When a State-Specific Municipal Bond Fund Makes Sense

In general, interest income from municipal bonds is exempt from federal taxes, and for in-state municipal bonds, state taxes can be avoided as well. Given that muni bonds have had very low default rates compared to similarly rated corporate bonds, they can be a desirable holding for investors in high federal income tax brackets, even if they are not subject to state income taxes. They become even more desirable for residents of high income tax states like California and New York.

To determine whether muni bonds are appropriate for a given investor, one of the parameters we evaluate is the taxable-equivalent yield. Given the yield of a tax-exempt bond, the taxable-equivalent yield is calculated as the tax-exempt bond yield divided by one minus the tax rate applicable to a taxable bond. In other words, the taxable-equivalent yield tells us the minimum yield required on a taxable bond (of comparable term and credit risk) for the investor to prefer it over the tax-exempt bond.

Let’s work through an example. As of today’s close, the Vanguard California Tax-Exempt Intermediate-Term Municipal Bond Fund (VCADX) had a 30-day SEC yield of 2.24%. Assuming a California investor who is subject to the highest federal rate of 37%, the Affordable Care Act Investment Income Tax of 3.8%, and the highest California rate of 13.3%, the taxable-equivalent yield is calculated as 4.88%, which is significantly higher than the 3.57% yield of the Vanguard Intermediate-Term Investment Grade Bond Fund. Even though both funds have similar duration and an average credit rating of A, it is important to remember that an A-rated muni bond has a lower probability of default than an A-rated corporate bond, based on past experience. The default risk of muni bonds can be mitigated by concentrating on general obligation and revenue bonds that are based on essential state services. We do not consider it necessary to restrict ourselves to insured bonds, as the 2008 financial crisis demonstrated that the muni bond insurers are not immune from insolvency.

Of course, the higher taxable-equivalent yield of in-state muni bonds is not a free lunch. It is not uncommon for a state’s economy to take a hit from a natural disaster or an economic shock such as the impact of lower oil prices on North Dakota. A definite concern for muni bonds across the board is the understatement of pension liabilities, and in the majority of municipal bankruptcies experienced so far, bondholders have been hit harder than pensioners.

At Clarity Capital Advisors, we continue to advise the use of low-cost municipal bond funds in taxable accounts for investors in high tax brackets. We consider them to be preferable to a portfolio of individual bonds because of the high level of diversification of both issuers and maturity lengths, not to mention avoidance of potentially high trading costs to purchase the initial portfolio of individual bonds. In a well-structured and prudently managed fund, it is quite possible to achieve the advantages of a laddered portfolio of individual bonds without taking the risk of a single default wreaking havoc on the portfolio.

If you would like to learn more about Clarity’s approach to bond investing, please call us at 800-345-4635 or email us info@clarityca.com.