INSIGHTS

On July 10, 2017

AAM Viewpoints – State-Specific Municipal Bond Portfolios: 3 Reasons They Might Not Be a Good Investment

Investors seem to naturally gravitate toward municipal bond portfolios that are only invested in the state in which they live. There are several common reasons given for choosing state-specific municipal bond portfolios but regardless of the rationale they generally fall into two camps:

1. If an investor lives in a state that taxes the income from out-of-state municipal bonds, then the investor may decide to buy only municipals that are issued within the state in which they live to save money on state taxes. Many investors do not want to pay state taxes…period.


2. The investor would rather invest in local municipal issuers in order to “know or be familiar with the issuer.” For example, an investor may choose to invest in a university bond from an institution that they attended.

I certainly understand the reasoning and the logic involved in making this decision, but I would like to suggest a couple reasons why an investor may want to consider investing, at least a portion of their investable portfolio in general market out-of-state holdings.

1. Diversification
   
   Placing all of your municipal bond investments in one state has the potential to be an unwise decision. An economic downturn in a state or region may weaken the credit quality of a particular security. Current examples of this would be the State of Illinois and some of the issuers within the state such as Illinois public universities whose economic health depends on a varying degree on state subsidies. How about natural disasters? An example of this would be Hurricane Katrina and Louisiana. Sure, the state pulled out of it economically, but it took time and during that period if an investor needed cash, generally speaking, the value of some issuers’ municipal bonds were depressed.
   
   
   
   


2. The Hurdle Rate
   
   Generally speaking, the hurdle rate to beat or meet the yield of an in-state bond with an out-of-state bond is just not that large. In most cases, the applicable state tax is only applied against the amount of income that remains after paying federal taxes. The additional yield necessary to cover the state tax will vary from state to state due to differences in state income taxes For example, a Massachusetts resident in the highest federal income tax bracket needs just 3.08% basis points in additional yield per 100 basis points to cover the state taxes after accounting for the local and state exemption. If a Massachusetts bond yields 2.00%, the out-of-state yield needs to be 2.076% or higher to cover the state income tax and net the same return as buying an in-state Massachusetts bond. An out-of-state bond would need to yield a 3.0924% or call it 3.10% to net out the same income as 3% in-state Massachusetts bond after paying the state income tax.
   
   California, which has the highest state income tax, leaves a resident that is in the highest federal income tax bracket needing an increase in yield on an out-of-state municipal bond of 7.43 basis points per 100 basis points to cover paying the state tax. An in-state California bond that yields a 2.00% would require a yield of 2.1486 or 2.15% yield out of state to cover paying the state income tax and net the same yield to the investor as buying an in-state California municipal bond.
   
   
   
   


3. Greater Choice and Availability
   
   The probability of buying higher yielding bonds of similar quality in some states, especially those that do not have a state income tax, is usually pretty high versus states with state income taxes because the yield received on bonds in those states without income taxes – such as Florida and Texas –must compete in the general market. There is no tax incentive to the residents in Florida and Texas to invest in their respective in-state municipal bond issues.
   
   Couple the above with the fact that when an investor looks for bonds nationally the availability of bonds of similar type is multiple times higher than focusing on just one state. This increases the probability of finding higher yielding bonds. As an example, I ran three bond queries on a commonly used industry trading platform with the same bond parameters and the variable being the state of issuance.
   
   The first state was Colorado, a moderate supply state; California, a heavy volume state; and the entire nation. There were 48 offerings in Colorado, 138 offerings in California and over 2,000 offerings nationally. The breadth of offerings available on a national basis lends itself to maximizing after-tax returns even after paying state income taxes.

Investors may want to consider investing in general market municipal portfolios to achieve diversification and for greater choice and availability of municipal bond offerings while being able in many cases to meet or achieve their state income tax hurdle rates.

As always, please consult a financial consultant and/or a tax advisor before making any investment decisions.

CRN: 2017-0710-6032R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.

AAM was not involved with the preparation of the articles linked to in this email and the opinions expressed in these articles are not necessarily those of AAM.