Muni Risk Reduced in Near Term

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WASHINGTON — In the shadow of the fiscal cliff agreement, the likelihood of comprehensive tax reform that would seriously damage municipal bonds this year has slightly diminished, according to a research firm and other market participants.

Municipal Market Advisors cut their 2013 forecast to a “still-worrisome” 30% to 40% that lawmakers will succeed in overhauling the tax code and make serious changes to tax exemption. Its new forecast comes after projecting, for more than a year, that the odds of sweeping tax reform in 2013 would be 50% or higher.

“This does not mean that pressure has disappeared; both borrowers and lenders should assume that, over the next few years at least, Democrats and Republicans will nominally pursue programs to reduce the value of tax expenditures, in particular for taxpayers in higher marginal tax brackets,” wrote Matt Fabian, managing director with MMA in a research note Tuesday.

MMA said discussions of future revenue raisers are likely, though the firm assumes Congress “will remain prone to avoiding hard discussions whenever possible.”

“Issuers and holders are advised to take a longer view, remain cautious about the downside possibilities in the next few years, and not relent on nascent advocacy programs to Congress on the benefits of public infrastructure,” Fabian wrote.

Several obstacles to tax reform include: the fiscal cliff agreement did not create a sense of bipartisan compromise; the Republican party appears weakened and may struggle to hold its caucus together; and with permanently fixed tax rates, there is no looming deadline to force congressional action on taxes this year, MMA said.

While munis may not be included in any immediate tax reform proposal this year, spending cut discussions might make the idea of new taxes more attractive, Fabian said. His firm forecasts a higher risk of piecemeal revenue raisers inserted into spending cut legislation and corporate tax reform where munis would be at risk.

Top Democratic and Republican Senate leaders appeared on the Sunday talk show circuits, expressing starkly different views about how to approach the upcoming fiscal discussions, namely the debt ceiling, sequestration and the soon-to-expire continuing resolution to keep the federal government funded.

“We’ve resolved the tax issue now,” Senate Minority Leader Mitch McConnell, R-Ky., said on NBC’s Meet The Press on Sunday. “It’s over. It’s behind us. The biggest problem confronting the country is our excessive spending.”

McConnell also reiterated that tax reform should remain revenue neutral.

Senate Democratic Whip Dick Durbin, D-Ill., however, urged lawmakers to look at tax reform as a way to raise revenue and help solve the country’s deficit challenges. “I can tell you that there are still deductions, credits, special treatments under the tax code which ought to be looked at very carefully,” he said on CNN’s State of the Union.

Mike Nicholas, chief executive officer at Bond Dealers of America, said the threat to tax exemption is very real right now and future fiscal reform discussions will include raising revenue, but won’t be about tax rates, which were set in the fiscal cliff agreement.

“Instead the discussion will be about limiting exempt deductions and exemptions including muni bonds interest,” Nicholas said, adding that tax reform can take a long time and the prospects of it happening with a highly polarized Congress this year is unlikely.

Micah Green, a partner at Patton Boggs, said the focus over tax rates may be over but that exerts additional pressure on scaling back existing expenditures and tax exemption will likely be on the table.

Several market participants said that the immediate threat to tax exemption has diminished in the near term but the next three to six months are likely to present some tensions for the muni market.

“Clearly the threat of a 28% cap has significantly diminished from where it was three to four weeks ago, but there is a good chance there will be some tax elements at least once and maybe multiple times this year,” said Chuck Samuels, a lawyer at Mint, Levin, , Cohn, Ferris, Glovsky and Popeo PC.

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