Geographic risk in municipal bond portfolios.
We always recommend national portfolios when managing a substantial allocation to municipal bonds. Clients often ask about losing the state tax income benefits by buying out of state municipal bonds. Our answer has always been that we believe it is crucial to control geographic risk and concentration, particularly since these can be idiosyncratic, tail-event type risks.
In past discussions with clients, we’ve focused on how certain states and municipalities can have an over-reliance on one or two industries and be impacted by a cyclical or secular downturn. We’ve also pointed out that certain natural disasters can impact a geographic area so severely that a short-term recovery becomes difficult or even impractical. Many disasters can erode the tax base and asset values to such an extent that creditors may suffer substantial losses in default.
For instance, environmental devastation during the dust-bowl era wreaked immense damage on agricultural production in many states and this impacted state and local finances significantly. The tragic events unfolding at present in Japan should remind investors that natural and environment disasters can devastate communities for extended periods of time. When these disasters come in the form of a dam failure or nuclear accident, they can make a large area inhabitable.
Such events are inherently unpredictable, and highlight the need for geographic diversification in investment portfolios of all types. Humans are fallible creatures, in investing as in many other things. Geographic diversification is a way to limit the impact of that fallibility.