UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED
MANAGEMENT INVESTMENT COMPANIES
Investment Company Act File Number: 811-04521
| T. Rowe Price State Tax-Free Income Trust |
| (Exact name of registrant as specified in charter) |
| 100 East Pratt Street, Baltimore, MD 21202 |
| (Address of principal executive offices) |
| David Oestreicher |
| 100 East Pratt Street, Baltimore, MD 21202 |
| (Name and address of agent for service) |
Registrant’s telephone number, including area code: (410) 345-2000
Date of fiscal year end: February 28
Date of reporting period: August 31, 2015
Item 1. Report to Shareholders
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| New Jersey Tax-Free Bond Fund | August 31, 2015 |
The views and opinions in this report were current as of August 31, 2015. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.
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Manager’s Letter
Fellow Shareholders
New Jersey municipal bonds fared poorly over the past six months as a lagging economic recovery and growing budgetary pressures highlighted the state’s precarious finances, causing credit spreads to widen over the period. Concerns about New Jersey’s large and growing pension funding gap, among other issues, spurred declines in the state’s general obligation (GO) and appropriation-backed bonds, making it the worst performer in the Barclays Municipal Bond Index’s state category. The New Jersey Tax-Free Bond Fund, however, surpassed its benchmark and posted a flat return for the six months ended August 31, 2015. The fund’s outperformance was driven by our conservative positioning on the State of New Jersey, which reflects our long-held caution regarding the state’s fiscal position.
ECONOMY AND INTEREST RATES
The economy improved from sluggish first-quarter growth, expanding at an annualized pace of 3.7% in the second quarter of 2015 according to the most recent estimates. The labor market continued to improve, with solid job gains driving the national unemployment rate down to 5.1% in August, its lowest level since 2008. Inflation is likely to remain very low in the near term due to recent declines in oil and other commodity prices. Lower energy costs bode well for consumer spending in the second half of the year. Despite the recent global financial market volatility, the Fed still seems to be on track to begin raising short-term U.S. interest rates at some point in the months ahead. Subsequent rate hikes are expected to be very gradual.
There were large fluctuations in U.S. Treasury and municipal yields during the reporting period in anticipation of the onset of tighter Fed monetary policy and in response to turmoil in global markets. Both the U.S. Treasury and municipal yield curves steepened over the period, though long-term municipal yields did not rise as much as their Treasury counterparts with similar maturities. At the end of the reporting period, 30-year municipal bonds yielded more than comparable-maturity Treasuries, making them attractive versus taxable bonds as an alternative for taxable fixed income investors.
As an illustration of their relative attractiveness, on August 31, 2015, the 3.10% yield offered by a 30-year tax-free GO bond rated AAA was about 105% of the 2.95% pretax yield offered by a 30-year Treasury bond. Including the 3.8% net investment income tax that took effect in 2013 as part of the Affordable Care Act, the top marginal federal tax rate currently stands at 43.4%. An investor in this tax bracket would need to invest in a taxable bond yielding about 5.48% to receive the same after-tax income as that generated by the municipal bond. (To calculate a municipal bond’s taxable-equivalent yield, divide the yield by the quantity of 1.00 minus your federal tax bracket expressed as a decimal—in this case, 1.00 – 0.434, or 0.566.)
MUNICIPAL MARKET NEWS
In the first eight months of 2015, total municipal bond issuance was $289 billion, according to The Bond Buyer, a substantial year-over-year increase. Refunding debt has been rising significantly, as muni issuers have been taking advantage of cheap borrowing costs to refinance older, higher-cost debt. Inflows into the muni market in the first quarter of the year transitioned into a slow but steady pace of outflows during the summer months, though demand from individual investors has been picking up in response to higher muni yields. Overall, flows remain positive year-to-date.
With a few exceptions, fundamentals for municipal issuers remain solid overall. The overwhelming number of issuers in the $3.7 trillion municipal bond market are acting responsibly—raising revenues, reducing expenses, balancing budgets, and taking steps to address long-term liability issues. Most state and local governments have been very cautious about adding to indebtedness since the financial crisis, and a strengthening economy has helped tax revenues rebound. Over 60% of the market is AAA or AA rated, as measured by the Barclays Municipal Bond Index.
Although the market is overwhelmingly high quality, many states and municipalities are grappling with underfunded pensions and other post-employment benefit (OPEB) obligations. Investors often overlooked this long-term risk in the past. We believe the market will price in pension risks over time, as the magnitude of unfunded liabilities becomes more conspicuous. New reporting rules from the Governmental Accounting Standards Board (GASB) will bring greater transparency to state and local governments’ pension funding gaps.
In the last six months, Chicago’s financial problems, highlighted by an underfunded pension system and other considerations, drew increasing attention after the city’s GO debt was downgraded to below investment-grade status by Moody’s in May. The timing of the move by Moody’s came just as the Illinois Supreme Court had reversed steps toward pension reform that had recently been introduced in the state. In July, Chicago’s plan to reform a portion of its underfunded pension system was similarly struck down by an Illinois Circuit Court judge who ruled that the proposed changes diminish pension benefits for individual workers and violate the state constitution, which led to further credit spread widening for both the city and the state. The recent developments in the city reinforce our bias for revenue bonds that are more insulated from the pension funding risks faced by GO debt.
Puerto Rico was also in the headlines during our reporting period. In late June, Governor Alejandro García Padilla conceded that the U.S. territory could not continue servicing its roughly $72 billion in public debt. Puerto Rico subsequently experienced its first official default when it failed to make the full payment due on its Public Finance Corporation bonds at the beginning of August; while this event weighed on the high yield muni index, contagion in the broad muni market has been limited. After our reporting period ended, Puerto Rico released a fiscal and economic growth plan that will likely entail a debt restructuring, as the priority of paying debt service as scheduled was notably absent from the plan. T. Rowe Price’s municipal team has maintained for some time that Puerto Rico’s debt burden is unsustainable and would eventually need to be restructured. We have no direct exposure to Puerto Rico in the New Jersey Tax-Free Bond Fund.
In terms of sector performance, revenue bonds outperformed GO debt over the last six months. We continue to favor bonds backed by a dedicated revenue stream over GOs, with a preference for higher-yielding health care and transportation debt. Among revenue bonds, housing, hospital, and water and sewer bonds posted the strongest performance, while leasing was the only revenue sector to post negative returns. High yield tobacco performed particularly well over the period, outpacing the broad municipal market by a wide margin.
NEW JERSEY MARKET NEWS
New Jersey’s GO debt is rated A1 by Moody’s Investors Service, A by Standard & Poor’s, and A by Fitch. Standard & Poor’s and Fitch have a stable outlook on the state, while Moody’s has a negative outlook. All three credit rating agencies downgraded New Jersey’s rating in 2014 due to fiscal pressures stemming from growing fixed costs, elevated long-term liabilities, and a lagging economic recovery.
New Jersey benefits from a diverse economy and high wealth levels. The state’s 2013 per-capita personal income was 124% of the national average, ranking it third highest among the states. The state’s 6.2% jobless rate as of July 2015, however, continued to exceed the national unemployment rate for the same period. New Jersey’s economic rebound has been slow, and we expect overall growth will remain muted.
Long-term liabilities continue to weigh on the state’s fiscal stability and are a growing concern. According to Moody’s, New Jersey is the third most heavily indebted state with $37 billion of net tax-supported debt and ranks fourth highest among all states for debt per capita and debt as a percentage of personal income. Most of New Jersey’s debt is appropriation backed, meaning that debt service can only be paid if the state legislature annually appropriates funds to do so. New Jersey also faces significant future liabilities for pension and OPEB. The state has taken steps toward pension reform but continues to fall short of its annual required contribution for pensions. As a result, the funded ratio fell to 67% in 2014. Under new reporting standards required by GASB Statement No. 67, the state projects that the pension-funded ratio declined to a very low 44% on an aggregate basis. New Jersey’s OPEB liability is elevated at $67 billion and largely reflects post-employment health benefits for retired state employees and teachers. This liability was completely unfunded as of fiscal year 2014.
New Jersey’s fiscal position remains under pressure despite spending cuts. Audited results for the fiscal year ended June 30, 2014, show that revenues trailed budgeted forecasts, producing a sizable operating deficit. New Jersey ended the year with a cash balance of $300 million, or a very narrow 0.9% of its appropriations. Unaudited estimates for fiscal 2015 show that ending cash balances improved slightly to $388 million but remain narrow at 1.2% of appropriations.
Finally, New Jersey continues to experience significant challenges making statutory pension contributions. The New Jersey Supreme Court recently upheld Governor Chris Christie’s fiscal year 2015 pension contribution, which was far below statutorily required levels. While this ruling allowed the state to avoid significant budgetary stress at the end of the fiscal year, inadequate contributions will further strain the pension funds going forward.
PORTFOLIO PERFORMANCE AND STRATEGY REVIEW
The New Jersey Tax-Free Bond Fund returned 0.03% for the six months ended August 31, 2015, exceeding the -1.00% return of its Lipper peer group average, thanks to our conservative positioning in the State of New Jersey-backed bonds. The fund’s performance versus its peers is solid, placing it in the top decile in the trailing one- and three-year periods and in the top quintile in the past 5- and 10-year periods. Based on cumulative total return, Lipper ranked the New Jersey Tax-Free Bond Fund 1 of 49, 3 of 45, 7 of 43, and 6 of 31 New Jersey municipal debt funds for the 1-, 3-, 5-, and 10-year periods ended August 31, 2015, respectively. (Results will vary for other time periods. Past performance cannot guarantee future results.)
The fund’s duration was 4.7 years at period-end, unchanged from six months ago and close to that of the Barclays index and its peer group. (A longer duration means the fund is more sensitive to changes in interest rates.) Its weighted average maturity was also unchanged, ending the period at 15.6 years. In terms of yield curve positioning, we maintained an overweight to bonds with maturities of 15 years and longer relative to the Barclays Municipal Bond Index. We maintained this curve positioning for the added yield offered by longer-dated bonds and due to our expectations of higher short-term rates as the Fed draws closer to tightening monetary policy. Unlike past periods when longer-dated bonds outperformed, returns were generally flat across the yield curve over the past six months.
Given the state’s ongoing fiscal problems, we were vigilant about keeping our direct exposure to the State of New Jersey at historic lows and continued to reduce our holdings. Our exposure to the State of New Jersey—which was well below that of our peer group—reflects our longstanding concerns about the state’s underfunded pension system and persistent budgetary pressures despite improved revenues. New Jersey issued debt for the first time in roughly two years in August, and investors demanded higher yields as New Jersey GO and appropriation-backed bonds have underperformed the market. Given the negative returns of New Jersey State GO and appropriation-backed bonds over the past six months, our relatively low exposure to the state guarantor helped relative performance over the period.
With few exceptions, sector weightings remained broadly unchanged in the past six months. Health care, which typically offers higher-than-average yields in the tax-exempt muni market, remained the largest allocation at roughly 24% of the fund. Education revenue bonds increased by about 4% as we sought to diversify our holdings. Purchases in this sector included Montclair State University, William Paterson University, and The College of New Jersey. Exposure to the leasing sector declined by over 1% as we sold state appropriation-backed debt. (Please refer to the fund’s portfolio of investments for a complete list of our holdings and the amount each represents in the portfolio.)
Regarding quality diversification, we slightly increased the fund’s A rated holdings, which comprised 58% of assets at period-end. This shift reflects our belief that A rated investments offer greater value than higher-quality alternatives. The fund remains overweight in A and BBB rated bonds versus the Barclays index. With the fund’s flat return for the period, holdings that fared best varied in structure and characteristics. A number of lower-rated holdings continued to perform well, as did bonds with near-term issuer prepayment options that were priced at or near par. Underperformers consisted mainly of state-backed holdings. As always, we will continue to focus on the best long-term prospects in the municipal market, driven by our fundamental research-based investment process.
OUTLOOK
We believe that the municipal bond market remains a high-quality market that offers good opportunities for long-term investors seeking tax-free income. While fundamentals are sound overall and technical support should persist, there could be hurdles later in 2015. In particular, with the Fed preparing to tighten monetary policy, we are mindful that rising rates would likely weaken the appetite for bonds with higher interest rate risk. However, with the Fed likely to act cautiously, the transition to higher rates may not be as painful as some fear.
While we believe that many states deserve high credit ratings and will be able to continue servicing their debts, we have longer-term concerns about significant funding shortfalls for pensions and OPEB obligations in some jurisdictions. These funding gaps stem from investment losses during the financial crisis, insufficient plan contributions over time, and unrealistic return projections. Although few large plans are at risk of insolvency in the near term, the magnitude of unfunded liabilities is becoming more conspicuous in a few states.
Ultimately, we believe T. Rowe Price’s independent credit research is our greatest strength and will remain an asset for our investors as we navigate the current market environment. As always, we focus on finding attractively valued bonds issued by municipalities with good long-term fundamentals—an investment strategy that we believe will continue to serve our investors well.
Thank you for investing with T. Rowe Price.
Respectfully submitted,
Konstantine B. Mallas
Chairman of the Investment Advisory Committee
September 16, 2015
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.
RISKS OF FIXED INCOME INVESTING
Bonds are subject to interest rate risk (the decline in bond prices that usually accompanies a rise in interest rates) and credit risk (the chance that any fund holding could have its credit rating downgraded or that a bond issuer will default by failing to make timely payments of interest or principal), potentially reducing the fund’s income level and share price. The New Jersey Tax-Free Bond Fund is less diversified than one investing nationally. Some income may be subject to state and local taxes and the federal alternative minimum tax.
GLOSSARY
Barclays Municipal Bond Index: A broadly diversified index of tax-exempt bonds.
Basis point: One one-hundredth of one percentage point, or 0.01%.
Duration: A measure of a bond fund’s sensitivity to changes in interest rates. For example, a fund with a duration of five years would fall about 5% in price in response to a one-percentage-point rise in interest rates, and vice versa.
Federal funds rate: The interest rate charged on overnight loans of reserves by one financial institution to another in the United States. The Federal Reserve sets a target federal funds rate to affect the direction of interest rates.
General obligation (GO) debt: A government’s strongest pledge that obligates its full faith and credit, including, if necessary, its ability to raise taxes.
Lipper averages: The averages of available mutual fund performance returns for specified time periods in categories defined by Lipper.
Other post-employment benefits liability (OPEB): Benefits paid to an employee after retirement, such as premiums for life and health insurance.
SEC yield (30-day): A method of calculating a fund’s yield that assumes all portfolio securities are held until maturity. The Securities and Exchange Commission (SEC) requires all bond funds to calculate this yield. Yield will vary and is not guaranteed.
Weighted average maturity: A measure of a fund’s interest rate sensitivity. In general, the longer the average maturity, the greater the fund’s sensitivity to interest rate changes. The weighted average maturity may take into account the interest rate readjustment dates for certain securities. Money funds must maintain a weighted average maturity of less than 60 days.
Yield curve: A graphic depiction of the relationship between yields and maturity dates for a set of similar securities. A security with a longer maturity usually has a higher yield. If a short-term security offers a higher yield, then the curve is said to be “inverted.” If short- and long-term bonds are offering equivalent yields, then the curve is said to be “flat.”
Performance and Expenses
| Growth of $10,000 |
This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.
| Fund Expense Example |
As a mutual fund shareholder, you may incur two types of costs: (1) transaction costs, such as redemption fees or sales loads, and (2) ongoing costs, including management fees, distribution and service (12b-1) fees, and other fund expenses. The following example is intended to help you understand your ongoing costs (in dollars) of investing in the fund and to compare these costs with the ongoing costs of investing in other mutual funds. The example is based on an investment of $1,000 invested at the beginning of the most recent six-month period and held for the entire period.
Actual Expenses
The first line of the following table (Actual) provides information about actual account values and expenses based on the fund’s actual returns. You may use the information on this line, together with your account balance, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number on the first line under the heading “Expenses Paid During Period” to estimate the expenses you paid on your account during this period.
Hypothetical Example for Comparison Purposes
The information on the second line of the table (Hypothetical) is based on hypothetical account values and expenses derived from the fund’s actual expense ratio and an assumed 5% per year rate of return before expenses (not the fund’s actual return). You may compare the ongoing costs of investing in the fund with other funds by contrasting this 5% hypothetical example and the 5% hypothetical examples that appear in the shareholder reports of the other funds. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period.
Note: T. Rowe Price charges an annual account service fee of $20, generally for accounts with less than $10,000. The fee is waived for any investor whose T. Rowe Price mutual fund accounts total $50,000 or more; accounts electing to receive electronic delivery of account statements, transaction confirmations, prospectuses, and shareholder reports; or accounts of an investor who is a T. Rowe Price Preferred Services, Personal Services, or Enhanced Personal Services client (enrollment in these programs generally requires T. Rowe Price assets of at least $100,000). This fee is not included in the accompanying table. If you are subject to the fee, keep it in mind when you are estimating the ongoing expenses of investing in the fund and when comparing the expenses of this fund with other funds.
You should also be aware that the expenses shown in the table highlight only your ongoing costs and do not reflect any transaction costs, such as redemption fees or sales loads. Therefore, the second line of the table is useful in comparing ongoing costs only and will not help you determine the relative total costs of owning different funds. To the extent a fund charges transaction costs, however, the total cost of owning that fund is higher.
Unaudited
The accompanying notes are an integral part of these financial statements.
Unaudited
The accompanying notes are an integral part of these financial statements.
Unaudited
The accompanying notes are an integral part of these financial statements.
Unaudited
The accompanying notes are an integral part of these financial statements.
Unaudited
The accompanying notes are an integral part of these financial statements.
Unaudited
| Notes to Financial Statements |
T. Rowe Price State Tax-Free Income Trust (the trust), is registered under the Investment Company Act of 1940 (the 1940 Act). The New Jersey Tax-Free Bond Fund (the fund) is a nondiversified, open-end management investment company established by the trust. The fund commenced operations on April 30, 1991. The fund seeks to provide, consistent with prudent portfolio management, the highest level of income exempt from federal and New Jersey state income taxes by investing primarily in investment-grade New Jersey municipal bonds.
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
Basis of Preparation The fund is an investment company and follows accounting and reporting guidance in the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 946 (ASC 946). The accompanying financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), including but not limited to ASC 946. GAAP requires the use of estimates made by management. Management believes that estimates and valuations are appropriate; however, actual results may differ from those estimates, and the valuations reflected in the accompanying financial statements may differ from the value ultimately realized upon sale or maturity.
Investment Transactions, Investment Income, and Distributions Income and expenses are recorded on the accrual basis. Premiums and discounts on debt securities are amortized for financial reporting purposes. Income tax-related interest and penalties, if incurred, would be recorded as income tax expense. Investment transactions are accounted for on the trade date. Realized gains and losses are reported on the identified cost basis. Distributions to shareholders are recorded on the ex-dividend date. Income distributions are declared daily and paid monthly. Capital gain distributions, if any, are generally declared and paid by the fund annually.
New Accounting Guidance In May 2015, FASB issued ASU No. 2015-07, Fair Value Measurement (Topic 820), Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). The ASU removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient and amends certain disclosure requirements for such investments. The ASU is effective for interim and annual reporting periods beginning after December 15, 2015. Adoption will have no effect on the fund’s net assets or results of operations.
NOTE 2 - VALUATION
The fund’s financial instruments are valued and its net asset value (NAV) per share is computed at the close of the New York Stock Exchange (NYSE), normally 4 p.m. ET, each day the NYSE is open for business.
Fair Value The fund’s financial instruments are reported at fair value, which GAAP defines as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The T. Rowe Price Valuation Committee (the Valuation Committee) has been established by the fund’s Board of Trustees (the Board) to ensure that financial instruments are appropriately priced at fair value in accordance with GAAP and the 1940 Act. Subject to oversight by the Board, the Valuation Committee develops and oversees pricing-related policies and procedures and approves all fair value determinations. Specifically, the Valuation Committee establishes procedures to value securities; determines pricing techniques, sources, and persons eligible to effect fair value pricing actions; oversees the selection, services, and performance of pricing vendors; oversees valuation-related business continuity practices; and provides guidance on internal controls and valuation-related matters. The Valuation Committee reports to the Board and has representation from legal, portfolio management and trading, operations, risk management, and the fund’s treasurer.
Various valuation techniques and inputs are used to determine the fair value of financial instruments. GAAP establishes the following fair value hierarchy that categorizes the inputs used to measure fair value:
Level 1 – quoted prices (unadjusted) in active markets for identical financial instruments that the fund can access at the reporting date
Level 2 – inputs other than Level 1 quoted prices that are observable, either directly or indirectly (including, but not limited to, quoted prices for similar financial instruments in active markets, quoted prices for identical or similar financial instruments in inactive markets, interest rates and yield curves, implied volatilities, and credit spreads)
Level 3 – unobservable inputs
Observable inputs are developed using market data, such as publicly available information about actual events or transactions, and reflect the assumptions that market participants would use to price the financial instrument. Unobservable inputs are those for which market data are not available and are developed using the best information available about the assumptions that market participants would use to price the financial instrument. GAAP requires valuation techniques to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. When multiple inputs are used to derive fair value, the financial instrument is assigned to the level within the fair value hierarchy based on the lowest-level input that is significant to the fair value of the financial instrument. Input levels are not necessarily an indication of the risk or liquidity associated with financial instruments at that level but rather the degree of judgment used in determining those values.
Valuation Techniques Debt securities generally are traded in the over-the-counter (OTC) market. Securities with remaining maturities of one year or more at the time of acquisition are valued at prices furnished by dealers who make markets in such securities or by an independent pricing service, which considers the yield or price of bonds of comparable quality, coupon, maturity, and type, as well as prices quoted by dealers who make markets in such securities. Securities with remaining maturities of less than one year at the time of acquisition generally use amortized cost in local currency to approximate fair value. However, if amortized cost is deemed not to reflect fair value or the fund holds a significant amount of such securities with remaining maturities of more than 60 days, the securities are valued at prices furnished by dealers who make markets in such securities or by an independent pricing service. Generally, debt securities are categorized in Level 2 of the fair value hierarchy; however, to the extent the valuations include significant unobservable inputs, the securities would be categorized in Level 3.
Financial futures contracts are valued at closing settlement prices and are categorized in Level 1 of the fair value hierarchy. Assets and liabilities other than financial instruments, including short-term receivables and payables, are carried at cost, or estimated realizable value, if less, which approximates fair value.
Thinly traded financial instruments and those for which the above valuation procedures are inappropriate or are deemed not to reflect fair value are stated at fair value as determined in good faith by the Valuation Committee. The objective of any fair value pricing determination is to arrive at a price that could reasonably be expected from a current sale. Financial instruments fair valued by the Valuation Committee are primarily private placements, restricted securities, warrants, rights, and other securities that are not publicly traded.
Subject to oversight by the Board, the Valuation Committee regularly makes good faith judgments to establish and adjust the fair valuations of certain securities as events occur and circumstances warrant. For instance, in determining the fair value of troubled or thinly traded debt instruments, the Valuation Committee considers a variety of factors, which may include, but are not limited to, the issuer’s business prospects, its financial standing and performance, recent investment transactions in the issuer, strategic events affecting the company, market liquidity for the issuer, and general economic conditions and events. In consultation with the investment and pricing teams, the Valuation Committee will determine an appropriate valuation technique based on available information, which may include both observable and unobservable inputs. The Valuation Committee typically will afford greatest weight to actual prices in arm’s length transactions, to the extent they represent orderly transactions between market participants; transaction information can be reliably obtained; and prices are deemed representative of fair value. However, the Valuation Committee may also consider other valuation methods such as a discount or premium from market value of a similar, freely traded security of the same issuer; discounted cash flows; yield to maturity; or some combination. Fair value determinations are reviewed on a regular basis and updated as information becomes available, including actual purchase and sale transactions of the issue. Because any fair value determination involves a significant amount of judgment, there is a degree of subjectivity inherent in such pricing decisions, and fair value prices determined by the Valuation Committee could differ from those of other market participants. Depending on the relative significance of unobservable inputs, including the valuation technique(s) used, fair valued securities may be categorized in Level 2 or 3 of the fair value hierarchy.
Valuation Inputs The following table summarizes the fund’s financial instruments, based on the inputs used to determine their fair values on August 31, 2015:
There were no material transfers between Levels 1 and 2 during the six months ended August 31, 2015.
NOTE 3 - DERIVATIVE INSTRUMENTS
During the six months ended August 31, 2015, the fund invested in derivative instruments. As defined by GAAP, a derivative is a financial instrument whose value is derived from an underlying security price, foreign exchange rate, interest rate, index of prices or rates, or other variable; it requires little or no initial investment and permits or requires net settlement. The fund invests in derivatives only if the expected risks and rewards are consistent with its investment objectives, policies, and overall risk profile, as described in its prospectus and Statement of Additional Information. The fund may use derivatives for a variety of purposes, such as seeking to hedge against declines in principal value, increase yield, invest in an asset with greater efficiency and at a lower cost than is possible through direct investment, or to adjust portfolio duration and credit exposure. The risks associated with the use of derivatives are different from, and potentially much greater than, the risks associated with investing directly in the instruments on which the derivatives are based. The fund at all times maintains sufficient cash reserves, liquid assets, or other SEC-permitted asset types to cover its settlement obligations under open derivative contracts.
The fund values its derivatives at fair value, as described in Note 2, and recognizes changes in fair value currently in its results of operations. Accordingly, the fund does not follow hedge accounting, even for derivatives employed as economic hedges. Generally, the fund accounts for its derivatives on a gross basis. It does not offset the fair value of derivative liabilities against the fair value of derivative assets on its financial statements, nor does it offset the fair value of derivative instruments against the right to reclaim or obligation to return collateral. As of August 31, 2015, the fund held interest rate futures with cumulative unrealized gain of $4,000; the value reflected on the accompanying Statement of Assets and Liabilities is the related unsettled variation margin.
Additionally, during the six months ended August 31, 2015, the fund recognized $14,000 of realized loss on Futures and a $9,000 change in unrealized gain/loss on Futures related to its investments in interest rate derivatives; such amounts are included on the accompanying Statement of Operations.
Counterparty Risk and Collateral The fund invests in exchange-traded or centrally cleared derivative contracts, such as futures, exchange-traded options, and centrally cleared swaps. Counterparty risk on such derivatives is minimal because the clearinghouse provides protection against counterparty defaults. For futures and centrally cleared swaps, the fund is required to deposit collateral in an amount equal to a certain percentage of the contract value (margin requirement), and the margin requirement must be maintained over the life of the contract. Each clearing broker, in its sole discretion, may adjust the margin requirements applicable to the fund.
Collateral may be in the form of cash or debt securities issued by the U.S. government or related agencies. Cash and currencies posted by the fund are reflected as cash deposits in the accompanying financial statements and generally are restricted from withdrawal by the fund; securities posted by the fund are so noted in the accompanying Portfolio of Investments; both remain in the fund’s assets. As of August 31, 2015, cash of $14,000 had been posted by the fund for exchange-traded and/or centrally cleared derivatives.
Futures Contracts The fund is subject to interest rate risk in the normal course of pursuing its investment objectives and uses futures contracts to help manage such risk. The fund may enter into futures contracts to manage exposure to interest rate and yield curve movements, security prices, foreign currencies, credit quality, and mortgage prepayments; as an efficient mean of adjusting exposure to all or part of a target market; to enhance income; as a cash management tool; or to adjust portfolio duration and credit exposure. A futures contract provides for the future sale by one party and purchase by another of a specified amount of a specific underlying financial instrument at an agreed-upon price, date, time, and place. The fund currently invests only in exchange-traded futures, which generally are standardized as to maturity date, underlying financial instrument, and other contract terms. Payments are made or received by the fund each day to settle daily fluctuations in the value of the contract (variation margin), which reflect changes in the value of the underlying financial instrument. Variation margin is recorded as unrealized gain or loss until the contract is closed. The value of a futures contract included in net assets is the amount of unsettled variation margin; net variation margin receivable is reflected as an asset and net variation margin payable is reflected as a liability on the accompanying Statement of Assets and Liabilities. Risks related to the use of futures contracts include possible illiquidity of the futures markets, contract prices that can be highly volatile and imperfectly correlated to movements in hedged security values and/or interest rates, and potential losses in excess of the fund’s initial investment. During the year ended August 31, 2015, the volume of the fund’s activity in futures, based on underlying notional amounts, was generally less than 1% of net assets.
NOTE 4 - OTHER INVESTMENT TRANSACTIONS
Consistent with its investment objective, the fund engages in the following practices to manage exposure to certain risks and/or to enhance performance. The investment objective, policies, program, and risk factors of the fund are described more fully in the fund’s prospectus and Statement of Additional Information.
When-Issued Securities The fund may enter into when-issued purchase or sale commitments, pursuant to which it agrees to purchase or sell, respectively, an authorized but not yet issued security for a fixed unit price, with payment and delivery not due until issuance of the security on a scheduled future date. When-issued securities may be new securities or securities issued through a corporate action, such as a reorganization or restructuring. Until settlement, the fund maintains liquid assets sufficient to settle its commitment to purchase a when-issued security or, in the case of a sale commitment, the fund maintains an entitlement to the security to be sold. Amounts realized on when-issued transactions are included in realized gain/loss on securities in the accompanying financial statements.
Other Purchases and sales of portfolio securities other than short-term securities aggregated $29,023,000 and $15,411,000, respectively, for the six months ended August 31, 2015.
NOTE 5 - FEDERAL INCOME TAXES
No provision for federal income taxes is required since the fund intends to continue to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code and distribute to shareholders all of its income and gains. Distributions determined in accordance with federal income tax regulations may differ in amount or character from net investment income and realized gains for financial reporting purposes. Financial reporting records are adjusted for permanent book/tax differences to reflect tax character but are not adjusted for temporary differences. The amount and character of tax-basis distributions and composition of net assets are finalized at fiscal year-end; accordingly, tax-basis balances have not been determined as of the date of this report.
The fund intends to retain realized gains to the extent of available capital loss carryforwards. Because the fund is required to use capital loss carryforwards that do not expire before those with expiration dates, all or a portion of its capital loss carryforwards subject to expiration could ultimately go unused. As of February 28, 2015, the fund had $2,592,000 of available capital loss carryforwards, which expire as follows: $93,000 in fiscal 2016 and $413,000 in fiscal 2017; $2,086,000 have no expiration.
At August 31, 2015, the cost of investments for federal income tax purposes was $328,849,000. Net unrealized gain aggregated $14,986,000 at period-end, of which $16,124,000 related to appreciated investments and $1,138,000 related to depreciated investments.
NOTE 6 - RELATED PARTY TRANSACTIONS
The fund is managed by T. Rowe Price Associates, Inc. (Price Associates), a wholly owned subsidiary of T. Rowe Price Group, Inc. (Price Group). The investment management agreement between the fund and Price Associates provides for an annual investment management fee, which is computed daily and paid monthly. The fee consists of an individual fund fee, equal to 0.10% of the fund’s average daily net assets, and a group fee. The group fee rate is calculated based on the combined net assets of certain mutual funds sponsored by Price Associates (the group) applied to a graduated fee schedule, with rates ranging from 0.48% for the first $1 billion of assets to 0.275% for assets in excess of $400 billion. The fund’s group fee is determined by applying the group fee rate to the fund’s average daily net assets. At August 31, 2015, the effective annual group fee rate was 0.29%.
In addition, the fund has entered into service agreements with Price Associates and a wholly owned subsidiary of Price Associates (collectively, Price). Price Associates provides certain accounting and administrative services to the fund. T. Rowe Price Services, Inc., provides shareholder and administrative services in its capacity as the fund’s transfer and dividend-disbursing agent. For the six months ended August 31, 2015, expenses incurred pursuant to these service agreements were $43,000 for Price Associates and $39,000 for T. Rowe Price Services, Inc. The total amount payable at period-end pursuant to these service agreements is reflected as Due to Affiliates in the accompanying financial statements.
| Information on Proxy Voting Policies, Procedures, and Records |
A description of the policies and procedures used by T. Rowe Price funds and portfolios to determine how to vote proxies relating to portfolio securities is available in each fund’s Statement of Additional Information. You may request this document by calling 1-800-225-5132 or by accessing the SEC’s website, sec.gov.
The description of our proxy voting policies and procedures is also available on our website, troweprice.com. To access it, click on the words “Social Responsibility” at the top of our corporate homepage. Next, click on the words “Conducting Business Responsibly” on the left side of the page that appears. Finally, click on the words “Proxy Voting Policies” on the left side of the page that appears.
Each fund’s most recent annual proxy voting record is available on our website and through the SEC’s website. To access it through our website, follow the above directions to reach the “Conducting Business Responsibly” page. Click on the words “Proxy Voting Records” on the left side of that page, and then click on the “View Proxy Voting Records” link at the bottom of the page that appears.
| How to Obtain Quarterly Portfolio Holdings |
The fund files a complete schedule of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year on Form N-Q. The fund’s Form N-Q is available electronically on the SEC’s website (sec.gov); hard copies may be reviewed and copied at the SEC’s Public Reference Room, 100 F St. N.E., Washington, DC 20549. For more information on the Public Reference Room, call 1-800-SEC-0330.
| Approval of Investment Management Agreement |
On March 13, 2015, the fund’s Board of Trustees (Board), including a majority of the fund’s independent trustees, approved the continuation of the investment management agreement (Advisory Contract) between the fund and its investment advisor, T. Rowe Price Associates, Inc. (Advisor). In connection with its deliberations, the Board requested, and the Advisor provided, such information as the Board (with advice from independent legal counsel) deemed reasonably necessary. The Board considered a variety of factors in connection with its review of the Advisory Contract, also taking into account information provided by the Advisor during the course of the year, as discussed below:
Services Provided by the Advisor
The Board considered the nature, quality, and extent of the services provided to the fund by the Advisor. These services included, but were not limited to, directing the fund’s investments in accordance with its investment program and the overall management of the fund’s portfolio, as well as a variety of related activities such as financial, investment operations, and administrative services; compliance; maintaining the fund’s records and registrations; and shareholder communications. The Board also reviewed the background and experience of the Advisor’s senior management team and investment personnel involved in the management of the fund, as well as the Advisor’s compliance record. The Board concluded that it was satisfied with the nature, quality, and extent of the services provided by the Advisor.
Investment Performance of the Fund
The Board reviewed the fund’s three-month, one-year, and year-by-year returns, as well as the fund’s average annualized total returns over the 3-, 5-, and 10-year periods, and compared these returns with a wide variety of previously agreed-upon comparable performance measures and market data, including those supplied by Lipper and Morningstar, which are independent providers of mutual fund data.
On the basis of this evaluation and the Board’s ongoing review of investment results, and factoring in the relative market conditions during certain of the performance periods, the Board concluded that the fund’s performance was satisfactory.
Costs, Benefits, Profits, and Economies of Scale
The Board reviewed detailed information regarding the revenues received by the Advisor under the Advisory Contract and other benefits that the Advisor (and its affiliates) may have realized from its relationship with the fund, including any research received under “soft dollar” agreements and commission-sharing arrangements with broker-dealers. The Board considered that the Advisor may receive some benefit from soft-dollar arrangements pursuant to which research is received from broker-dealers that execute the applicable fund’s portfolio transactions. The Board received information on the estimated costs incurred and profits realized by the Advisor from managing T. Rowe Price mutual funds. The Board also reviewed estimates of the profits realized from managing the fund in particular, and the Board concluded that the Advisor’s profits were reasonable in light of the services provided to the fund.
The Board also considered whether the fund benefits under the fee levels set forth in the Advisory Contract from any economies of scale realized by the Advisor. Under the Advisory Contract, the fund pays a fee to the Advisor for investment management services composed of two components—a group fee rate based on the combined average net assets of most of the T. Rowe Price mutual funds (including the fund) that declines at certain asset levels and an individual fund fee rate based on the fund’s average daily net assets—and the fund pays its own expenses of operations. At the March 13, 2015, meeting, the Board approved an additional 0.005% breakpoint to the group fee schedule, effective May 1, 2015. With the new breakpoint, the group fee rate will decline to 0.270% when the combined average net assets of the applicable T. Rowe Price funds exceed $500 billion. The Board concluded that the advisory fee structure for the fund continued to provide for a reasonable sharing of benefits from any economies of scale with the fund’s investors.
Fees
The Board was provided with information regarding industry trends in management fees and expenses, and the Board reviewed the fund’s management fee rate, operating expenses, and total expense ratio in comparison with fees and expenses of other comparable funds based on information and data supplied by Lipper. The information provided to the Board indicated that the fund’s management fee rate and total expense ratio were above the median for certain groups of comparable funds and at or below the median for other groups of comparable funds.
The Board also reviewed the fee schedules for institutional accounts and private accounts with similar mandates that are advised or subadvised by the Advisor and its affiliates. Management provided the Board with information about the Advisor’s responsibilities and services provided to institutional account clients, including information about how the requirements and economics of the institutional business are fundamentally different from those of the mutual fund business. The Board considered information showing that the mutual fund business is generally more complex from a business and compliance perspective than the institutional business and that the Advisor generally performs significant additional services and assumes greater risk in managing the fund and other T. Rowe Price mutual funds than it does for institutional account clients.
On the basis of the information provided and the factors considered, the Board concluded that the fees paid by the fund under the Advisory Contract are reasonable.
Approval of the Advisory Contract
As noted, the Board approved the continuation of the Advisory Contract. No single factor was considered in isolation or to be determinative to the decision. Rather, the Board concluded, in light of a weighting and balancing of all factors considered, that it was in the best interests of the fund and its shareholders for the Board to approve the continuation of the Advisory Contract (including the fees to be charged for services thereunder). The independent trustees were advised throughout the process by independent legal counsel.
Item 2. Code of Ethics.
A code of ethics, as defined in Item 2 of Form N-CSR, applicable to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions is filed as an exhibit to the registrant’s annual Form N-CSR. No substantive amendments were approved or waivers were granted to this code of ethics during the registrant’s most recent fiscal half-year.
Item 3. Audit Committee Financial Expert.
Disclosure required in registrant’s annual Form N-CSR.
Item 4. Principal Accountant Fees and Services.
Disclosure required in registrant’s annual Form N-CSR.
Item 5. Audit Committee of Listed Registrants.
Not applicable.
Item 6. Investments.
(a) Not applicable. The complete schedule of investments is included in Item 1 of this Form N-CSR.
(b) Not applicable.
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
Not applicable.
Item 8. Portfolio Managers of Closed-End Management Investment Companies.
Not applicable.
Item 9. Purchases of Equity Securities by Closed-End Management Investment Company and Affiliated Purchasers.
Not applicable.
Item 10. Submission of Matters to a Vote of Security Holders.
Not applicable.
Item 11. Controls and Procedures.
(a) The registrant’s principal executive officer and principal financial officer have evaluated the registrant’s disclosure controls and procedures within 90 days of this filing and have concluded that the registrant’s disclosure controls and procedures were effective, as of that date, in ensuring that information required to be disclosed by the registrant in this Form N-CSR was recorded, processed, summarized, and reported timely.
(b) The registrant’s principal executive officer and principal financial officer are aware of no change in the registrant’s internal control over financial reporting that occurred during the registrant’s second fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.
Item 12. Exhibits.
(a)(1) The registrant’s code of ethics pursuant to Item 2 of Form N-CSR is filed with the registrant’s annual Form N-CSR.
(2) Separate certifications by the registrant's principal executive officer and principal financial officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and required by Rule 30a-2(a) under the Investment Company Act of 1940, are attached.
(3) Written solicitation to repurchase securities issued by closed-end companies: not applicable.
(b) A certification by the registrant's principal executive officer and principal financial officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and required by Rule 30a-2(b) under the Investment Company Act of 1940, is attached.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
T. Rowe Price State Tax-Free Income Trust
| By | /s/ Edward C. Bernard | |
| Edward C. Bernard | ||
| Principal Executive Officer | ||
| Date October 15, 2015 | ||
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| By | /s/ Edward C. Bernard | |
| Edward C. Bernard | ||
| Principal Executive Officer | ||
| Date October 15, 2015 | ||
| By | /s/ Catherine D. Mathews | |
| Catherine D. Mathews | ||
| Principal Financial Officer | ||
| Date October 15, 2015 | ||