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AAM Viewpoints - Municipal Bond Portfolios, Recent Federal Tax Reform, and Unintended Consequences


With the new federal tax legislation capping state and local tax (SALT) deductions at a maximum of $10,000 for Federal taxes, in the case of high state income tax states, the unintended consequence may be that Municipal Bond investors residing in those states have become too highly concentrated in their own state-issued municipal bonds. 


Even before the recent tax legislation, investors seemed to naturally gravitate toward municipal bond portfolios that are invested only in the state in which they live. There are probably multiple reasons for this; however, a couple more common reasons are:


First, the investor would rather invest in local municipal issuers that they know or may be familiar with the issuer. For example, an investor may choose to invest in a university bond from an institution that they attended or which they are familiar; “know what you own”.


Second, 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. Now, with the recent Federal tax reform that limits state and local tax deductions that can be deducted from Federal taxes, investors have more reason to buy in state municipal bond issues. 


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 municipal holdings.


 


Diversification


Placing all 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 issuer. 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 eventually 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 was depressed.


 


More 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 comparable credit quality offerings.


Recently the demand for Municipal bonds and their federally tax-exempt interest income is especially high. 


Ratios for municipal bonds interest rates as a percentage of US Treasury bond interest rates demonstrate the strength of the municipal market year-over-year.  The following are Municipal AAA benchmark yields as a percentage against US Treasuries yields of like maturities.  The ratios as of 04-16-2019 reflect not only a low percentage against the year before, but also historically.


 


10-Yr ratios 04-16-2018……. 84.5%                30-Yr Ratios 04-16-18…. 97.0%


10-Yr ratios 04-16-2019……. 75.7%                30-Yr Ratios 04-16-19…. 90.2%


Source: Bloomberg


 


To exacerbate this historically low percentage relationship appears to be a very strong demand for in-state municipal bond purchases in states with high income rates such as New York. These high state income tax states are having many credits trade as much as 15-20 basis points tighter on strong demand for paper for investors seeking the tax-exemption. This dynamic appeared to start in late-January to early-February presumably once tax payers felt the effect of the SALT deduction upon their 2018 tax filings. This phenomenon would make it even more justifiable to invest in out-of-state bonds for diversification as the fiscal impact of paying the additional Federal tax is lessened.


Investors may want to consider investing in general market municipal portfolios to achieve diversification, greater choice, and greater availability of municipal bond offerings. Depending on market conditions, the investor may be able to achieve a higher yield on out of state bonds to minimize or offset the additional taxes incurred with the new Federal tax laws. Regardless, some geographic diversification in a municipal bond portfolio may well be worth the higher taxes that may be paid. As always please consult your financial advisor before making investment decisions.


CRN: 2019-0405-7355R




Investors may want to consider investing in general market municipal portfolios to achieve diversification, greater choice and greater availability of municipal bond offerings.  Depending on market conditions, the investor may be able to achieve a higher yield on out of state bonds to minimize or offset the additional taxes incurred with the new Federal tax laws.  Regardless, some geographic diversification in a municipal bond portfolio may well be worth the higher taxes that may be paid.  As always please consult your financial advisor before making investment decisions.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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