Over the last couple of years municipal bonds issued by entities in the state of California (including the state itself) have grown more and more expensive. One big factor has been improving credit quality at the state level since issuing IOUs in 2009 due to budget shortfalls. Since then the recovery has taken hold and buoyed the state’s finances. The other driving forces are the generally high wealth levels within the state and the very high state income tax rate. In-state issues’ interest income is exempt from both state and federal income taxes. These circumstances have resulted in demand for California paper vastly outstripping the available supply despite California topping the charts for total issuance. Due to the low yield environment, the additional yield required for an out-of-state bond to compare favorably, even after the state tax is deducted, is remarkably low.
With no sign of a reversal in sight, we are lowering our target for in-state exposure minimums for California residents from 80% to 70%.
See below for the underlying tax math:
The state effective marginal tax rate for an investor in the 13.3% bracket is 7.53% and is calculated using the following formula: State Marginal Rate * (1 – Federal Marginal Rate – Net Investment Income Tax).
The in-state municipal equivalent yield multiplier is 1.081x (meaning you need 1.081x as much yield for an out-of-state bond to equal an in-state bond in yield terms after deducting the state income tax).
The calculation is as follows: 1/(1 – State Effective Marginal Rate).
To help drive home this point, see select 5- and 10-year bond yields from new issues that came to market last week:
We highlight these new issues because of their comparable ratings. The Hawaii issue is interesting in that Hawaii itself has a high state tax rate of 11%, yet still trades cheaper than California.
Source: Bloomberg, Fidelity Capital Markets