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.