Many municipal bond’s interest payments are exempt from state income taxes, which means that resident investors realize the greatest benefit. For example, a New York resident purchasing a Florida muni bond must report that interest income on their New York income tax return. The same investor purchasing a New York muni bond could avoid reporting that interest income on their New York tax return and realize a higher tax-equivalent yield on the bond.
Given these tax advantages, many investors assume that they should never purchase out-of-state muni bonds, since they’d forego these advantages. Investors that subscribe to this belief may be leaving money on the table by avoiding out-of-state muni bonds that could offer better yields – even without certain tax advantages. In fact, there are many other advantages that investors would also be foregoing by investing in only local muni bonds.
In this article, we’ll take a look at why investors may want to look at out-of-state muni bonds in addition to muni bonds sold in their state of residence.
Comparing Tax-Equivalent Yields
The best comparison metric for municipal bonds is tax-equivalent yield, which can be used to compare muni bonds with all other types of bonds. When calculating these yields, it’s important to factor in local, state, and federal taxes in order to make the most accurate comparisons. The formula for computing tax-equivalent yield is simply the tax-free muni bond yield divided by one minus the tax rate – or blended tax rate.
For example, a tax-free bond with a yield of 10% and a tax rate of 5% would have a tax-equivalent yield of about 10.53%. This means that an investor would need to find a taxable bond with a yield greater than 10.53% in order to justify foregoing the 10% muni bond.
It’s worth noting that some tax rates do not always apply to investors. Residents of Washington, Texas, Florida, Alaska, South Dakota, Wyoming, and Nevada don’t have to pay any state income taxes, which means that there’s no state-level “savings” from purchasing muni bonds. These investors may be indifferent as to whether or not to purchase out-of-state muni bonds, since they realize the same tax savings regardless of where they invest.
Importance of Diversification
Investors that avoid purchasing out-of-state municipal bonds may suffer from a lack of diversification compared to those holding diversified muni bond portfolios. While the default rates of many bonds are very low, there’s still an element of risk involved in any investment that’s important to consider. Diversification is especially important if the investor doesn’t plan on holding the muni bonds through maturity, since prices may fall based on perceived risks.
For example, investors holding exclusively Detroit or Chicago muni bonds could have suffered significant losses over the past couple of years. In the case of Detroit, the city defaulted on some of its debts and investors could have lost money even when holding until maturity. In the case of Chicago, many muni bonds have witnessed price drops that could result in losses if the investor were to sell bonds at a lower price than they purchased them.
The Bottom Line
Many investors could benefit from holding a diverse muni bond portfolio, while being cognizant of tax-equivalent yields. Investors in states without income taxes may have a much easier time finding out-of-state muni bonds, but even those in states with high income taxes may want to consider adding at least some out-of-state exposure to build a well-rounded portfolio.