Reevaluating state-specific muni bond funds.
While municipal bonds or funds often avoid regular federal taxation, they might be subject to the Alternative Minimum Tax (AMT). Additionally, state and local taxation can be costly and needs to be planned for accordingly. Within these limitations, taxpayers are confronted with a multitude of factors to consider and weigh against each other. Given the recent and ongoing fixed-income investment debacles, an investor's tax-exempt income objectives will need to be reexamined. This is especially critical for investors in state-specific municipal bond funds which, by design, lack geographical diversification. Embedded in state-specific municipal funds are moral hazard implications that are still routinely ignored by investors, fund managers, auditors, regulators, and legislators--even in the midst of the ongoing financial crisis.
A Multitude of Risks
When investing in state-specific municipal bonds, taxpayers are confronted with several interrelated risks:
* State-specific risks, geographical concentration, and issuer-specific risks;
* Principal and credit risks;
* Income risks; and
* Lack of diversification risks.
Each of these principal and interest risks must be weighed against one another when assessing potential municipal bond investments. Taxpayers invested in a state-specific bond fund have essentially traded a measure of diversification risk for maximum tax savings. While this approach has typically been effective in the past, the ongoing financial crisis demands a reassessment of the costs and benefits of these investments.
Exhibit 1 highlights readily available state-specific municipal fund offerings from Fidelity, Pimco, and Vanguard. Fidelity and Vanguard are often regarded as leaders in low-cost debt funds that have high underlying credit quality. Pimco's managing director, William H. Gross, is often called the Warren Buffett of bonds. These funds are good proxies for the fund industry's state-specific municipal bond offerings. There are even state-specific municipal exchange traded funds.
EXHIBIT 1 Sampling of Single-State Municipal Bond Funds Provider State Duration Assets Fidelity Arizona Intermediate $143 million Fidelity California Long $1,500 million Fidelity California Short-Intermediate $434 million Fidelity Connecticut Intermediate $528 million Fidelity Maryland Intermediate $155 million Fidelity Massachusetts Intermediate $2,100 million Fidelity Michigan Intermediate $597 million Fidelity Minnesota Intermediate $432 million Fidelity New Jersey Intermediate $605 million Fidelity New York Long $1,500 million Fidelity Ohio Intermediate $471 million Fidelity Pennsylvania Intermediate $370 million Pimco California Short $152 million Pimco California Intermediate $104 million Pimco New York Intermediate $136 million Vanguard California Short $6,300 million Vanguard California Intermediate $4,700 million Vanguard California Long $2,800 million Vanguard New Jersey Short $2,900 million Vanguard Ohio Short $1,000 million Vanguard Pennsylvania Short $3,700 million Vanguard Florida Long $974 million Vanguard Massachusetts Long $832 million Vanguard New Jersey Long $1,900 million Vanguard New York Short $4,400 million Vanguard New York Long $2,800 million Vanguard Ohio Long $876 million Vanguard Pennsylvania Long $2,600 million Provider State Stated Annualized Return Inception Date Fidelity Arizona 3.27% 10/11/1994 Fidelity California 0.21% 07/07/1984 Fidelity California 4.89% 10/25/2005 Fidelity Connecticut 4.40% 10/29/1987 Fidelity Maryland 3.35% 04/22/1993 Fidelity Massachusetts 2.84% 11/10/1983 Fidelity Michigan 3.57% 11/12/1985 Fidelity Minnesota 4.75% 11/21/1985 Fidelity New Jersey 2.72% 01/01/1988 Fidelity New York 3.18% 07/10/1984 Fidelity Ohio 3.81% 11/15/1985 Fidelity Pennsylvania 3.74% 08/06/1986 Pimco California 2.97% 08/31/2006 Pimco California -1.34% 08/31/1999 Pimco New York -0.19% 08/31/1999 Vanguard California 1.24% 06/01/1987 Vanguard California 2.12% 03/04/1994 Vanguard California -0.14% 04/07/1986 Vanguard New Jersey 1.35% 02/03/1988 Vanguard Ohio 1.5% 06/18/1990 Vanguard Pennsylvania 1.52% 06/13/1988 Vanguard Florida 1.59% 09/01/1992 Vanguard Massachusetts 3.74% 12/09/1998 Vanguard New Jersey 2.89% 02/03/1988 Vanguard New York 1.35% 09/03/1997 Vanguard New York 2.18% 04/07/1986 Vanguard Ohio 3.71% 06/18/1990 Vanguard Pennsylvania 2.53% 04/07/1986 Sources: personal.fidelity.com/products/funds/mutual_funds_ overview.shtml.cvsr, www.pimco.com/TopNav/Home/Default.htm https://personal.vanguard.com/us/funds/vanguard/all?sort=name&sortorder =asc
While investors in municipal funds need to be vigilant when assessing the specific-credit risks of any government obligation, those invested in single-state municipal bond funds are keenly exposed to single-state risks. As Vanguard's New York Tax Exempt Funds Prospectus states--
State-specific risk ... is the chance that developments in New York will adversely affect the securities held by the Fund. Because the Fund invests primarily in securities issued by New York and its municipalities, it is more vulnerable to unfavorable developments in New York than are funds that invest in municipal securities of many states. Unfavorable developments in any economic sector may have far- reaching ramifications on the overall New York municipal market.
In general, a greater number of state-focused municipal funds are available for larger states. Arizona, California, and New York, which were particularly hit hard by the current real estate meltdown, each have state-specific funds. While investing in state-specific funds can offer some of the highest federal and state after-tax returns for municipal fund investments, one must be concerned about the inherently riskier nature of a fund of this type.
In order to reduce credit risks, state-specific funds often invest in high-quality municipal securities. For example. Vanguard's New York Tax-Exempt Money Market Fund prospectus states that at least 80% of its assets are invested in "high-quality, short-term" securities, and Fidelity's California Municipal Income Fund normally invests at least 80% of its assets in "investment-grade" securities. Unfortunately, as the subprime debacle has proved, Moody's, Standard & Poor's, and Fitch's credit ratings cannot be blindly relied upon.
A critical concern has to do with the percentage of fund assets--often around 20% or more--that can be invested in obligations of lower quality and higher yield. Even this limited ability to invest in lower-quality securities can be devastating. As participants in the Oppenheimer U.S. Government bond fund for IRC section 529 plans (the tax-favored educational savings account) experienced firsthand, the risk of this ability to invest in lower quality securities (e.g., mortgage-backed securities) can result in losses. Another example of this propensity for excessive risk exposure can be seen in the Oppenheimer Rochester National Municipal Fund, which fell by nearly 50% in 2008. It had been a top performing fund from 2003 through 2006 by concentrating on low-quality bonds. Fund investors probably took little comfort from this fund's manager retiring in mid-2009. One must wonder if certain managers invest in riskier securities for greater stated annualized returns and thus greater asset inflow and commensurately larger fees.
Because of a high state income tax rate of up to 10.3% and a large population, investment funds often offer California state-specific bond funds of varying maturities. For example, Vanguard offers three California state-specific municipal bond funds, each targeted to a different maturity time frame (short-, intermediate-, and long-term). In June 2009, California's chronic budgetary problems resulted in the state's $92 billion general fund facing a $24 billion shortfall. A 2009 political stalemate in the California government led to a situation where the state controller was issuing IOUs during a budgetary impasse.
Investors in California debt obligations, so far, seem to dismiss outright the risks of defaults or delayed payments. In March 2009, when California sought to place $4 billion in debt, it actually received $6.5 billion (a pretax yield of 6.1% was highly attractive to California residents). During the week that Fitch downgraded California general obligation debt to A-, Barron's observed that while outright default is hard to "conceive," prudence would dictate looking at diversifying risks. Fitch downgraded California's debt obligations based on "the magnitude of the state's financial and institutional challenges and persistent economic and revenue weakening." In other words, caveat emptor.
With states (including California) taking extreme measures such as delaying tax refunds, threatening wage payments to state employees, forced days off, or partial shutdowns, the outright dismissal of principal risks would seem imprudent. While many consider a default on California general obligation debt as unrealistic, the default of local government debt within California is not so easily dismissed.
Moody's Muni View
In April 2009, Moody's Investors Service released a report, "Moody's Assigns Negative Outlook to U.S. Local Government Sector," that cast doubt on the credit quality of all local governments. Although the outlook is generally pessimistic, several specific areas are mentioned as being particularly susceptible to downward ratings pressures due to heightened exposures to certain economically affected industries:
* Local areas in Florida and California (the slowdown in real estate development);
* Michigan, Indiana, and Ohio (the collapse of auto manufacturing); and
* New York, New Jersey, and Connecticut (the turmoil within the financial services industry).
Moody's observed that challenges facing local governments and their reactions to them will vary greatly between and within states. The report concludes that, although many local governments' ratings will remain unchanged, there is an increased possibility of negative ratings revisions in this sector.
Interestingly, the pricing of municipal debt issuances around the release of the Moody's report does not appear to have been negatively impacted, despite the "headline risk." Some contend that the increased risk was already taken into account by institutional investors. In any case, the warning signs are clear in the rapidly deteriorating fiscal health of local governments, cautionary rating agency publications, and increased coverage of municipal bond market challenges in the financial press.
To ignore the increased risks and continue operating under the assumption that municipal bonds are reasonably immune to default pressures would be a significant oversight in the current environment. As the National Governors Association observed in January 2009:
States are facing fiscal conditions not seen since the Great Depression--anticipated budget shortfalls are expected in excess of $200 billion. To address these shortfalls and meet balanced budget requirements, states have begun taking action to cut government services or increase revenue. Absent federal action, states will have to take even stronger actions that will make the recession more severe and slow the nation's economic recovery.
In December 2009, the U.S. Census Bureau reported that quarterly revenue for state and local governments fell by 6.7%. This was the fourth consecutive quarterly decline in state and local revenue.
Municipal Bond Defaults
Historically, municipal bonds have been perceived as relatively safe investments with respect to the risk of default. This perception is being tested by increased fiscal and debt pressures at the local government level. A noteworthy rise in municipal bond defaults occurred from 2007 to 2008 (see Exhibit 2). Defaults went from $329 million in 2007 to over $7.5 billion in 2008, a staggering but seemingly overlooked reality. Significant municipal bond defaults in 2008 included the following:
EXHIBIT 2 Growing Annual Default Rates 2007 2008 Quarter Issues Value Issues Value 1st 11 $113 million 10 $ 862 million 2nd 4 $ 86 million 52 $1,120 million 3rd 4 $ 33 million 27 $1,225 million 4th 10 $ 97 million 36 $4,306 million Total 29 $ 329 million 125 $7,500 million Source: www.forbes.com/2009/01/15/monorail-vegas-ethanol-pf-ii in_jc_0115distresseddebt_inl.html
* A sewer bond issue in Jefferson County, Ala. ($3.8 billion);
* A group of 62 housing-related issues ($1.2 billion);
* The Las Vegas Monorail issue ($451 million); and
* The Chapter 9 bankruptcy in Vallejo, Calif. ($280 million).
Given the current set of crises, which is exacerbated by the reduced effectiveness of bond insurers, municipal bond defaults will almost certainly get worse before they get better. Currently, certain municipal bond insurers' ability to continue as a going concern is openly being questioned.
In two reports on municipal defaults (1999 and 2003), Fitch observed low cumulative default rates, consistent with the perceived historical trend. These studies, however, did find a significant correlation between economic cycles (with a one-year lag) and default rates, suggesting that the current economic distress will be accompanied by higher municipal defaults in years to come. In 2007, Fitch observed that even when municipal bond defaults occur, the debt holder typically recovers the par value of the bond and only suffers losses related to forgone interest payments (see Exhibit 3). Importantly, however, the findings in this study indicate that default recoveries vary considerably across municipal subsectors. In fact, recovery rates can be under 25% of the par value of the bonds.
Recoveries on a Municipal Default
A 2007 Fitch Ratings report on municipal defaults observed that not only have municipal defaults been extremely rare, but often debt holders eventually receive recoveries that approach 100%. This compares with an average recovery of 40% on corporate bond defaults. However, this rosy outcome is not assured. In 1982, when the Washington Public Power Supply System defaulted on its bonds, debt holders recovered less than 25 cents on the dollar. Upon default, Fitch classified expected debt recoveries into six categories. Even at a 100% recovery rate, debt holders often lose interest payments on claims made.
EXHIBIT 3 Fitch's 2007 Expected Recoveries upon Default Classes Summarized Composition Par Recovery Class 1 State General Obligations (GO) State sales tax 100% Class 2 Local GO Tax-backed debt Insured healthcare, 100% housing, and public college GO (related) Transit, water, sewer, and gas Class 3 Lease/appropriation-backed Airports, marine 100% ports, public power distribution Class 4 Continuing Care Retirement Communities (CCRCs) 90% Nursing homes Private college GO (related) State/local multifamily Tax-increment financing/tax allocation bonds (TIFs/TABs) Museums, stadiums, parking, bridges/toll roads (established), public power generation and waste disposal Class 5 Military housing Bridges/toll roads (startup) 70% Class 6 Hospitals Private college (auxiliary revenue) 40% Source: www.cdfa.ne1/cdfa/cdfaweb.nsf/fbaad5956b2928b086256efaa05c5f78/ 306821b3f8baaafc862572f80052a025/$FILE/Fitch%20Default%20Risk%20and%20R eco very%20Rates%20on%20US%20Municipal%20Bonds.pdf
Another factor affecting bond investing is the decline in the underlying market price of a bond when a government debt obligation is downgraded. For municipal bond fund investors, this typically results in a decrease in the fund's net asset value (NAV). In addition, funds and other debt holders can be forced to sell when debt ratings are lowered.
Besides state-specific credit risk, any debt obligation has the underlying risk that interest and debt payments will not materialize. In the SEC's hearings on money market funds in June 2009, many contended that the fund industry routinely disregards the implications of these risks to their investors. A prima facie example is that money market funds are actually marketed based on their requirements to be managed to maintain $1 per share NAV. The sad reality is that even U.S. Treasury money market funds are not guaranteed to achieve this goal. Those who continue to dismiss this risk--or pay lip service to the idea that it does not exist (investors, managers, auditors, regulators, and legislators)--ignore the critical lessons to be learned from the downfall of the Reserve Primary Fund.
The Reserve Primary Fund, a $63 billion money market, was the first major money market fund to "break the buck," due in part to investments in Lehman Brothers Holdings' debt securities (which offered a slightly higher return before Lehman declared bankruptcy). This is indeed ironic, as Bruce Bent II, chairman and CEO of the Reserve Fund, was a founder of the first money market fund. Investors in his fund are now projected to receive about $0.92 on the dollar, but when they will receive their funds is an open question (more than 30 lawsuits are pending as of this writing). In addition to various legal fees, management fees to the Reserve Fund are still accruing. Lack of access to funds on a timely basis is another material and unrecognized risk of bond fund investing and debt investing in general.
Bond Yield Gamesmanship
A key consideration in investing in fixed-income products is determining an investor's expected income. For fixed-rate bonds, determining the "stated yield" is as simple as determining its coupon rate. Determining a municipal bond fund's current yield, however, is a high-stakes game. The problem is that to determine the current yield, one must verify the market price of the underlying assets of the fund (thus, the daily repricing of often infrequently traded securities becomes a contentious issue).
With a municipal bond fund typically having hundreds of different debt securities, the process of accurately determining its value on any given day is nearly impossible. Compounding the problem is the fact that reported yield changes depend upon how such changes are measured. Major bond yield calculations include--
* trailing 12-month (based on prior 12 months income),
* "distribution yield" (based on the most current distribution), and
* SEC yield (an attempt to harmonize yield calculations across funds).
Thus, just determining investors' expected income--a major consideration when evaluating municipal bond funds--is extremely problematic. Materially adding to this impossible task is the fact that, in actively managed funds, bonds are regularly being bought and sold, bonds are maturing, and investor currency is routinely flowing in and out of the fund. It is no wonder that income risk (interest income declining over time) is listed as a standard risk in a bond fund's prospectus.
Bernanke's Municipal Perspective
In March 2009, Ben Bernanke, chairman of the Federal Reserve, contended in a letter to a member of Congress that fixed-rate markets for municipal securities were performing relatively well, despite municipal yields remaining "elevated relative to those of comparable maturity Treasury bonds." This is the opposite of what should occur in normally functioning debt markets, because Treasury securities are fully taxable on the federal level and municipal securities are not. However, the letter did acknowledge problems by stating:
Segments of the municipal debt market are certainly under stress. In particular, many issuers are currently paying more to issue new debt or service their existing debt than they did in 2007. Some past issuers of variable-rate demand notes are experiencing substantial increases in the costs of such debt, and the auction rate security market is dysfunctional.
Moral Hazard Implications
Embedded in the ongoing credit and equity crisis facing the nation is whether moral hazards are being abdicated by federal intervention. The federal government's direct and unprecedented intervention in companies such as AIG, Bear Stearns, Citigroup, Merrill Lynch, and General Motors proves that the concept of "too big to fail" was indeed correct to a degree. California, New York, and other states are now specifically pleading for budgetary and debt aid.
The menace is that these actions can paradoxically result in businesses and governments taking more risks in their debt issuances and counter parties accepting these risks to a large degree based on the potential of unlimited federal government intervention. In Bank of America's problematic (and seemingly federally-forced) rescue of Merrill Lynch, it has been disclosed that counterparty risks were literally in the hundreds of billions of dollars. For the top three creditors alone, the figure is over $130 billion: Bank of New York ($46 billion), State Street ($45 billion), and JPMorgan Chase ($42 billion).
Many would consider the potential of a state's general obligation debt default, with the government's unlimited taxing ability, as remote or impossible. This sentiment is indeed likely correct. However, defaults on local debt and special government-related projects (e.g., stadiums or toll roads) are threats that are less easily dismissed. Even federal printing presses likely have limits.
Investors, fund managers, and their auditors need to assess the potential for defaults or delayed or reduced payments when producing and reviewing critical municipal bond fund documents (e.g., prospectus, statement of additional information, or annual reports). Regulators and legislators must consider whether the rules of the game are requiring and instituting the needed level of disclosure and transparency (although the rules seem to change daily and are never definitive). While the federal government did preserve entities based on the "too big to fail" premise, many parties in the deals have not been bailed out or were outright penalized. While the current fiscal crisis may indeed be averted due to unprecedented federal intervention, the seeds for the next crisis may well be contained within the foundation of this recovery. Municipal bond debt implications are embedded in this reality.
Invest Carefully, Limit Risk Exposure
While municipal debt markets, as all debt markets, have been a source of concern in the current crisis, this does not mean that investors should abandon them. In fact, quite the opposite is true, as significant investment opportunities abound in the municipal arena. Nonetheless, for investors, fund managers, auditors, regulators, and legislators to dismiss the serious budgetary constraints and risks in municipal bond investing is a flawed perspective. CPAs must advise their clients about the increased risks in their municipal bond holdings, given their widespread acceptance as vehicles in an efficient and effective tax planning strategy.
Investing in a state-specific municipal bond fund is likely not advisable at the present time. Regardless of the ultimate outcome, it is not worth the risk to most mainstream investors. Those already invested in state-specific funds should consider steps to limit their risk exposure.
As the past two years have shown, even remote underlying risks can result in devastating losses for clients. CPAs should stand at the forefront in advising clients about the underlying risk exposures in their investments, particularly for a state-specific municipal bond fund, because their main selling point is the potential avoidance of all federal and state income tax. The cost in terms of lack of geographical diversification is likely too steep a price to pay, given the current and ongoing fiscal budgetary crises facing state and local governments.
William M. VanDenburgh, PhD, is the Robinson, Farmer, Cox Faculty Fellow Assistant Professor of Accounting at James Madison University, Harrisonburg, Va. Philip J. Harmelink, PhD, CPA, is the Ernst & Young Professor of Accounting at the University of New Orleans, New Orleans, La. Edward M. Werner, PhD, CPA, is an assistant professor of accounting at Drexel University, Philadelphia, Pa.
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|Title Annotation:||personal financial planning|
|Author:||VanDenburgh, William M.; Harmelink, Philip J.; Werner, Edward M.|
|Publication:||The CPA Journal|
|Date:||Feb 1, 2010|
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