For investors in states with higher income taxes, tax-efficient strategies are especially top of mind. Limitation to the State and Local Tax (SALT) deduction has led investors to seek out municipal bonds as a source of tax-free income. Traditionally, muni investors have stayed landlocked, investing only in home state municipal bonds. However, we believe a national opportunity set can add value to municipal investors in today’s market for three key reasons.
1) Higher Tax-Equivalent Yields
Nationally diversified municipal bonds have the potential to offer attractive after-tax yields relative to state-specific bonds. High tax states like California (Exhibit 1) have benefited from voracious municipal demand, compressing yields across the curve. By broadening the opportunity set to consider national bonds, investors can access attractively priced bonds from lower tax states. These interstate bonds can provide better income that more than offsets the impact of state taxes. A national muni strategy that can work for California residents, who have the highest personal income tax rate in the country, may offer similar benefits for residents of other high income tax states.
Source: Bloomberg and GSAM. As of February 25, 2020. Please see additional disclosures at the end of this document. Past performance does not guarantee future results, which may vary. Goldman Sachs does not provide accounting, tax, or legal advice. Please see additional disclosures at the end of this document.
2) Broader Opportunity Set
Strong municipal bond demand has been met with limited growth in overall issuance, creating both a solid technical backdrop and a challenge for investors limited to their own state’s inventory. A national municipal portfolio can improve portfolio diversification across credit ratings, sectors, and geographies.
For example, investors locked into New York specific municipal bonds incur both lower yields and less diversification on a security and sector level. More than half of the New York municipal market is marked as state and local tax-backed (compared to 30% nationally), leaving investors at risk of state appropriation decisions and more sensitive to the overall health of the local economy.
In California, municipal investors have historically been challenged by the boom-bust nature of the golden state’s economy. Conservative budgeting and higher taxes in the last decade have improved the state’s reserves and creditworthiness, though from a technical perspective California bonds come at a high cost and low yield relative to national bonds. For investors focused on safety and stability, a pillar of municipal investing, better diversification as well as potentially greater after-tax income may exist outside one’s home state. We believe that optimal results are borne from broad exposure to the municipal market.
3) Better Liquidity
The municipal market is broad and complex, and liquidity can be a challenge for investors. According to the Municipal Securities Rulemaking Board, the market boasts $3.8T of bonds outstanding spread across nearly one million CUSIPs. Roughly one half of all municipal bonds are held by individual investors who tend to take a buy-and-hold approach. The result is more limited liquidity than in US Treasury or corporate bond markets. And the liquidity crunch tightens at the state-specific level: California bonds, the most-traded state market by volume, have 2/3 the turnover that national municipal bonds do in aggregate. National exposure may be helpful in dynamically managing municipal opportunities.
In sum, given the unique dynamics of the municipal bond markets we see value in considering a nationally diversified opportunity set. Doing so may boost yields, enhance diversification, and improve liquidity for municipal investors seeking tax-free income in a low-yield, high-valuation world.