Bond Of America: State Investment Destinations

The Bond Fund of America is a diversified bond fund with a proven track record, investing in corporate debt securities, U.S. and other government securities, mortgage-related securities, and cash. The fund's objective is to provide a high level of current income while preserving capital. It has a broad investment scope, including corporate bonds, U.S. government securities, and money market instruments, with a focus on high-quality holdings. As of 2023, the fund held assets worth almost $73.75 billion across 3,882 different holdings. While the fund's performance has been slightly disappointing over the last decade, it has generally kept pace with its competitors and benchmarks. The fund's management, Capital Research and Management Company, is one of the oldest and largest investment firms in the nation, known for its long-term investment approach and attention to risk.

California and New York's budget gaps

California and New York are among the 12 US states that are at risk of budget cuts or scaling back programs in essential areas like education and public safety when the federal government's historic stimulus package expires in 2026.

California has allocated all of its $27 billion in federal funds, half of which is going toward revenue replacement to fund expenditures like health and human services programs, higher education, and courts. New York has spent or disbursed $7.6 billion of the $13.5 billion in federal aid as of August 31, 2023.

New York City, whose budget is bigger than all but a handful of states, often forecasts budget gaps but is required to close those gaps when budgeting for the coming year. The city's November 2023 update to its financial plan projects gaps to decline slightly in the coming years ($6.5 billion in FY 2026 and $6.4 billion in FY 2027) due mostly to savings actions the city plans to take.

However, spending risks to the city budget, including the costs for asylum seekers and an expanded rental assistance program, could average nearly $7.3 billion per fiscal year beginning in FY 2025. This could push budget gaps to $8.7 billion in FY 2025, $13.7 billion in FY 2026, and $15.5 billion in FY 2027.

To address the budget gap, New York City announced its FY 2024 program to eliminate the gap (PEG) in September 2023, which could become the largest annual gap-closing program since at least FY 2008. The first round of the PEG, released in November, is expected to generate nearly $3.7 billion through FY 2025 and more than $1.9 billion annually in each subsequent year. It would also reduce planned staffing by 2,873 positions by the end of FY 2025.

While there is still some cause for optimism, with 38 states facing a low risk of a fiscal cliff and strong job market performance, states that have been cutting taxes dramatically could face pressure as federal aid runs out.

Muni market credit quality

The municipal bond market is a $3.9 trillion mosaic with tens of thousands of issuers and nearly one million individual securities. The market is made up of states, local governments, counties, and tax-backed bonds, as well as revenue bonds that are relatively stable and highly rated.

The municipal market has shown resilience during the Covid-19 pandemic, with state and local governments entering 2020 with sizable rainy-day funds after years of conservative budgeting. However, as federal pandemic aid winds down, credit quality in the $4 trillion municipal bond market is showing early signs of pressure. Revenue growth is slowing, and in states such as California, tax and fee collections are dropping.

Despite these challenges, municipal credit is considered far more stable than similarly rated corporate credit. Municipal credit quality tends to remain in a very tight band throughout a cycle, and states and local governments have demonstrated their ability to power through economic cycles.

In terms of revenue trends, while state tax collections have generally recorded growth year over year, there are a few noteworthy exceptions. For example, California income tax receipts are projected to be about -8% compared to the 2024 budget, and corporate taxes are weaker by about -3%. On the other hand, New York's revenues are budgeted to come in at -1.3% year over year, but with a record reserve level equal to 15% of spending.

Overall, the muni market credit quality is expected to remain stable even as the economy slows down. Investors should take a long-term view and resist turning away from municipal bonds during difficult periods.

The Bond Fund of America's investment strategy

The Bond Fund of America® (ABNDX) is a high-quality, broadly diversified core bond portfolio. The fund's investment objective is to provide a high level of current income while preserving capital. It aims to achieve this by investing primarily in corporate debt securities, U.S. and other government securities, mortgage-related securities, and cash.

The fund has the ability to invest in every sector of the bond market and pursue multiple sources of active return. It normally invests at least 80% of its assets in bonds and other debt securities, including U.S. government, corporate, and mortgage-backed securities. The fund may also invest up to 25% of its assets in securities of issuers outside the United States.

The majority of the fund's investments are rated A or better (or unrated but determined to be of equivalent quality) at the time of purchase. The fund's current practice is to not invest more than 10% of its assets in debt securities rated BB or below.

The fund is managed by Capital Research and Management Company, one of the nation's oldest and largest investment management firms. Capital Research has invested with a long-term focus since 1931, based on thorough research and attention to risk.

The Bond Fund of America has a proven track record and is suitable for individuals seeking a diversified approach to fixed-income investing and income-oriented investors who want a solid core holding for their financial programs. It is also appropriate for investors seeking a well-diversified bond fund to balance their overall portfolios.

Capital Group's share classes

Capital Group offers a range of share classes to meet the needs of different investor types. These share classes combine specific product features to cater to investors' requirements. While not all share classes are available for every fund, the following are some of the options provided by Capital Group:

Retail (allowing commission)

This share class allows for the payment of commissions to financial professionals at the time of sale. It also offers ongoing asset-based service fees as a compensation option.

Retail ('clean')

The 'clean' share class does not involve the payment of commissions.

Dividend-distributing

This share class offers dividends to investors, with variations depending on the specific type chosen:

• D: The dividend generally represents all of the net investment income.
• Gd: The dividend generally represents a substantial part of the gross investment income.
• H: Seeks to limit exposure to currencies other than the denomination currency.
• Dh: Combines the features of 'd' and 'h' share classes.
• Gdh: Combines the features of 'gd' and 'h' share classes.

These share classes are available in various currencies, including CHF, EUR, GBP, JPY, and USD, or any other freely convertible currency.

It is important to note that share prices or net asset values are typically released and published on the business day following the relevant valuation date.

The benefits of muni bonds

Municipal bonds, or "munis", are issued by states or local governments to finance public works and infrastructure projects. They are generally exempt from federal taxes and often exempt from state and local taxes, although investors may be subject to the federal Alternative Minimum Tax.

High-Quality and Safe Investments

Muni bonds are considered high-quality investments that are well-positioned to weather potential recessions. The five-year cumulative default rate for muni bonds was only 0.08% from 1970-2022, compared to 6.9% for global corporate bonds over the same period. Muni bonds are also relatively low-risk compared to other investments, such as stocks.

Tax Advantages

Muni bonds offer several tax advantages over corporate bonds. Most muni bonds are exempt from federal taxes, and some are also tax-free at the state and local levels. When you factor in the tax impact, a completely tax-free municipal bond will usually present a more profitable opportunity.

Favourable Supply/Demand Balance

In 2023, local and state governments issued fewer new muni bonds due to the Federal Reserve raising interest rates to fight inflation. This trend is expected to continue in 2024, resulting in a favourable supply/demand balance for investors.

Portfolio Diversification

Muni bonds can help diversify your portfolio as they are domestically focused, while many stocks have global exposure and are more sensitive to macroeconomic developments.

Recession Resistance

Muni bonds may be well-positioned to withstand a recession as many municipalities have strong balance sheets thanks to federal aid during the pandemic. Additionally, muni bonds often fund essential services such as sewer, water, and garbage collection, which are less likely to be cut during a recession.

In summary, muni bonds offer a range of benefits, including high-quality and safe investments, tax advantages, favourable supply and demand dynamics, portfolio diversification, and recession resistance. However, it is important to carefully consider the potential drawbacks and risks before investing in muni bonds.

Frequently asked questions