|Exhibit I: Tax Cost on
Out-of-State Bonds (Basis Points)*
|State||Top Tax Bracket (%)||2.0||2.5||3.0||3.5|
|Assumes NY residents are eligible to, and itemize,
deductions for state tax purposes
|Sources: Bloomberg and BBH Analysis|
From Sinatra’s “New York, New York” to the Mamas and the Papas “California Dreamin’,” nothing stirs up local pride like a good hometown song. Likewise, many municipal investors have an undeniable preference towards bonds from their home states, as many have a total aversion towards paying taxes. Yes, the vast majority of home state municipals enjoy a state tax exemption in addition to their Federal tax exemption. The key question is whether the benefit of saving some state tax outweighs the better risk-adjusted return potential of a broader national opportunity set. We think not.
Ranked among the highest state tax rates in the nation, it is not surprising that many residents of New York and California demand in-state bonds. If rockers Jon Bon Jovi and Bruce Springsteen followed this same logic, they would opt for securities from within New Jersey as their home state not-so-proudly ranks fourth in the nation in terms of highest tax rates. Independent of pride, how much is this in-state exclusion worth? Said differently, how much extra yield must an out-of-state bond provide to compensate for the additional state taxes an investor will pay? Before answering the question, we must remember that the 2017 Tax Cuts and Jobs Act capped state and local tax deductions against Federal taxes at $10,000, resulting in higher overall tax burdens for residents of high-tax states. The tax hurdle depends upon the level of interest rates and the home state tax rate. Essentially, the tax value represents the product of the net state tax rate multiplied by the yield on the in-state bond. The lower the interest rate environment, the lower the in-state tax value and vice-versa.
For example, if a California resident purchased $1mm of a California general obligation (GO) bond yielding 2.5%, the entire annual income of $25,000 would be tax free (see Exhibit I). However, if the California resident purchased an out-of-state municipal security at the same yield, there would be a state tax liability of $3,325 (13.3% of $25,000). To earn the equivalent after-tax yield of the California general obligation bond by investing out of state, the California resident would need to purchase a bond with a yield of 2.88%. Naturally, states with lower tax rates present lower hurdles. The question we then ask ourselves as value investors is, “Can we do better with securities that satisfy our investment criteria?” Under most market circumstances, the answer is an unequivocal yes.
Our investment process is most effective when applied nationally and not artificially constrained by geography. We understand investors’ preference to avoid state taxes, but it has been our experience that we achieve more attractive after-tax returns when investing nationwide than on a state-specific basis. There are two major reasons for this. First, our typical investments comfortably cover state tax costs. Second, the high demand for in-state securities by residents drives down yields and limits the availability of traditional municipal bond opportunities, particularly in high-tax states.
We designed our investment process to take advantage of the municipal market’s vast diversity. Nationwide, the municipal market features over 50,000 issuers and we focus on less than one-half of one percent of them which must satisfy both our credit and valuation criteria. Excluding pre-refunded securities backed by US government collateral, the top-200 credits we follow comprise over 95% of our municipal investments (see Exhibit II). Individual state exposures typically comprise less than 10% of a client’s portfolio market value. Today, only two states exceed 10%. The first is Texas, which aside from having the country’s second largest economy, does not have an income tax. States with no income tax have less in-state competition for their bonds. The State of California is second. Even though the state has the nation’s highest state tax rate, our holdings are disproportionately comprised of zero-coupon school district bonds that often fall outside of the preferences of household investors.
Exhibit II shows the share of the top 200 municipal bond holdings by state. Texas has the largest representation at 14%, followed by California at 10%, and New York at 9%.
We also believe a national approach provides protection against downside risks associated with exogenous shocks. For example, Hurricane Katrina devastated Louisiana, resulting in a downgrade of the state and brought its largest city’s rating below investment grade. A national opportunity set also protects against economic concentration. For instance, the financial services industry generates more than a quarter of New York’s GDP. Though the sector is concentrated in Manhattan, its profits flow to every corner of the state through taxation and ultimately transfer payments to far away local governments.
Finally, even the strongest states are just one over-zealous legislative session away from potential downgrades. Poor governance remains the largest threat to any municipal credit. Puerto Rico investors learned this the hard way. Because bonds from the U.S. territories are triple tax-exempt, many state-specific funds include bonds from Puerto Rico to enhance portfolio yields. Recovering from a negative credit event is difficult in a high-quality sector like Munis. If you can access a wider opportunity set that also offers a diversification benefit, you should.
Historically, national strategies have generated a return advantage over California and New York state-specific funds. As shown in Exhibit III, we can see that over most, but not all, periods national funds overcome their tax hurdles. This data reflects the median gross performance of intermediate funds. We strive for, and have delivered, better than median performance over many years through a variety of market environments, including two major crises.
|Exhibit III: Intermediate Muni State vs. National Performance*|
|* Annualized, gross median fund performance
Past performance does not guarantee future results
Trailing periods as of June 30, 2022
|Sources: Morningstar, Bloomberg, and BBH Analysis|
Our investment process guides us to invest in a limited number of durable credits when they are available at attractive yields. Our success depends on our ability to remain diligent, turn our backs to herd behavior, and focus on opportunities that meet our investment criteria. We admit to being diehard patriots who love an emotional rendition of “America the Beautiful”. However, succumbing to emotions in investing can be dangerous, which is why we stick to our criteria as we seek attractive opportunities from sea to shining sea.
* One "basis point" or "bp" is 1/100th of a percent (0.01% or 0.0001).
Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
Brown Brothers Harriman & Co. ("BBH") may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2022. All rights reserved. IM-11313-2022-07-11
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