Buyers: Sometimes Out-of-State Makes Sense

Participants in the municipal bond market say they are seeing more investors buy bonds from other states despite the tax exposure as fatter yields outweigh in-state tax considerations.

Investors have increasingly purchased out-of-state paper for two principal reasons, these people say.

One is the upswing in yields for certain states means income on those states' bonds is attractive even if the bondholder has to pay state taxes on that income in his or her home state.

"We have noticed a significant amount of out-of-state purchases," said Scott Colyer, chief executive officer at Advisors Asset Management. "Even after looking at the [state tax] exemption, the yields are much higher."

Under centuries-old law upheld by the Supreme Court last year in Kentucky v. Davis, investors in most states do not have to pay state income taxes on the interest earned on tax-free municipal bonds issued in the state where they live. They do, however, have to pay state income taxes earned on government debt from other states.

All else being equal, this argues for buying in-state munis. An investor effectively collects a higher yield by not paying state income taxes on the bond.

If the yield on an out-of-state bond is high enough, though, it may make sense for the investor to sacrifice the exemption and pay state taxes on a higher yield.

Many participants say this is what happened with the $6.5 billion California general obligation bond sale last month.

Yields on that sale came in at more than 6% for long-term bonds. That yield twisted the calculus. Many investors said it made sense to buy into that deal out-of-state and pay state taxes on it.

"Clients who live in New York, I sold them the most recent California GO deal," said John Colleary, director of fixed income at Long Island-based CFM Advisors. "It didn't matter where you lived, that California deal, in my opinion, was attractively priced for all of my clients."

In some ways, the decision to buy out of state is simple mathematics.

Take generic California paper, which according to Municipal Market Data's yield curve scale yields 5.94% at a 30-year maturity.

An investor in the top tax bracket in New York would have to pay 6.85% in state taxes on payments from California's bonds. That state tax would be deductible from federal income tax, so the effective state tax rate would be 4.45%, assuming the investor is in the 35% federal tax bracket.

State taxes for this investor would thus slice the 5.94% yield on California 30-year bonds into a 5.68% yield.

That is not competitive with an investor in California, who would collect the entire yield tax free.

However, consider that generic New York paper at 30 years yields 5.18%, according to MMD. Even after out-of-state taxes, California offers a spread of 50 basis points.

"It's just purely a mathematical equation, where there are times when it makes sense to go out of state," said Colin O'Neill of Connecticut-based Bond Advisors LLC. "In California, you had a lot of non-Cal buyers buy it. ... You're picking up enough incremental yield."

Colyer said this trend has accelerated because the market has bifurcated between stronger and weaker credits. The blow-out in the bond insurance industry and a general risk-aversion among investors has pushed up yields on weaker credits and generated preference for stronger credits.

The spread of 30-year Louisiana GOs, rated in the A-range, over 30-year Delaware bonds, rated triple-A, was just 13 basis points in mid-October. Now the spread is 95 basis points.

Yields on double-A range Nevada 30-years traded only 19 basis points higher than triple-A Maryland 30-years in mid-October. The spread today is 66 basis points.

That makes reaching out of state more attractive for some investors, according to Colyer.

He cautioned against simply buying the bond with the highest after-tax yield. That would lead investors into weak, high-yielding credits that do not necessarily justify the risk, he said.

The trick is to determine whether the after-tax yield compensates the investor for the credit and liquidity risk, Colyer said.

"The first thing we look at is, are we paid to go there and buy that credit?" he said. "Is our bottom line higher by buying the out-of-state credit?"

The other reason for the out-of-state buying trend is the turmoil in financial markets has prompted investors to place greater emphasis on diversification. That means populating a portfolio with a greater variety of bonds, including paper from other states.

While a lot of investors from outside California bought into the state's bonds last month, some investors in California are looking at other states.

The Golden State around the time of the sale was grappling with a projected $41 billion budget gap over 18 months, plus a 10.5% unemployment rate and an ailing real estate market.

"California's been dealing with a lot of issues, and some people have been getting nervous about it," said Alexander Anderson Jr., a portfolio manager at Envision Capital Management in Los Angeles. "What we have been doing with some of our clients is moving a portion of their portfolios into the safety of national names that don't have as many budget issues."

Anderson said he looks at Texas, Minnesota, Wisconsin, and Washington as financially healthier states. His clients are willing to sacrifice yield to be in these kinds of safer names, he said.

According to MMD, yields in 30 years on those states' bonds respectively are lower than California's 30-year bond yields by 95 basis points, 118 basis points, 88 basis points, and 93 basis points. Those spreads do not account for taxes.

"If you're a more conservative investor, you're willing to go out and seek safety, and you lose that tax exemption," Anderson said. "Safety is more important in these turbulent times."

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