Municipal Bonds: When Does It Make Sense to Go Local?

The case for munis, certainly relative to Treasurys, seems clear. Yet as with most investments, there's more to the story.

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It generally makes sense for investors to expand their horizons and diversify into foreign stocks and bonds, but when it comes to one type of asset, municipal bonds, could a local outlook be more suitable?

Well-off investors have long used municipal bonds, often called munis, for tax-smart investing, particularly because their interest generally incurs no federal income-tax liability.

Munis became even more useful in 2013, when tax rates went up. The top rate was raised to 39.6% from 35%, and an additional 3.8% tax on investment income for high earners, a provision of the Affordable Care Act, was introduced.

But why settle for one tax write-off when you can get two or even three? States generally don't tax interest on munis issued within their borders, so residents who buy them can collect interest free of state and federal tax alike.

Residents of cities or counties that assess their own income tax could deduct income on munis issued within the state on their city tax forms, too, completing a tax-break trifecta. New York is the most notable example of a city that has its own income tax, but it's far from alone. Yonkers, just over the New York City border from the Bronx, is another one, as are Wilmington, Delaware; Birmingham, Alabama; eight cities in Kentucky and on and on.

Muni-bond investments in taxable accounts are smart choices for residents of New York or other cities with income taxes, and a sensible (or clear) choice for those who live in high-tax states. But they may even make sense for everyone else who gets to deduct the earnings from their federal income taxes. Consult a tax professional to learn the full tax consequences of munis for your financial situation.

By investing locally, you may get all the tax breaks, but you leave yourself highly exposed to other breaks that may not go your way.

The federal tax deduction would seem to make municipal bonds excellent assets for high-income investors. The state deduction would seem to make homegrown issues even better holdings for investors who live in high-tax states such as New York, New Jersey and California, and seem even better still for residents of New York City and, perhaps, Wilmington.

Some financial advisors encourage their clients to keep nearly all, or at least most, of their bond exposure in munis. It's easy to see why with a look at mutual fund performance over the medium to long run.

The average municipal bond fund returned 4.7% a year in the five years through this March, according to research firm Morningstar, about the same as for the average bond fund that provides no tax break.

Municipal yields continue to exceed those of Treasury instruments across the yield curve. Ten-year munis recently yielded 2.3% on average, according to Bloomberg, compared with 2.1% for 10-year Treasurys. The corresponding figures for two-year issues were 0.65% and 0.5%.

The case for munis, certainly relative to Treasurys, seems clear. Yet as with most investments, there's more to the story. It's important to remember, for instance, that while muni returns have been adequate, they have not been spectacular despite nearly ideal conditions of a slowly recovering economy and ultra-low interest rates.

Interest-Rate Connection

With rates on nearly all debt low by historical standards, the path of least resistance seems up. If Treasury yields move higher, municipal yields are likely to do the same; that raises the chance of a capital loss to go along with coupon income that could start to look meager compared to alternatives in the marketplace.

If Treasury rates stay low, on the other hand, it's likely to be a reflection of worsening economic conditions. That could leave state and local authorities in a bind by limiting tax receipts, along with the usage fees that big municipal borrowers, like operators of transportation and utility infrastructure, depend on.

Behind Muni Yield: Tax Rates

You may try to reassure yourself that authorities can resort to Plan A and raise tax rates to get over the hump, but that opportunity may be nearing exhaustion.

In theory, anyway, the ability to raise taxes should give state and local governments a ready supply of cash to cover debt payments. In practice, however, the powers that be in many states don't see taxation and borrowing as an either/or proposition.

States that borrow a lot to fill their coffers also have a habit of raising taxes and making already high rates even higher. California, first in the nation in so many ways, has a top income-tax rate of 12.3%, plus a surcharge of one percentage point—called the Mental Health Services Tax—on incomes above $1 million.

That rate puts California ahead of all other states in that category. Even so, Standard & Poor's, as of 2014, gives it the second-lowest credit rating—A—among all 50 states.

An A may look good on your kid's report card, but rating agencies grade government finances on a much higher curve; the only state with a lower rating, A-, is Illinois, another high-tax state. Florida and Texas, by contrast, which have no income tax on individuals, get S&P's highest rating, AAA.

These details reveal the wisdom of an old saying: If you give politicians more money to spend, they'll spend it. And not always wisely, as confirmed by the 2013 bankruptcy of Detroit and the downgrade last month of Chicago's debt to junk status by Moody's Investors Service after the Illinois Supreme Court ruled that the city couldn't cut benefits to shore up its teetering pension system.

Developments like these highlight the double-edged sword of concentrating on local municipal bonds and ignoring the usual—and usually wise—advice to diversify a portfolio.

By investing locally, you may get all the tax breaks, but you leave yourself highly exposed to other breaks that may not go your way.

This article originally appeared on CNBC.