California’s economy, and by extension it’s municipal bond market, can best be described as one of booms and busts. When the U.S. economy and financial markets are strong, the state’s financial situation typically does well as the 13.3% top individual marginal state tax rate, the highest in the nation, drives revenue when residents are employed and capital gains are being generated. The opposite is also true. We don’t have to look very far back to the post financial crisis period of 2009 when California had to resort to issuing IOU’s just to pay its bills.
These trends impact not just the state economy, but the California municipal bond market as well. The yield relationship between California municipal bonds and bonds issued by municipalities in other states has varied over time as the State’s financial position has changed and tax policy at both the state and federal level as shifted.
Back in 2009 during the heart of the State’s budget crisis, the yield premium to buy California general obligation bonds versus national general obligation bonds was as wide as 1.67% in certain maturities. Today, that premium is roughly 0%.
The strong state economy, a multi-notch ratings upgrade, the high state income tax rate and the limit on state and local tax deductions included in the recent federal tax legislation have all been contributing factors to the relative richness. For other California municipal credits, the relative yield picture is even more dramatic with many trading at yield discounts to national municipals.
What this means in practice is that California residents can buy national municipal bonds and realize a yield advantage versus California municipals, even after paying state taxes on bond interest payments from national municipal holdings. While there have always been opportunities to own non-CA munis, they are becoming more frequent as CA municipal bonds become more expensive. As such, we are lowering the in-state target for our California municipal strategy from 70% to 60%. This follows a reduction from 80% to 70% in October 2016 and is a reflection of where we are seeing value in the market and what we feel is in the best interest of our clients.
Recent issues over the past few weeks highlight the point. On May 21st, the AA-rated University of California System issued $745 million in limited project revenue bonds of varying maturities. The 2023 maturity was priced to yield 1.81%, which, compared to the AAA-rated national municipal yield curve, was 0.27% lower. Compare this to the May 21st debt issuance by Katy Independent School District in Texas. Katy ISD issued bonds, which carry insurance from the Texas Permanent School Fund and are rated AAA, on May 21st at a yield of 2.14%, or 0.06% higher than the AAA-rated national municipal benchmark yield curve. For California investors, the Katy issue carries both a higher rating and yield.
To see the math, we use the Municipal Equivalent Yield Multiplier, which essentially details the amount of yield a California resident needs on an out of state bond to equal that of an in-state bond. Currently this number is 1.153x. Important to note is that this assumes the highest marginal effective state tax rate of 13.3%, which is applicable to investors with annual income above $1mm. For investors in a lower state tax-bracket, the argument for investing out-of-state becomes stronger.
The yield relationship is even more compelling for bonds with lower credit ratings and in different sectors. In addition to the yield advantage, allocating a higher percentage of portfolios to non-California issues can improve the opportunity for sector, ratings category and geographic diversification.
Should the situation change and California municipal yields revert back to a more favorable relationship relative to national municipals, we won’t hesitate to change our target allocation to in-state bonds. We believe that actively managing taxes is a key value-add for municipal managers and is something that we are continuously monitoring as part of our investment process.
Source: Bloomberg, Fidelity Capital Markets, MMD
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