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Conventional wisdom holds that municipal bond investors living in high-tax states should focus on owning bonds issued in their state of residence in order to earn income free from federal, state, and potentially, local taxes.
However, the decision to only invest in bonds from your home state is not always clear-cut, especially if the investor is interested in maximizing after-tax income in their portfolio rather than attempting to minimize their tax bill. The 2018 tax law changes capped the deductibility of state and local taxes at $10,000 for joint filers, which will drive up effective tax rates for investors in a number of higher-tax states. With this phase out, investors in these high-tax states are even more incentivized, in our opinion, to look to generate the tax-advantaged income that municipal bonds can provide.
Maximizing after-tax yield
Investors who are subject to higher state tax rates and focus solely on in-state bonds may be limiting their after-tax income. Why? Out-of-state muni bonds (national) tend to offer higher yields (more income) than in-state muni bonds after adjusting for taxes. Occasionally, when demand is particularly high, in-state bonds can trade at lower yields than higher rated, national bonds. Why? States with very high personal income tax rates create an outsized appetite for in-state bonds, thus driving in-state bond prices higher. In this situation, it can make sense for a muni investor to look beyond the borders of their state as there can be a substantial income pickup even when factoring in the tax bill on out-of-state municipal income. You need an apples- to-apples comparison and the best way to do that is to focus on equivalent after-state-tax yields. As an example, some residents of New York fall into the state’s highest income tax bracket of 8.82%. As of 11/17/18, the Bloomberg yield curve for State of New York General Obligation bonds shows an in-state yield of 2.71%. Due to excess demand from the state’s high tax rate, this is a lower yield than the Bloomberg National AAA-rated ten-year yield of 2.76%. Any out-of- state bond with a yield above 2.97%1 would provide a higher after-state-tax equivalent yield. In the current market, it is possible to find national AA-rated, ten-year bonds above this breakeven yield. These relationships change often due to state supply and demand, so check yield levels before purchasing national bonds.
Moreover, there are seven states2 that do not currently have a state income tax. Without the excess demand from in-state investors, a bond from those states can often provide more yield (income) than a similarly rated bond from a high-tax state. Depending on current yield levels, looking for municipal bonds outside of your home state may provide higher income.
Increased diversification with less concentrated credit risk
While most states’ fiscal conditions have improved in recent years, there continues to be wide variability in ratings, from AAA-rated states like Florida to BBB- in the case of Illinois. Just like the nation, states go through economic cycles that are not necessarily in sync with other states. Your single-state portfolio could underperform in a state downturn, periods of political turmoil or fiscal deterioration. Further, just five states accounted for nearly half of municipal bond issuance during 2017: California (15.5%), New York (11.1%), Texas (9.5%), Illinois (4.9%) and Pennsylvania (4.7%). It is important to consider the size and diversity of your state’s municipal bond market before investing in a single-state portfolio. Geographic diversification is an important component for risk management in municipal bond portfolios.
In summary, you may think it’s just common sense to limit purchases to in-state municipal bonds. Investors should take the extra step and compare the yield of in-state municipal bonds to the after-tax yields on national municipal bonds. Additionally, the benefits of diversification should be apparent if your home state ever experiences economic or financial difficulties. Consult with your wealth and tax advisor to determine what may be best for your situation.
1 The calculation is In-State Bond Yield ÷ (1-State Income Tax Rate) or 2.71% ÷ ( 1-8.82%) = 2.97%.
2 Bonds in these states without an income tax may offer higher yields than states with high income tax rates: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. All of these factors can subject the funds to increased loss of principal.
Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall.
Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.
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