The value of the $3.7 trillion municipal-bond market may drop by $200 billion, or about 5 percent, under President Barack Obama’s plan to limit income-tax deductions to 28 percent, according to Citigroup Inc.

To make up for reducing the amount of investment earnings that can be deducted from federal income taxes, investors will demand that tax-exempt yields rise by at least 0.6 percentage point, George Friedlander, senior muni strategist at New York- based Citigroup, wrote in a report this week. Bond prices move in the opposite direction of yields.

Obama has proposed capping the value of itemized deductions below the current 35 percent ceiling for families earning more than $250,000 annually in adjusted gross income. At the same time, he wants to raise the top tax rate on ordinary income to 39.6 percent from 35 percent, and to increase taxes on capital gains and dividends.

The cap plan would “severely damage the value of existing municipal bonds, and push the borrowing cost for new bonds substantially higher,” Friedlander said in the report.

If tax rates remain unchanged and a cap were introduced, a 10-year, tax-exempt bond with a 5 percent coupon would fall in value by $3.24, based on a security with a current price of $132.60 and a yield of 1.48 percent, Vikram Rai, a Citigroup muni strategist, wrote in a separate report.

Under the 39.6 percent tax rate in the president’s proposal, the same bond would drop in price by $5.37.

“An investor will demand higher yield to compensate for the taxation of the coupon income,” Rai said in an interview.

Any increase in yields may attract investors from Treasuries and corporate debt, according to Rai.

“As yield move higher as a consequence of the cap, crossover buyers should find munis more attractive at the margin, thereby mitigating the effect of the cap,” Rai wrote in the report.

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