While municipal bonds are becoming increasingly politicized as the debate over eliminating their tax exemption heats up, many analysts say it won’t become a serious issue until the 2012 elections.
When discussing the possibility of muni bonds becoming taxable, “the more likely outcome remains the path of least resistance: no change at least until after the 2012 election,” researchers at Morgan Stanley wrote in a report last week.
They added, however, that the market should begin considering the ramifications of potential muni tax-policy changes, and that the uncertainty around the future of tax-exempts “can contribute to ongoing volatility in the market.”
This uncertainty also “serves as another psychological barrier to muni investment that adds to volatility risk and undermines the market’s ability to maintain stable risk premiums for sustained periods,” they said.
And while the uncertainty could remain until the elections, investors see more risk in munis right now.
“There is no longer any constitutional limit on Congress if it chooses to subject muni bond interest to taxation,” said Gregory Whiteley, head of government securities at DoubleLine Capital. “And with our fiscal situation and pressure to reduce the deficit, investors have to consider that to be on the table.”
Whiteley stressed that it is very possible for increased volatility to remain while uncertainty lingers.
“When and if something is put into place, a lot of that uncertainty will be resolved and there may be volatility while issuers and investors make some adjustments to the new regime,” he said. “But that too will work itself out.”
At DoubleLine, Whiteley is cautious about the muni market in its entirety.
“We are out of munis right now,” he said. “We’re anticipating increased muni supply and more bad news on municipal finances. These will create an opportunity to make a significant allocation to munis, probably later this year, but that opportunity has not materialized just yet.”
If and when Congress makes a decision regarding tax exemption of munis, Whiteley said one of the more realistic proposals that is both economically efficient and legislatively possible would be to restrict the use of the muni interest deduction by higher-income individuals, perhaps by limiting it to the 28% tax bracket.
“Republicans can then say they managed to retain tax exemption for munis and Democrats can say they took away some tax breaks for rich people,” Whiteley said.
That option could take the least amount of legislation, could allow both parties to claim some measure of victory, and will allow the federal government to increase or reduce that 28% limit in different economic times, he added.
Morgan Stanley researchers Michael Zezas and Julie Powers also noted that limiting the tax exemption would appease both sides.
“This would achieve the goal of increasing tax revenue for the federal government while preserving a subsidy for municipal issuers, albeit at a lower level,” they wrote.
There is also increasing pressure to reduce or eliminate tax exemption for municipal bonds because it is an easier way to increase income than to increase taxes.
“Policymakers can raise revenue by cutting tax expenditures, the benefits of which are not entirely transparent to the average taxpayer,” Zezas and Powers wrote.
Tax exemption also affects fewer voters. “The municipal tax exemption benefits a relatively narrow portion of the U.S. population and potential U.S. voters,” they said.
However, not all municipal bond experts agree.
John Mousseau, portfolio manager and head of tax-free munis at Cumberland Advisors, said he doesn’t think Congress will try to eliminate tax exemption.
Almost all the proposals he has seen include tax-credit bonds, which Mousseau said would make munis illiquid, or a permanent Build America Bond market with lower subsidies than during that program’s first incarnation — similar to the 28% instead of the 35% tax bracket.
“The problem is that this includes elimination of the deductibility of mortgage interest, which the housing lobby will kill,” he said.
In a televised webcast on the current state of the municipal bond market Wednesday morning, George Friedlander, senior U.S. municipal securities strategist at Citi, said: “There is no way Congress will take away the tax exemption from munis.”