20 Hoosier Banker September 2015 DIRECTORS / SENIOR MANAGEMENT In recent years the relative value of high-grade, bank-qualified municipal bonds has been excellent for taxable banks. However portfolio managers have at times been constrained by a limited supply of good bonds. One solution to this problem may be as simple as looking across state borders to find good bonds with strong credit issued by municipalities in different parts of the country. Geographic diversification is desirable for a number of reasons beyond supply alone. Not considering bonds of issuers that are not in your own state may significantly limit your choices in the security selection process. In the absence of broad geographic consideration, good investment opportunities in stable municipalities may be missed. Some of these bonds may be backed by state credit enhancement programs that greatly decrease the amount of credit risk the investor assumes. An example is Texas, where the Texas Permanent School Fund is an excellent credit enhancement and a AAA credit. Another is Missouri, which offers a state aid credit enhancement program to school districts that essentially redirects state aid to bondholders in the event the school district needs help making its bond payments. Missouri is rated AAA by both S&P and Moody’s, and the credit enhancement program is rated AA+ by S&P, indicating a low probability of the credit enhancement program defaulting on obligations. Other states have similar programs that help ease credit concerns when purchasing out-of-state municipal bonds. Another reason to cast a wide net when looking for munis is the potential for better relative value on bonds in other states. Even strong credits may show higher yields as a result of “knock-on” effects from isolated concerns in the state that may only relate to one specific issuer, but which keep prices lower for all bonds issued in that state. Developing a thorough credit analysis process using publicly available documents and focusing on key ratios and trends can help a portfolio manager determine whether or not the bond is an acceptable credit by the manager’s standards, even if not personally familiar with the municipality. Robust credit analysis tools and resources are available to aid in the understanding of credit quality of municipalities, regardless of prior area knowledge. It is also worth noting that community banks do most of their lending within their market areas, and already have a significant exposure to the local economy. Adding highgrade bonds issued by municipalities in other states generally reduces concentration risk and diversifies the credit risk component of the portfolio by decreasing the portion of the portfolio that is exposed to adverse shocks in one particular area. Consider a bank that only buys municipals from its home state. If investors or traders have concerns, for example, about the state’s pension funding status, the prices of bonds issued by municipalities in the state, even those with state credit enhancement or other forms of state backing, could suffer and could cause the value of this muni portfolio to decline, simply because all the eggs are in one basket. Finally, some states, such as Texas and Nevada, do not tax income at the state level. Investors in these states receive no tax advantage for purchasing tax-exempt municipal bonds in their home states, so there are no tax-related reasons to not consider out-of-state munis. In conclusion, when looking for potential municipal bond investments, bank investment officers should consider all available supply within their credit-quality parameters. This is especially true if the investor does not benefit from state-tax exemption. Diversification is always a good idea when it comes to portfolio management and, these days, it is particularly true for municipal bonds. t About the Author Dana Sparkman is a municipal analyst in the financial strategies group of The Baker Group. She manages a municipal credit database that covers more than 100,000 municipal bonds. Sparkman earned a bachelor’s degree from the University of Central Oklahoma. The author can be reached at 405-4157223, email: dana@gobaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider. Diversification of Bank Municipal Bond Holdings Don’t Be Afraid to Buy Out-of-State
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