In the municipal debt markets, investors have generally gravitated toward their own state-specific municipal debt instruments due to their tax-exempt status and the “triple tax exemption” from federal, state and local taxes on coupon payments.
Due to the same reasons, these instruments have been more attractive investment options for high earners; therefore, investors from high-taxing states like California, Hawaii and New York have been more inclined to seek out municipal debt from within their respective states. On the contrary, muni debt instruments from other states can be a viable option in one’s portfolio solely on the basis of risk mitigation. Unlike state-specific muni bonds, municipal issues from across the U.S. can help an investor to diversify and minimize any form of concentration risk, which can also help investors attain their efficient frontier, risk-reward relation on their portfolio by providing better risk-adjusted returns.
Although there are many factors investors must weigh to compare state-specific and out-of-state municipal bonds, the question remains whether risk mitigation through out-of-state muni bonds outweighs the tax benefits of state-specific muni investments.
In this article, we will take a closer look at some of the main benefits of investing into state-specific debt, and whether out-of-state debt can add value to either enhance your yield or mitigate some concentration risk.
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Why State-Specific Debt?
Municipal securities have always been attractive investment vehicles for those looking to benefit from tax exemption while still generating decent returns. In addition to their federal and, often, state tax-free statuses, these securities are often backed by strong revenue streams and reserves, creating higher credit qualities and making them even more desirable than their taxable counterparts. In your own state debt instruments, the tax exemption often applies on all three levels: federal tax exempt, state tax exempt and local tax exempt.
In many instances, investors solely focus on the tax-exempt nature of the investment vehicles and often overlook the bigger picture. Any tax-exempt security will provide a higher benefit to someone in a high tax bracket than someone who is in a lower tax bracket. This is due to the tax-equivalent yield.
Unlike state-specific debt, out-of-state debt instruments will have a similar debt structure, but their coupon payments will be taxable to someone who is from out of state. For example: If an investor from California buys a bond from Nevada that’s paying a higher coupon than the similar bond issued in California, he or she will have to pay state and local taxes on the income from the Nevada bond.
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Tax-Free Vs. Tax-Equivalent Yields
These two concepts are quite valuable when comparing two different bonds with similar structures but different tax treatments of their respective coupons. Let us consider a state-specific municipal bond that has a coupon of 6% with 10-years’ maturity. Next, we have an out-of-state bond with a 7.5% coupon and a similar maturity. Assuming your state tax bracket is 25%, which bond will be more profitable for you? Now we know that 7.5% will be taxable bond and its income will be taxed at 25%, which also means that the real return of this bond is 5.625% (7.5%*.75). When comparing this yield to the state-specific tax-free yield of 6%, the state-specific bond is the more lucrative option.
Learn more about tax implications for municipal bonds here.
The Uncertainty With State-Specific Bonds
In the municipal debt markets, investors have generally gravitated toward their own state-specific municipal debt instruments due to the added incentives of state and local tax exemptions.
However, there are certain situations where it is actually beneficial to opt for out-of-state municipal bonds. Some of these are highlighted below:
Classic examples like the 2008 financial crisis in the U.S. – during which some of the biggest municipalities filed for bankruptcy – help demonstrate why diversification across states can be beneficial. In addition, concern of municipal defaults is progressively increasing due to various reasons. For instance, historic droughts in California have led local governments to employ extreme water conservation measures that have impacted water revenues and the ability of the local governments to meet bond covenants. Furthermore, several municipalities have been facing growing pension liabilities due to considerably lower returns on their pension portfolios and increasing healthcare costs for retirees. Although some risks are shared across states, risks that are state specific, like California’s water drought, can be diversified by purchasing out-of-state bonds.
Even though certain risks are still prevalent in out-of-state bonds, they often help you diversify your investment holding and mitigate the concentration risk. Many investors also find out-of-state municipal debt instruments that provide better after-tax returns than some tax-exempt state-specific municipal instruments.
Investors looking to solely capitalize on tax-free returns may be inclined toward buying state-specific bonds; however, investors must keep in mind that federal tax exemption applies to almost all in-state and out-of-state muni issuers, and the majority of tax savings come from the federal tax exemptions rather than the state tax exemptions.
Be sure to read this article to remain aware of the due diligence process for evaluating municipal bonds.
The Bottom Line
For any investor, their investment objectives, risk tolerance, time horizon and tax bracket are a few of the many factors that determine whether they should invest in out-of-state municipal debt.
The potentially higher returns of out-of-state municipal bonds shouldn’t be the only deciding factor for investors, as they also provide risk mitigation from concentration risk and help avoid too much fixed-income exposure to one state or local government. It is also important to consider the fact that investors living in states where municipalities share similar political, geographic and economic risks might want to diversify their holdings to other states in order to mitigate these risks.
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