If the proposed 28% cap on the value of tax exemption were enacted, the municipal bond market would become more volatile and would likely significantly deter investors from buying munis, Loop Capital Market’s analysts said Monday.

In their 5th annual outlook conference call with investors and issuers, the analysts discussed various factors affecting the muni market right now, including the 28% cap that was proposed by President Obama twice and recently floated during the fiscal cliff discussions between the administration and Congress.

Market participants are increasingly worried that the 28% cap could be included in upcoming fiscal discussions between the White House and Congress, including fights over raising the debt ceiling, allowing sequestration to occur and enacting a continuing resolution to keep the government funded.

“I think it’s a very bad dynamic for the muni market,” said Chris Mier, chief strategist and director of the Loop Capital Markets’ Analytical Services Division. “I would rather see the market become 100% taxable than see this because it becomes so easy for the government to adjust this.”

Mier added that it’s likely that the market would  be fundamentally impaired and a slight reduction in participation of institutional investors in the marketplace.

In a follow-up conversation, Mier explained that the cost of the cap is as much as 70 basis points, based on current yield levels to a taxpayer in the 39.6% bracket, currently the highest individual tax bracket.

Mier said investors would likely apply an additional “penalty” for the risk that the government might further apply direct or indirect taxation to the muni market at some point in the future.

It’s also likely that buyers would have to be compensated for the risk that their own tax rates might fluctuate, he said.

“Any changes in the muni market right now are lodged in this whole 28% cap,” Mier said. “The other alternatives appeared to have died. I think it’s the likely direction of least resistance at this point.”

When asked by a conference call participant if the 28% cap was a paper threat or reality, Mier said; “This is the real deal.”

The muni market faces an uphill battle primarily because there aren’t many advocates on Capitol Hill defending tax exemption and there appears to be disdain for munis from both congressional parties, he said. In general, Republicans have argued that tax exemption is another example of bloated government while Democrats say it’s a freebie investment tool for the wealthy.

Mier acknowledged the lobbying work of the recently formed Municipal Bonds for America coalition, but said that there is an institutional hostility to the muni market.

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