Muni Bond Investors Win One
A Kentucky couple recently won a lawsuit challenging the state's authority to tax them on earnings from out-of-state municipal bonds. If the ruling holds up, it would be good news for all municipal bond investors. Similar suits are winding their way through courts in Arizona and North Carolina with other states expected to follow.
Even without tax on out-of-state bonds, we've always thought investors were over sensitive to not owning out-of-state bonds. Consider the difference between owning a 10-year California insured bond compared with a 10-year Texas AAA rated bond. The Cal bond yields 3.80% while the Texas bond yields 3.97%. If a California investor purchased the Texas bond the current effective return would be 3.97% less the California tax adjusted for the federal marginal tax rate (because any additional California tax is deductible for federal tax). At a 35% marginal tax rate the effective return on the Texas bond is 3.73% (or 3.97% - (9.3% - 35%)). In this case, the return difference is 0.07% (3.73% - 3.80%). Hardly enough to justify a geographically non-diversified portfolio. Additionally, there are a lot of interesting opportunities available in municipal bonds that a single state investor foregoes.
We also never understood the rationale for taxing out-of-state bonds from the perspective of the issuer. Our studies indicate that the yield difference on issuance is at most 0.01% and once you condition your state's residents to purchase in-state, the incremental income tax revenue is negligible. Hardly enough reason to antagonize your wealthiest constituents.
Even without tax on out-of-state bonds, we've always thought investors were over sensitive to not owning out-of-state bonds. Consider the difference between owning a 10-year California insured bond compared with a 10-year Texas AAA rated bond. The Cal bond yields 3.80% while the Texas bond yields 3.97%. If a California investor purchased the Texas bond the current effective return would be 3.97% less the California tax adjusted for the federal marginal tax rate (because any additional California tax is deductible for federal tax). At a 35% marginal tax rate the effective return on the Texas bond is 3.73% (or 3.97% - (9.3% - 35%)). In this case, the return difference is 0.07% (3.73% - 3.80%). Hardly enough to justify a geographically non-diversified portfolio. Additionally, there are a lot of interesting opportunities available in municipal bonds that a single state investor foregoes.
We also never understood the rationale for taxing out-of-state bonds from the perspective of the issuer. Our studies indicate that the yield difference on issuance is at most 0.01% and once you condition your state's residents to purchase in-state, the incremental income tax revenue is negligible. Hardly enough reason to antagonize your wealthiest constituents.
posted by WRA Strategy Group at 7:48 AM
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