A major benefit of municipal bonds, or “munis,” can be summed up in two words: tax breaks.
Interest payments on munis, which are issued by cities, states and local governments to fund daily operations or building projects, are generally exempt from federal income taxes.1 They may also be exempt from state income taxes—but this exemption tends to apply only if the issuer is from your home state. In other words, some of the tax breaks stop at the state line.
That may seem like a compelling argument for sticking with in-state munis. After all, the combined tax breaks they offer someone in a high-tax state could be pretty large.
But are there good reasons to invest in out-of-state munis? We found five cases where they might make sense.
1. You live in a state with low or no income taxes.
If your state income tax bill is not an important consideration, then you may benefit from diversifying your muni portfolio with out-of-state issuers.
The map below shows the maximum marginal income tax rate by state for married taxpayers filing jointly.
2. You could earn a higher yield, even without state tax breaks.
Some out-of-state muni bonds offer higher yields than in-state munis, even after accounting for any state income taxes.
It depends on where you look, though. The table below shows the yield investors in certain states would have to earn on out-of-state munis compared with the yield on an index of 10-year general obligation (GO) bonds from their home state to make up for the lack of state-income-tax breaks. The investors are in their home states’ highest marginal state tax bracket, and the difference in yield is expressed in basis points (hundredths of a percentage point). Note that Florida, Texas and Washington don’t have state income taxes, so there’s no spread.
To call out one example, the yield on the 10-year California GO bond index is 1.84%. A married couple in the highest marginal tax bracket would have to earn a yield of at least 2.12% on a bond from outside of California to achieve the same after-tax yield as the in-state bond. That could be possible with a bond from Illinois, New Jersey or Pennsylvania. Of course, higher yields generally also mean higher risks, so investors should keep that in mind.
Types of muni bonds
General obligation (GO) bonds: Generally backed by the issuer’s authority to collect, these bonds are often repaid with property taxes, but can also be supported by a dedicated tax enacted to repay bondholders.
Revenue bonds: These bonds aren’t backed by a municipality’s taxing power, but pay bondholders with revenues from things like leases, water and sewer utility charges and income from airports or public transit systems. Credit quality can vary significantly, depending on the revenue source.
3. You could earn higher total returns on munis from other states.
If you’re investing in other states’ munis through a bond fund or actively managed account, the fund manager could identify higher-yielding and potentially undervalued securities to help drive returns. Remember, total returns come from two primary sources: interest payments and changes in prices.
Changes in economic conditions among the different states can affect credit conditions, which can affect bond prices in turn. Some state-specific funds—California’s, for example—have benefited recently from improving credit quality and higher prices. Other state-specific funds, like New Jersey’s, have been hurt by deteriorating credit quality and falling prices.
4. Economic conditions in your home state are deteriorating.
The muni market is big—there are approximately $3.6 trillion of muni bonds outstanding,2 with more than 12,400 different issuers rated by Moody’s Investors Service3—and the credit quality of each state and issuer could be impacted by different economic conditions or sources of revenue. If the conditions in your home state, or regions of your home state, aren’t favorable, other states’ bonds might be more appealing.
It also might make sense for investors living in states where municipalities share similar political, geographic and economic risks to diversify into other states to reduce these risks. Credit quality is generally stronger in areas with steadily increasing populations, skilled workforces and diverse economies. Issuers in the aging industrial centers and areas that rely heavily on the oil and gas industry should be considered cautiously.
5. You live in a state with few choices.
We recommend holding at least 10 different bonds from issuers with dissimilar credit characteristics. This could be difficult if your home state has a relatively small number of issuers with similar risks. States with a large inventory of bonds from issuers with different credit characteristics, like California, may not have this problem.
1 Some types of municipal bonds are not tax-exempt, for example, and some investors may be subject to the alternative minimum tax for interest paid on certain types of municipal bonds.
2 Bloomberg, as of 5/9/2016.
3 Moody’s Investors Service, as of 2/8/2016.