When Does State-Specific Customization of a Municipal Bond Portfolio Make Sense?
It is human nature to want to minimize taxes. But in some instances, investors’ determination to pay as little tax as possible may cause them to sacrifice the potential for higher after-tax returns. At PIMCO, our municipal strategies focus on maximizing after-tax returns rather than simply minimizing taxes.
There are situations where customization is essential or highly desirable: haircuts, housing, medical care, education, and occasionally financial services. But in all cases, it’s important for the purchasers and prospective providers of the service to make sure the potential benefits of customization will outweigh the costs.
PIMCO often receives client requests to customize municipal bond portfolios – state-specific portfolios are among the most frequent. And while it may be feasible for us to accommodate these requests, we do our best to evaluate beforehand whether a restriction is likely to add value before accepting it. Just because a state preference portfolio is possible, does not mean it is optimal. The idiosyncratic nature of the municipal market creates opportunities for customization, but in many cases the costs of customization outweigh the benefits.
Home-state portfolios – not always the best option
Take state preference portfolios as an example. Investors who live in Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming are lucky enough to not pay any state income taxes. Yet professionally managed, 100% statespecific products for these states exist for investors looking for this preference.
Investors often have a tendency to strongly prefer municipal bonds within their home state, even if out-of-state bonds provide superior after-tax yields. A home bias may make sense in cases where individual investors are selecting bonds based on their own experience and acumen. However, asking an investment manager to accept this restriction limits portfolio manager flexibility and the investment universe without necessarily adding tax efficiency. For a restriction to make financial sense, the value to an investor of limiting security selection must be greater than the cost of imposing the restriction on the investment manager. An investor living in a state where there is no state tax adds little by way of after-tax returns by limiting a strategy to his or her home state.
Relative supply versus demand
At PIMCO, we believe this logic also extends to investors living in states that do have an income tax but where investor demand far exceeds a limited amount of tax-exempt supply. An imbalance of supply and demand may cause bonds to trade at yields so low that it negates the benefit of the state tax exemption. It’s important to remember that the vast majority of tax savings from investing in municipal bonds results from the federal income tax exemption. Consequently, it may not always be necessary to focus on buying bonds exempt from an individual’s state income taxes.
This is particularly true for a buy-and-hold mandate like a laddered municipal bond portfolio, where the initial investment has the largest impact on long-term returns. Let’s consider Vermont as an example. Vermont has a relatively high state income tax rate of up to 8.95%, but very little tax-exempt municipal supply. In fact, there were only five tax-exempt Vermont deals above $25 million in all of 2015. A deeper dive into the largest state general obligation (GO) issuance of the year provides an interesting comparison.
- On the week of 5 October 2015, a new issue AAA-rated, 5% coupon Vermont GO maturing 8/15/2025 (924258V78) came to market yielding 1.94%.
- On the same week, a AAA-rated, 5% coupon Texas Water Development Board bond maturing 10/15/2025 (882854WH1) came to market yielding 2.25%.
- Even after paying Vermont state taxes on the 2.25% yield found out of state, it equates to a 2.11%1 yield for a Vermont resident (vs. 1.94% on the Vermont deal). Consequently, a manager not restricted to a Vermont-only universe might consider the Texas new issue as an attractive opportunity to diversify the portfolio and add yield.
This is, of course, just one example and is not meant to imply that an unrestricted, or nationally diversified, portfolio is always the most desirable option. There are instances where a home-state municipal portfolio does offer added tax benefits. However, investment managers can and should use their institutional market access and expertise to determine whether the benefits of investing in-state will generally outweigh the costs of a limited investment universe.
Where state preference portfolios make sense
PIMCO believes the benefits to building an in-state portfolio for residents of California and New York resoundingly outweigh the costs. State and local income taxes for California and New York can be as high as 13.30% and 12.70%, respectively. And in stark contrast to Vermont, both California and New York are often among the top three states by issuance (see Figure 1). The intersection of high taxes and very high supply frequently creates an attractive investment opportunity. Regardless of when a client funds an account, there is likely to be enough issuance from a diversified set of issuers to build a well-balanced, properly diversified portfolio that offers tax-efficient value.
Of course, there is a wide spectrum between, say, New York, where we are comfortable allocating 100% of a portfolio, and Vermont, where we currently offer no state preference option. On a quarterly basis, PIMCO portfolio managers review and update a list of states where we believe there is adequate supply to build a high quality, diversified and tax efficient portfolio. For most states, other than New York and California, this may result in a 0-40% minimum in-state allocation.
The benefits of manager flexibility
A state’s municipal market factors like supply, demand and liquidity are crucial to evaluating the advisability of a state-specific customization. It’s important to help clients see clearly the benefits of a more nationally oriented portfolio that may be sacrificed with a state preference portfolio.
- Institutional execution: Investment managers can often improve execution via buying in bulk. By imposing unique restrictions on a portfolio, clients may inadvertently give up the improved pricing, and higher yields, a manager seeks to capture when buying for many accounts simultaneously (see Figure 2).
- Expanded investment opportunity set: Opportunities often exist in states with low or no state tax, versus states with higher in-state taxes where higher demand from natural buyers may contribute to yield compression. Expanding the opportunity set and portfolio manager discretion may also allow for better navigation of supply and demand which is critical in the municipal market.
- Cross-state diversification: Allowing managers to invest selectively in the best credits nationally should help to improve portfolio diversification which may boost return potential and help to mitigate risk.
- Enhanced liquidity: Expanding the investment universe from one state to 50 allows managers to consider more defensive coupon structures and larger deals, and may help improve future liquidity.
- Improved ongoing credit analysis: Issuers that come to market frequently may file financials with greater frequency and consistency, which improves a manager’s ability to evaluate credit quality on an ongoing basis. Constraining supply to a particular state may limit access to such frequent issuers.
An educated decision on whether to impose a restriction on an account requires an understanding of the associated costs and benefits. At PIMCO, we take our fiduciary responsibilities seriously, believing it’s our duty and obligation to work with clients and use our expertise to manage toward the best outcomes over the long term.
For strategies like municipal bond ladders where client relationships often last 10+ years, we recognize some additional education may be needed upfront on the cost versus benefits of customization. We see that as a worthwhile endeavor with the potential for long-term rewards.
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1 Using 39.6% federal, 3.8% Medicare surtax, top state rate, and assuming state taxes deducted at the federal level