boston, Charlotte, Chicago, Cleveland, Dallas, Denver, Detroit, Las Vegas, Los Angeles, Miami, Minneapolis, New York, Phoenix, Portland, San Diego, San Francisco, Seattle, Tampa and Washington, D.C.
Investments in separately managed accounts should be considered in view of a larger, more diversified investment portfolio. Index definitions Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.
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Barclays Municipal Bond: Local GO Index is the local GO component of the Barclays Municipal Bond: GO Bond Index
The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
