When investors think of the income from municipal bonds, they tend to think of the tax-exempt nature of this income from the federal level. That makes sense given the relatively high level of federal taxes compared to those at the state and local level. However, municipal bond investors would be remiss to ignore the impact that state and local taxes can have on an appropriate mix of in-state/out-of-state bonds in their municipal bond portfolios.

There are a variety of considerations and assessments needed to find an ideal mix of in-state/out-of-state bonds and the inputs to that analysis can change over time. This piece takes a closer look at how we, at Breckinridge, think about this ever-evolving process of building state preference municipal bond portfolios.

Where you live affects allocations to in-state vs out-of-state mix

1912 was a notable year, as the first eastbound U.S. transcontinental flight took place, the opulent Titanic infamously sank, and Fenway Park in Boston opened its gates for the first time. Also in 1912, the Badger State of Wisconsin put into place the first state income tax.

Today, state and local governments tax residents in various ways including taxes on income, purchases and property. For many states, the revenue derived from taxes on investment income is significant but for others it’s smaller and for a few its nil (See Figure 1). 

The interest payments from municipal bonds are typically exempt from state income tax if that income is from a bond issued within the state the investor resides. Interest from bonds outside of the state of residence will usually be subject to state income tax.

California residents, subject to a 13.3 percent state income tax rate, considering an out-of-state bond yielding 4 percent, for example, should adjust the after-tax yield down on the out-of-state bond to 3.47 percent (4 percent x (1-0.133)) in order to account for the state income tax, they will pay on that bond.

Looking at it another way, and assuming a 4 percent yield on an in-state California bond, the tax-equivalent yield needed for an out-of-state bond to yield an equal amount after taxes would be 4.61 percent (4 percent/(1-0.133)). In other words, and all else equal, the California investor would need to see an additional 0.61 percent or higher in after-tax yield on an out-of-state bond for it to make sense to forgo buying the in-state bond. 

Assessing the after-tax yield advantage is a key variable to consider when determining an appropriate mix of in-state and out-of-state bonds but it’s not the only one. Considering the supply and demand dynamics within a state is also quite important.

The chart below shows the top state income tax rate along with outstanding debt for each state. A simple rule of thumb to take away from this illustration is that, in most cases, for states where the bar and dot are relatively high, the tax and supply dynamics are such that a meaningful overweight to in-state bonds should be considered. Conversely, those states with an outstanding debt bar barely off of the x-axis are likely supply constrained and those with a tax rate dot closest to the X-axis, including on it for 0% state income tax, likely provide little after-tax benefit.

Balancing Diversification with In-State Preferences

Striking a balance between 1) building a diversified portfolio with a broad view of the market to find attractive investment opportunities and 2) taking advantage of in-state bonds that usually offer an after-tax advantage at the state and local level, is key to building a balanced state-preference municipal bond portfolio.

The depth of a state’s bond market will greatly influence the opportunity set in that market—from yield curve positioning to sector and credit exposure to varying call and coupon structures—just to name a few. Table 1 below provides a quick review of four states that fall into four different general categories: 

While the state income tax rate and the amount of a state’s bonds outstanding are primary inputs into an analysis of the mix of in-state and out-of-state bonds, there are plenty of idiosyncrasies across the country to consider.

For instance, although it is customary for states to tax out-of-state bonds only on the income cash flow after accounting for bond price amortization, a couple of notable exceptions are Connecticut and New York that tax the entirety of the coupon cash flow. This bolsters the case for increased in-state allocations as well as an attentiveness to coupon structure when buying out-of-state bonds for Connecticut or New York portfolios. Additionally, for New York City residents subject to the city income tax which can be as high as 3.88 percent, the hurdle for going out-of-state becomes that much higher.

On the other end of the spectrum is a state like Illinois, which taxes most in-state bonds similar to out-of-state bonds. Since the 4.95 percent state income tax for Illinois residents applies to the vast majority of both in-state and out-of-state bonds, there is not a compelling case for a meaningful overweight to in-state bonds for Illinois residents. As such, a nationally diversified portfolio with a preference for zero-tax states such as Texas, Florida, and Washington may be appropriate.

The reason zero-tax states bonds are generally preferred in this scenario is because, all else equal, their bonds will typically trade a bit cheaper (i.e. higher yields) than bonds of states with higher state income tax rates. Bonds from zero tax states tend to trade at higher yields than bonds from high tax states due to the demand, or lack thereof, from in-state residents trying to avoid the state tax liability. Those states with higher demand pushes yields lower on average, but oftentimes not low enough to negate the tax advantage for those residents subject to it. Lots to consider.

An Ever-Evolving Landscape

As mentioned at the beginning of this piece, the inputs for assessing in-state vs out-of-state in a given state preference portfolio often change. In addition to evolving credit fundamentals for any state and its issuers, there are the constantly shifting market technicals—supply and demand—that can impact relative value from week-to-week.

A recent example of the impact market technicals can have has been this year’s influence of an increased buying by exchange traded funds (ETF) in the market and where that capital is largely deployed. In short, in an effort to mimic the broad market, the large passive ETFs frequently steer their capital toward the biggest issuers in the market, and many of those are from states like California. A consequence of this demand dynamic in 2022 has been that certain high-tax states have at times become overly expensive, particularly the larger issuers within those markets, and have made the relative value for out-of-state bonds more attractive at times despite the high tax hurdle.

Whether at the state or federal level, tax policy is always a key attribute for tax-exempt bond investors to monitor. Recent examples of state level changes include the increase in Massachusetts of the top rate from 5 percent to 9 percent  and a reduction in the top rate in Arizona from 8 percent to 4.5 percent. In a vacuum, this would make in-state bonds more attractive for Massachusetts residents and less attractive for Arizona residents.

The biggest impact from federal policy in recent years has been the cap on state and local tax (i.e., SALT) deductions. Through the passage of the 2017 Tax Cuts and Jobs Act, individuals that could previously deduct SALT were now only able to do so up to a $10,000 cap. The impact of the SALT limit would most acutely be felt by those residing in higher income tax states who are also in higher tax brackets—this cohort is also generally perceived to be a meaningful buyer of municipal bonds, particularly from their home states. The market impact from SALT has been an increased demand for in-state bonds from buyer in high income tax states (e.g. CA, NY, NJ), as residents seek to minimize the impact from higher federal taxes due to the SALT cap. This increased demand has, at times, resulted in more expensive valuations for some high tax states.

Lastly, the overall level of interest rates will always impact the calculus for determining the in-state vs. out-of-state mix of bonds. Simply stated, higher interest rates make tax-exempt yield mathematically more meaningful than lower interest rates. The significant interest rate increases in 2022 certainly were large enough to have an impact in this way.

For example, the Bloomberg California 1-15 Year index yield-to-worst was 0.77 percent at the start of 2022 and 2.90 percent at the end of 2022. Using the tax-equivalent yield calculation from earlier in this piece, the hurdle level (i.e. how much additional yield for an out-of-state bond would be needed to make sense after-tax) at the beginning of 2022 was 0.89 percent (0.77 percent/(1-.133)) and at the end of 2022 was 3.34 percent (2.90 percent/(1-.133))—a delta of 12 basis points and 44 basis points, respectively. At first glance, that may not seem like a huge difference but, if you hold other factors constant such as credit quality, duration, structure, for example, the likelihood of a similar out-of-state bond out-yielding the in-state bond is far less likely at 44 basis points than at 12 basis points.

The fundamental point of these anecdotes is to underscore the importance of attentiveness when determining an appropriate mix of in-state and out-of-state municipal bonds. A cookie cutter approach can be easier to implement when managing a large number of municipal bond accounts but, in our view, that can miss the mark  when seeking to optimize after-tax income in a thoughtful way while maintaining diversity and integrity within portfolio construction.  

Managing State Allocations at Breckinridge

Approaching 30 years of managing municipal bond separate accounts, customization has long been a hallmark at Breckinridge and one of the essential ways we customize a municipal bond portfolio is to align it with a client’s state of residence and invest accordingly.

Over the years, we’ve made significant investments in people, processes, and technology to push forward our capabilities in managing state preference portfolios. We’ve built a deep, experienced credit team with the goal of achieving broad coverage that aids in building diverse in-state preference portfolios. We’ve developed technology and trading systems intended to source bonds efficiently across many different state markets. A good bond investor is always hesitant to convey too much certitude, but we do feel confident that continued changes to tax policy, supply and demand dynamics, and interest rate movements are certain to keep a thoughtful attentiveness to state preference investing quite important for the foreseeable future.  

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