Out-Of-State Muni Bonds Have Benefits

Making life difficult for advisors and income-oriented clients, including retirees, alike in 2022 was the fact that municipal bonds weren’t spared in the bond market carnage.

Fortunately, things are looking up for munis as the widely followed ICE AMT-Free US National Municipal Index is higher by 2.51% to start 2023. Additionally, last year’s drubbing made municipal bonds more appealing from a value standpoint entering 2023. Plus, it created a broader swath of opportunities. Adding to the allure of municipal bonds in 2023 is that there are attractive opportunities at both ends of the credit spectrum – investment-grade and high-yield.

For advisors, resurgent munis make the asset class easier to address and renew the allure for retirees – many of whom need steady, low-risk income. The rebound also makes now an ideal to consider more strategy around municipal debt, including allocating to bonds issued outside the client’s home state.

Why Out-of-State Munis Can Help Clients

As advisors know, municipal bonds offer an array of tax perks. Those include interest payments that are exempt from federal income taxes and state income tax if the client resides in the state that issued the bonds and that state has an income tax.

Still, clients in nearly all states – California and New York being the exceptions – can benefit from owning municipal debt issued by other jurisdictions. Advisors in California should note that some clients there can benefit from out-of-state munis, but that depends on the California tax bracket they’re in.

“In some instances, some states tax in-state bonds in the same manner they tax out-of-state bonds. For example, bonds issued by municipalities in Illinois are often subject to state income taxes—even if the tax filer is a resident of Illinois,” says Cooper Howard of Charles Schwab. “In other words, Illinois investors don't necessarily save on their state income tax bill by holding Illinois munis. The rules can get complicated at times, so it makes sense to consult with your tax advisor.”

Another reason to consider out-of-state munis for clients is that even accounting for the tax breaks offered by in-state munis, bonds issued by another state, in some cases, may offer larger after-tax yields.

Out-of-state munis are also valid considerations for clients in states that aren’t prolific issues of these bonds. California, New York and Texas combine for $687 billion worth of US municipal debt, according to Schwab data. That’s more than the next 11 largest state issuers combined.

Other Perks of Out-of-State Munis

Another advantage of embracing out-of-state munis is that clients can gain access to better credit quality. As just one example, advisors in Illinois, which faces substantial public pension debt, may want to consider such a strategy.

“It's easier to find highly rated munis if you live in a state like California, New York or Texas, where there are large numbers of bonds rated in the AAA and AA categories, as illustrated in the chart below. It's more difficult if you live in a state like Illinois, Pennsylvania, or New Jersey, where the majority of bonds are lower than AA-rated. Consider diversifying nationally if you live in a state with fewer highly rated options,” adds Howard.

On that note, advisors should heed demographic trends, such as population shifts, because states with strong credit quality are usually those with rising populations.

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