On the contrary, national muni ETFs have also solidified their existence on the basis of risk mitigation. Unlike, state-specific muni bonds, national muni ETFs invest in states across the U.S. along with other diversification strategies to mitigate the concentration risk. Although there are many factors investors must weigh to compare state-specific and national muni portfolios, the question remains whether risk mitigation through national ETFs outweighs the tax benefits of state-specific muni investments.

In this article, we’ll take a closer look at national muni ETFs and their overall benefits compared to state-specific pools and individual muni bonds.

Simply put, in national ETFs, the opportunity cost for an investor is giving up state tax exemption, while gaining on the portfolio-diversification front.

However, there are other factors that play important roles in deciding for one over the other. For instance, state of residence, income level, total investments and other holdings in your portfolio can significantly influence this decision.

This relation can be measured by the taxable yield and tax-free yield of respective portfolios. For example: a national ETF like iShare National Muni Bond ETF (MUB) had a 12-month yield of 2.21% (as on Jan 15, 2017) and is subject to a state tax. Yet, a similar state-specific portfolio would return 2.05%, which is equivalent to the national portfolio return due to the potential state tax savings (20% fed tax rate, 8% state).

Although the state tax savings may be enticing for residents of a credit-worthy state like New York, investors must also consider credit risk, concentration risk and the overall regional market volatility within specific states – a matter we’ll discuss further in this article.

Be sure to visit our Market Activity section to explore recent muni bond trades across all U.S. states. While you review state-specific muni bonds, you may want to read specific credit reports to determine their creditworthiness. You can immediately gain access to the Moody’s Credit Reports section by becoming a Premium member.

As mentioned above, state-specific portfolios have a core strategy that adheres to a composition of single-state munis to provide tax benefit to its in-state investors. Historically, the portfolio income has been better protected with the state-specific funds, primarily because of tax benefits, and investors had more faith and “sense of safety & control” while investing in their local municipalities.

As markets evolved, regional and state investments became more interlinked with the global economy. This required investors to potentially give up their modest state-specific tax savings and trade them for obtaining diversification as a risk-mitigation measure. In a national portfolio, investors hold an eclectic mix of municipal securities from different states and municipalities. Here are a few factors to consider when deciding between state and national muni ETFs.

• Benefit to investors from lower-taxing states: For many state-specific investors, state tax savings play an important role so they choose to forego the portfolio diversification. This may be untestable for investors who reside in states with stronger and more diverse economies; but for other states, one economic downturn can be detrimental. Along the same line, investors who live in states with lower taxes, the tax benefits on state-specific investments aren’t that big and national diversification can outweigh these small benefits. So, it is critical to weigh the health of a state’s economy and muni markets before looking at your tax breaks.

• Reduce concentration risk: The most distinct drawback of single state-specific munis is lack of diversification, which can not only affect the yield but also the marketability and potential loss of principal. The economy of any single state is typically dependent on few sectors or industries. For example: Wyoming has historically been known for its coal production. All major industries, jobs and the economy of Wyoming are heavily dependent on this sector. Now investors in Wyoming state-specific municipal debt are betting on good coal production year-over-year, which in turn will help state and municipalities run their operations and meet their financial obligations. If, for a couple of years, the coal production dampened in Wyoming, it could have a detrimental effect on the state’s financial obligations and, potentially, loss of capital for investors.

• Reduce liquidity risk: The trading volumes of national muni ETFs are much bigger than state-specific funds. This provides investors with more liquidity and ease to get in and out of the market. Moreover, at times, this type of liquidity is crucial to take advantage of inefficiencies in the muni market.

• Reduce credit risk: The risk tolerance and time horizon for an investment also plays an important role in choosing state-specific funds. When deciding to stick to owning a state’s muni bonds, investors can be subject to the credit risk of a particular state sector or economy. Some high-yielding, state-specific funds are often composed of securities that are below investment grade to generate high returns. This should not be an issue if the investor opts for national muni ETFs that tend to reduce the exposure of muni bonds to any specific geography, maturity and sector.

Before reading on, you may want to have a quick look at our Muni Bond ETF guide and some of its key tips on how to choose the right muni bond ETF.

Next, let’s take a close look at a national ETF vs. a state ETF and how they compare. For this purpose, we compare the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM), a national muni ETF, and PowerShares California AMT-Free Municipal Bond Portfolio ETF (PWZ), a state-specific muni ETF.

Comparison: Both the ETFs are strong contenders in their own categories. However, one provides diversification and one offers state-specific, tax-exempt returns.

Although PWZ holds the edge over others in terms of its 12-month trailing yield, that is primarily due to its longer duration of underlying securities. Meanwhile, ITM offers lower expense ratios, better diversification due to a broad range of underlying securities and comparatively lower interest rate risk.

It’s also worth looking at how state and national-level muni ETFs compare to their respective indices, S&P National AMT-free Muni Index and S&P California AMT-free Muni Index.

Investors should carefully weigh their options and consider the trade off between the tax benefit of state-specific munis with the diversification benefits of national muni ETFs. State-specific investments are not only more prone to credit and concentration risks, there are also factors like the environment that can be very region specific and, possibly, cripple regional economy (i.e. California droughts).

Although national muni ETFs could offer proper diversification, they can’t completely protect you from market conditions and potential capital loss. In general, national muni ETFs can be an obvious choice for investors from lower-taxing states, as portfolio diversification can trump small state-tax exemption benefits.

Keep in touch with our Muni Bond Investment section to learn about different strategies.