A spectre that periodically haunts the municipal bond market looms once again: the threat to alter the market’s sacrosanct tax-exempt status.
Brokers and investors mostly agree that the latest menace to munis’ tax-exemption, coming from President Obama’s 2013 budget proposal, has no chance of becoming a reality this year. But they are nonetheless troubled that the latest incarnation has taken on what they see as a particularly dangerous dimension because it would apply retroactively.
Obama’s proposed cap on tax-exempt interest would limit the benefits investors would see to the 28% tax bracket and would apply to all muni bonds — those in existence, as well as those yet to be. While issuers fear such a cap could raise their costs for future borrowing, it’s the absence of a grandfather clause for existing muni bonds that has the largest ramifications for investors in the market, muni pros say.
For implicit in the call for an all-encompassing and retroactive cap on exemptions lies the capacity for the federal government to revisit the issue of tax-exemption as they see fit, said Philip Condon, head of municipal bond portfolio management at DWS Investments.
He added that this uncertainty will likely daunt many investors, but particularly the retail variety, from looking for opportunities in the municipal market. Retail buyers — mom-and-pop investors — dominate the municipal market, either through direct purchases or investments in funds.
“If retail thought munis were somehow limited in their tax-exemption, there would be a reduction in demand,” Condon said. “Not because they do the math, but because they think, 'It could only get worse and I’m going to look elsewhere.’ But, as we saw a year ago, retail can get skittish.”
The industry remembers how retail investors at this time last year were exiting muni bond mutual funds following predictions that the market would see widespread defaults.
The cap on tax-exempt interest would prove very damaging to the market, agreed Chris Mauro, director of municipal bond research at RBC Capital Markets. Without a grandfather clause for existing bonds, he added, the cap would serve to reprice the whole market.
The 28% cap would likely create a significant tax-risk premium in the market, he said — greater than the one that that already exists. “Once the trust between the federal government and the bondholder is breached through this process,” Mauro said, “people are going to assume that the government can revisit this at any time.”
On Feb. 13 Obama proposed to limit the tax rate at which high-income earners can reduce their tax liability to 28% for individuals making more than $200,000 and married couples earning more than $250,000, rather than as high as the current 35%. The limit applies to tax-exempt interest from muni bonds.
In September, the president introduced the same proposal in his jobs bill.
Muni tax-exemption has undergone assaults at various times since the 16th Amendment, which was ratified in 1913, enacted the first Internal Revenue Code that bestowed upon municipal securities an exemption for interest. But Obama’s proposal goes the farthest by roping in all outstanding tax-exempt muni bonds. Today, around $3.0 trillion of the $3.7 trillion of muni bonds outstanding are fixed rate and tax-exempt, according to Citi estimates.
Still, the industry cited other concerns about the proposed cap’s fallout. For one, the measure would lower the benefit investors in the highest tax bracket get for owning tax-exempt debt, Citi’s George Friedlander wrote in an analyst report. The amount would be determined by the difference between the investor’s maximum tax rate and 28%, he wrote, or a maximum tax on muni interest of 35% minus 28%, or 7%, under current law.
“This, on the surface, does not seem like such a big hit — on a 4% bond, the after-tax yield would be reduced by 28 basis points before state tax effects are considered,” Friedlander wrote. “However, in our view, the potential cost to issuers of such a provision is much greater — as much as 75 basis points, as a first rough estimate.”
There would also be a significant impact on the value of existing holdings of municipal bonds. Citi estimated that a 75 basis point market hit would cause aggregate market value on existing muni bonds to tumble by some $200 billion.
In addition, Obama’s plan to impose a tax on income derived from tax-free bonds would instantly devalue portfolios currently amounting to about $500 billion in open-end mutual funds, James Colby, a portfolio manager and chief municipal strategist for Van Eck Global, wrote in a blog post for investors.
It would also increase the cost of capital for state and local municipalities that rely on the muni market to finance roads, bridges, schools and hospitals at low cost to their taxpayers, he wrote.
But even if the proposal should somehow pass through Congress, one shouldn’t assume that investors in the 35% tax bracket would immediately leave the muni bond market due to the reduced tax exemption, according to DWS’ Condon. If those investors still receive a better after-tax return on munis at 28%, depending on the valuations, he added, they would likely stay in munis.
Mostly, though, industry experts said that the cap, if passed as proposed, could create uncertainty that would subsequently complicate investors’ abilities to forecast and plan.
This would scare potential investors away from committing long-term to the market, said Kurt van Kuller, a director in the credit division for the Americas at Bank of Tokyo-Mitsubishi.
“Tax-exemption is the bedrock on which the market operates,” he said. “This is an attack on the foundation of the market — it’s not a nibbling at the margins.”