Show Notes
A municipal bond is a loan. A city might borrow to build a school, or a utility might borrow to upgrade its water system. The borrower promises to pay interest and return the money it borrowed. Some bonds are backed by a government’s general resources. Others are backed by a specific source of revenue, like the bills people pay for water.
The interest on most municipal bonds is exempt from federal income tax, but qualifying bonds from your home state can offer a state tax break too. That’s the appeal of a home-state fund.
But the tax break can affect the yield you start with. When more local investors want the same bonds for the exemption, their demand can push prices up and yields down. Research has found more concentrated local ownership in states with stronger tax preferences, along with yields that are more sensitive to changes in supply and local risk.
So before putting all your munis in one state, you should want to know how much extra income you’d actually keep for the additional risk you’re assuming by not diversifying nationally. Let’s run the numbers.
How do you compare municipal bond funds after state income taxes?
Say you have $1 million in munis and you’re comparing funds with similar credit quality and interest-rate sensitivity. In this hypothetical, yields are after fund expenses and bond funds’ income is federally tax-exempt.
The home-state fund’s income is fully exempt from state tax. The national fund’s income is fully taxable in your state at 10%, with no federal deduction for the state tax.
| Annual figures on $1 million | Home-state fund | National fund | National fund at a higher yield |
|---|---|---|---|
| Yield after fund expenses | 3.5% | 3.8% | 4.0% |
| Income before state tax | $35,000 | $38,000 | $40,000 |
| State income tax | $0 | $3,800 | $4,000 |
| Income after state tax | $35,000 | $34,200 | $36,000 |
The home-state fund generates $35,000 a year, and you keep all of it. The national fund generates $38,000. After a 10% state income tax, you keep $34,200.
So in this example, going all in on your home state puts an extra $800 in your pocket for the year.
Not a huge difference.
As I mentioned before, the difference in after tax return might be smaller than you expect because other investors want that same tax break. Research has shown that their demand can push up the price of local bonds and bring down the yield.
Now you might think, but it’s still a higher return–and I hear you, but I’d encourage you to think about the diversification risks you accept for that nominal amount of additional return.
What are the diversification risks of a single-state muni bond fund?
Let’s not forget that the main reason we own bonds is to reduce the overall volatility of your portfolio, which in turn makes it easier to stick with stocks when they experience the inevitable downturns.
I think that’s always helpful to remember whenever we are talking about squeezing more returns out of our bond portfolio.
Sure, a home-state muni fund can hold hundreds of bonds, but it’s not unusual for a single event to put pressure on several of them at once. And sometimes it can even reach bonds you’d never think to connect.
How did the California wildfires affect municipal bonds?
After the Los Angeles wildfires in January 2025, S&P downgraded the city utility’s water and power bonds. The rating agency was weighing whether the utility had enough cash and insurance to cover potential liabilities. It also raised concerns about how well the water system was prepared for emergencies.
Here’s what surprised most people: S&P also downgraded bonds tied to a wind farm in Utah. A separate public power authority issued those bonds, but L.A.’s power system was responsible for more than 90 percent of the project’s obligations. So even though the wind farm was hundreds of miles away, the bonds depended heavily on the financial health of the utility in Los Angeles.
What happened to New York municipal bonds in 2020?
I love that example because it crosses state lines in a way that most people don’t think about. The more common situation people think is more local.
For example, think back to 2020 when New York commuters stayed home, which led to transit ridership collapsing and falling fare revenue. The broader slowdown also put pressure on New York City’s and New York State’s budgets. Moody’s downgraded the transit authority’s revenue bonds in September, then cut its ratings on city and state debt the following month.
All three came under pressure at the same time, even though they had different ways of paying their debts. And while New York munis gained over the first eleven months of 2020, they trailed the national muni index by nearly a percentage point before investor taxes.
The point for people considering state-specific munis is that the next surprise could come from anywhere. By spreading your muni holdings across the country, less of your bond portfolio depends on what happens in any one region. So if something unexpected puts several local borrowers under pressure at once, it’s likely to affect a smaller share of the money you’re counting on for stability.
How do home-state munis affect your household’s overall investment risk?
Similarly, you ought to consider how much of your household’s financial life already depends on the local economy. If you own a local business and a downturn hits, you might need to draw from the portfolio just as some of your local bonds are under pressure. That’s a good reason to look at your muni holdings alongside the rest of your finances.
How can national muni funds find better-priced bonds?
In addition to the risk management side of diversification, the broader opportunity set of a national muni fund allows an investment manager to pass on bonds in your home state that look expensive and look for comparable bonds elsewhere.
Think back to the state tax break. If enough people want the same local bonds, they can bid up the price. When you pay more for the same payments, you earn a lower yield.
Samuel Wang at Dimensional looked at this across the country. In his study, bonds from states where the local tax break was less of a draw yielded a little over a tenth of a percentage point more, on average. The two groups had similar credit ratings, and their prices were about equally sensitive to changes in interest rates. The difference was easier to see in the yields investors could get up front than in the returns they would have earned over time.
Prices can also change depending on what’s for sale that week. Say several cities and utilities all bring new bonds to market at once. Some may have to offer a little more yield to find enough buyers. A national manager can take a look, even if there’s very little worth buying in your home state that week.
Vanguard found a wide range of yields among hundreds of muni bonds with the same credit rating. That’s where the manager has to do some homework. Is the bond paying more because it’s harder to sell? Can the borrower pay it back early? Or are there simply fewer buyers interested in it right now?
Sometimes the best deal will be in your home state, but you want to give your manager the ability to shop around.
When can state-specific municipal bond funds make sense?
If you’re in a high state tax bracket in California or New York, the extra tax break can be worth a closer look. In those situations, I like utilizing a separately managed account, or SMA.
In a muni SMA, you own individual bonds in your account, and a manager buys and sells them for you. You can give home-state bonds a preference and still give the manager room to buy elsewhere. Say the manager finds a bond in another state that pays just as much after state taxes and carries similar risks. That bond may earn a spot because it spreads some of your exposure outside your home state.
Where you live is one factor. So is when you’ll need the money and what you already own. If you expect to use some of that money in five years, the manager can look for bonds that come due around then. If you already own a lot of debt from a particular borrower, you can ask the manager to limit how much more they buy.
Thanks for listening. Until next time, to long-term investing.
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