With the passage of the “Millionaires Tax” in Washington State clients may be asking what it means for their municipal bond portfolios if they are likely to be subject to the tax as a Washington State resident. So far, the municipal bond market’s reaction to Washington’s new tax has generally been viewed as a modest positive for Washington-issued municipal bonds — especially for high-income in-state investors.
Why the market cares
Washington historically has had no state income tax which meant Washington investors had little reason to prefer Washington municipal bonds over bonds from other states. A Seattle investor could buy California, Texas, or New York municipals based mostly on yield and credit quality. Under the new 9.9% tax on income above $1 million, interest from Washington state and local municipal bonds remains exempt from the tax, while interest from many out-of-state municipals may effectively become taxable for Washington high earners. That creates, for the first time, a meaningful “home-state preference” dynamic similar to what exists in California or New York.
What municipal strategists are saying
The consensus among municipal strategists appears to be:
- Washington bonds could see higher in-state demand
- Yield spreads on Washington bonds could tighten modestly
- Existing Washington bonds could appreciate
- Washington could ultimately borrow somewhat more cheaply
The Bond Buyer, a municipal bond market newspaper, noted that Washington may evolve from a “general market” state into one where wealthy residents actively seek in-state tax exemption benefits. And in fact, portfolio managers we’ve talked to are saying that Washington bonds could begin trading more like high-tax-state bonds over time. However, it is likely an evolution not an immediate shift.
Walking through what this means in practice
For wealthy Washington investors, the after-tax math could change substantially. A Washington resident facing federal taxes, the existing capital gains tax, and now a state income tax, may suddenly value Washington tax-exempt income far more than before.
In other words, Washington bonds may begin to trade with a “scarcity premium” similar to other high-tax states. That said, we haven’t seen that behavior in the market yet. To this point, Washington GO bonds still trade near historical norms relative to the AAA national yield curve. Why?
- The tax does not begin until 2028
- Legal challenges are pending: Washington State’s supreme court will rule on the constitutionality of the tax
- Only a relatively small number of households are directly affected (roughly 20,000–30,000)
- Washington’s bond market is smaller and less retail investor driven than California or New York
- Some wealthy residents may relocate assets or residency rather than simply buying more Washington bonds
What are municipal separate account bond managers doing?
Municipal bonds managers aren’t moving decisively without a definitive answer to whether municipal bond income will be subject to the tax, but they are monitoring and will act as appropriate for impacted clients as we approach 2028 and the details are ironed out.
In the near-term, upon request, they are able to reinvest maturities in Washington bonds to begin to tilt portfolios more toward Washington State. They want to be mindful of any greater repositioning making sure that any potential after-tax yield pickup is not destroyed by capital gain realizations. Longer-term they would manage with a state-specific bias like they would with other high-income tax states.
Assuming the tax is upheld, as with other high-state-income-tax accounts, they will take a mathematical approach to security selection. If it is more beneficial from after-tax total return, yield, and diversification perspectives to own out of state bonds and pay the state income tax, they will still make those decisions. Washington bonds will serve as a hurdle for purchases out of the state, but alongside the requirement that they maintain appropriate quality, sector, and duration targets of our guidelines.
It is unlikely that portfolios would ever become 100% invested in Washington State bonds but would more likely be focused 60-70% Washington bonds with a reduced exposure to other states to complete diversification. That approach is similar to the one managers use for other smaller market issuers such as Oregon.
Unfortunately, because of the limited issuance in the market, as well as the relevant number of households issue mentioned above, it is unlikely that a commingled product focused on Washington bonds, whether mutual fund or ETF, is created in the near future. What that means is that fund investors will either need to fund a separately managed account if they are able or otherwise find themselves subject to the tax.
