Most private activity and conduit bonds do not have a substantial risk of being called if the proposed 28% cap on the value of tax exemption is enacted, Barclays Municipal Research said in a report this week.
After consulting with legal counsel, analyzing the proposed language of the 28% cap in President Obama’s 2011 jobs bill and reviewing tax call provisions in various official statements, Barclays concluded that most tax calls as written “have minimal risk” of triggering extraordinary mandatory redemption based on language of that proposed cap.
Barclays concluded that most tax calls are predicated on a blanket provision that bond income is added to gross income for tax purposes and, as a result, extraordinary redemption provisions would not be triggered.
“Certain taxpayers may have to pay an additional tax on itemized deductions and exemptions based on their individual tax situation or the additional tax is determined through an alternative calculation method that computes an amount to add to the standard tax owed by the taxpayer. In our view, the Jobs Act language should not result in the addition of muni bond interest income to gross income in determining tax liability,” the 12-page report said.
Private activity and conduit bonds affected by tax calls include those in the health care, private education, industrial development, pollution control revenue and utility sectors. Barclays estimates private and conduit bonds represent “roughly $290 billion of the $1.2 trillion Municipal Index.”
A tax call is traditionally considered an investor protection intended to force the issuer to affirmatively resolve a taxable event on the bonds.
“However, due to the current environment, outstanding municipal bonds generally trade at premium levels given the rally of the past several years, while many tax calls require redemption at par or with premiums below current market prices,” the report said.
Author Thomas Weyl, Barclays’ Senior Municipal Credit Analyst, wrote that ‘typical’ tax provisions are written from the standpoint of whether the bond issue or interest is declared taxable.
Similar to other market analysts, Weyl highlights that there are many variations of tax call language.
“A variation in the language includes situations where tax law changes or where an event occurs that causes the interest to become ‘included in gross income.’ The existing language of the 28% cap does not initially treat municipal bond interest as included in gross income,” Weyl wrote.
The report further broke down the risk of a bond being called into three broad categories: low-risk, medium risk and higher risk.
For low-risk tax calls, it is highly unlikely that legislative language with regard to the 28% cap would be triggered. Weyl explains that the most prevalent tax call is an event or action not taken by the company or borrower that causes the determination of taxability.
Medium risk tax calls are those that while unlikely to be triggered by the kind of language in the Jobs Act, could be triggered by changes to the language that preserve the economic intent but alter the calculation method.
Finally, if future proposed or actual legislation contains provisions that have certain differences from the language in the jobs bill, bonds could be characterized as high risk tax calls.