Municipal Bonds May Ease Taxes for California Investors

For many residents of high-tax states, such as California, implementing tax-advantaged investment strategies is a top priority. Californians face the highest income tax rates in the nation, underscoring why many investors strive to minimize the government’s take.

With a top state tax rate of 13.3% and a top federal rate of 37%, California’s combined income tax burden can be substantial. Moreover, Californians with annual incomes over $400,000 may be subject to an additional 3.8% net investment income tax (NIIT).

But California tax-exempt municipal bonds (munis) can help the state’s investors ease their tax burdens.

These securities deliver investment income exempt from federal and California state income taxes. What’s more, the California municipal bond market is among the nation’s largest, featuring a wide range of issuers with varying quality and maturity profiles. Given California's market size, diversity and complexity, we believe active management may be an ideal way to unleash the state’s investment opportunities.

Robust Economy & Diverse Population Support California’s Muni Market

In terms of economic might, California remains unmatched among its U.S. state peers. With a nearly $3.9 trillion economy, California represented the nation’s largest economic engine in 2023, accounting for approximately 14% of U.S. gross domestic product (GDP). Additionally, California ranked as the world’s fifth-largest economy, as Figure 1 illustrates.¹

A mix of industries powers California's economy. Like the nation, the private education and health services and trade, transportation and utilities categories employ the most people, as Figure 2 highlights.

Thirty-nine million people called California home in 2022, more than any other state in the nation.² Among them were 186 billionaires, making California the top state for ultra-wealthy residents.³ Additionally, in the 2021 tax year, 158,000 California taxpayers reported adjusted gross incomes of more than $1 million.⁴

Income taxes represent the state’s primary revenue source, while property taxes are the prime funding source for county, city and local entities. In the 2023-24 fiscal year budget plan, personal income taxes comprised 57% of California’s general fund revenues or $118.2 billion of the $208.7 billion general fund.⁵

Opportunities Abound in California’s Vast Muni Market

Backed by a huge, robust economy, the California muni market is among the nation’s largest and most diverse. It represents 17%, or $657 billion, of the $4 trillion national municipal bond market.⁶ Fitch Ratings, Moody’s Investor Services and Standard & Poor’s rate the state’s credit as AA, Aa2 and AA-, respectively.⁷

California’s municipal bond market offers investors broad yield and return opportunities. California’s diverse geography and range of industries and sectors create a multitude of investment options for residents seeking income exempt from state and federal taxes.

GO Bonds vs. Revenue Bonds: Understanding Types of California Munis

State and local governments issue general obligation (GO) bonds backed by the state’s taxing power. Because California – and other states – can raise taxes or impose fees to pay back their debt, GO bonds have typically been considered high quality. States typically issue GO bonds to build schools, hospitals, roads, parks, mass transit and other voter-approved projects.

In addition to the state, many other government entities issue munis to finance or improve income-generating projects and facilities. These issuers and projects vary, underscoring the importance of investing with professional managers attuned to the specific market. In California, these issuers include:⁸

• 57 counties.
  

• 482 incorporated cities.
  

• 1,005 school districts.

• 
  1,300 charter schools.

• 2,949 special districts that provide various services.⁹
  
  

Uncovering Value in California’s Varied Muni Bond Sectors

As the nation’s largest municipal bond market, California offers investors many options. But there’s much more to the opportunity set than volume.

Rather than a collection of homogenous securities, we view the California muni market as a dynamic collection of individual and distinct bonds. We believe investing in this vast market requires an active strategy bolstered by fundamental credit research to enhance performance potential and manage risk.

We aim to capitalize on the market’s broad diversity while emphasizing sectors and issuers we believe define and distinguish California’s muni opportunities from others. These potential opportunities include:

• Special tax districts. Community Facilities Districts (CFDs), commonly known as Mello-Roos, issue land-secured bonds. Bond proceeds fund a portion of public infrastructure projects (streets, water, sewer, storm drainage) for new developments, mainly residential master-planned communities. In turn, the CFDs repay the loans from a fixed special tax typically collected on the general property tax bill.

• Charter schools. Charter school bonds are generally secured by per-pupil state aid. These public grammar and high schools have less oversight and more autonomy than district schools and cannot charge tuition or affiliate with religious institutions. The schools commit to obtaining specific educational objectives in return for securing and renewing their charters. Charter schools are exempt from some operation and management rules but otherwise adhere to public school regulations.
  

• Student housing. Student housing bonds are project-financed college housing securities. They are secured by rents and, in some cases, college support.

• Health care. Health care bonds include debt from non-profit hospitals and health care systems, which secure their bonds based on gross revenues. Patient volumes derived from Medicare, Medicaid and commercial insurance comprise those revenues.

• Multifamily housing. Affordable housing bonds finance apartment projects for lower-income tenants (below 60% of the area median income). The operating income from these projects secures the bonds. Workforce Housing deals are secured by the net revenues of apartment projects targeting tenants earning between 60% and 120% of the median income.

Each sector in the California market contains varying degrees of credit risk and income opportunities – factors we seek to identify and leverage for our portfolios. We scan the state’s municipal bond spectrum for securities we believe offer a potentially attractive combination of tax-exempt income, risk exposure and total return potential.

Unlock Tax Advantages with California Municipal Bonds

The state’s high income taxes help drive consistent demand for California municipal bonds. And while top-bracket investors may realize the greatest potential tax benefits, the advantages aren’t reserved for the ultra-wealthy.

Figure 3 highlights the taxable-equivalent yields for California muni investors of different income levels and tax rates.¹⁰ A taxable-equivalent yield is the yield a taxable bond would have to pay to equal the tax-advantaged yield of a California municipal bond.

As you can see, for a hypothetical married couple earning $200,000 a year, a tax-exempt muni yield of 3.5% equals a taxable yield of 5.25%. For a married couple earning $1 million annually, the 3.5% tax-exempt yield translates to a taxable-equivalent yield of 7.63%. You can review different yield, income and tax-status scenarios with the interactive calculator available on the American Century Investments website.¹¹

Experienced California Municipal Bond Investors Oversee the Strategy

We believe the California municipal bond market could deliver value to investors by providing tax advantages, issuer diversity and solid performance potential. Given the size and complexity of the market, we also believe active management from California-based investors may be an ideal way to capture this value.

American Century’s municipal bond team is based in California and includes 13 experienced professionals averaging more than 21 years in the business. Our firm has managed California municipal bond portfolios for more than 40 years. Overall, American Century manages $8.2 billion in municipal bond assets.¹²