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Investors in high-tax locales can protect some of their portfolio income from steep levies by adding state-specific municipal bond funds to their fixed-income roster. Bonds have sold off hard as investors grapple with the notion of “higher for longer” policy from the Federal Reserve. Bond yields and their prices move inversely to one another. Municipal bonds haven’t been spared, as the iShares National Muni Bond ETF (MUB) is posting a year-to-date total return of -2.39% – and a total return of -5.07% for the past three months. Another way to contextualize the action is that income-yielding assets are for sale. “In the muni bond fund market, we’re seeing yields higher than they have been in more than a decade,” said Amy Arnott, portfolio strategist for Morningstar Research Services. This also spells an opportunity for residents who are in states with notoriously high levies on income. That’s because while muni bond income is generally free of federal taxes, it can also avoid state levies if the investor resides in the state where the bond was issued. That savings can be sizeable for residents who are in California, where the top marginal income tax rate is 13.3%, or in New York, which has a top rate of 10.9%. Hunting for income free of state taxes Municipal bonds generally make the most sense for high-income investors – those who are in the 32% marginal federal income tax bracket and higher. Purchasing individual issues can be complicated and cost prohibitive. Most munis are issued in minimum denominations of $5,000, and investors would have to perform their own due diligence picking through available issues. That’s where state-specific muni bond funds come into the picture. The Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) has a 30-day SEC yield of 3.82% and an investment minimum of $3,000. For New Yorkers, there’s the Vanguard New York Long-Term Tax-Exempt Fund (VNYTX) , which offers a 30-day SEC yield of 4.3%. See below for a chart of 10 large state-focused muni bond funds. But investors shouldn’t just hop right into one of these funds for the sake of tax savings. “You weigh the pros and cons of diversification and concentration,” said Dan Herron, CPA and certified financial planner at Elemental Wealth Advisors. Herron, whose practice is in California, said that when shopping for muni bond funds in the state, investors need to understand the issues of the underlying municipalities and their credit quality. The size of a given state’s municipal bond market is another consideration. “If it’s a large liquid market like California or New York, you can feel comfortable putting a pretty sizeable percentage of the portfolio in a single-state muni bond fund,” said Arnott. “But if you’re looking at a smaller state, like Massachusetts or Ohio, I would be more cautious because of the lack of diversification,” she said. Investors should also be mindful of duration, which measures the sensitivity of a bond’s price to changes in interest rates. Longer-dated bonds – and portfolios holding them – have greater duration and are more likely to see swings in prices as rates fluctuate. Indeed, strategists have recommended adding some duration via municipal bonds – say in the 5- to 7-year part of the muni bond curve – to lock in today’s higher interest rates. “For most people, it makes more sense to stick with intermediate or short-term maturities, unless you are saving for a very long term goal and won’t be tempted to sell if we have a market with significant losses for bond funds,” said Arnott. Finally, fees should be a factor in your decision. While large, diversified muni bond funds like MUB can be cheap (MUB has an expense ratio of 0.07%), you can expect to pay a little more for a state-focused fund. The Vanguard New Jersey Long-Term Tax-Exempt Fund (VNJTX) , for instance, costs 0.17%. “Fees are coming out of your returns, so the lower they are, the better,” said Arnott. -CNBC’s Gabriel Cortes contributed reporting.
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