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Threat to tax-exempt status ‘clear and present danger’

By Jeff Benjamin

January 9, 2013

The municipal bond market, having weathered the year-end fiscal cliff deal with its tax-exempt status unchanged, is poised to hit another pocket of volatility leading up to the debate in Washington over the debt ceiling and spending cuts.

Among the forces at play is the fact that tax-free muni bonds are increasingly popularly with high earners who have been hit with a tax hike on their investment income.

But taxpayers planning on employing munis for income have to deal with new fears that tax-exempt income could be eliminated or trimmed in the next round of budget talks.

“The threat [to the tax exemption] is real and it’s a clear and present danger because everything is on the table right now,” said Ronald Bernardi, president of Bernardi Securities Inc.

Fund flow data is not yet available for December, but net flows into muni bond funds from July to November averaged more than $5 billion per month, for total net inflows of nearly $54 billion during the first 11 months of 2012.

This compares to total net outflows of $12.7 billion in 2011.

“We saw the market’s reaction in the latter part of 2012 when just the prospect of higher marginal tax rates increased demand for tax-exempt income,” Mr. Bernardi added.

The Barclays Municipal Bond Index gained 6.8% last year, despite a 1.2% decline in December when it looked liked Congress might cut the tax exemption on muni gains.

Market watchers fear such volatility could hit the muni market again as lawmakers debate the muni tax exemption, which is estimated to cost the Treasury about $40 billion a year.

“In December, investors started moving away from the asset class due to the fiscal cliff talks and Congress,” said James Colby, senior municipal strategist at Van Eck Global.

“Now that we’re past Jan. 1, we have an adjustment in income taxes that makes the muni tax exemption that much more attractive” to investors, he said. “But, meanwhile, it appears the assault on tax exemption is not over yet.”

In some respects, the new taxes on high earners combined with the looming next wave of budget talks have created an almost schizophrenic mood in the muni bond market.

“In December the muni markets sold off, based on fears that did not come to pass, but as we get closer to the deadline on the debt ceiling debate, if we hear more about cutting the tax exemption the market will sell off again,” said Eric Freidland, head of municipal credit research at Schroders Investment Management North America Inc.

The muni market is already assuming Washington will honor President Barack Obama’s request to cap the exemption on muni bond income at 28%, he said.

For those in the highest tax bracket, such a cap would mean an exemption equal to about 9%.

But the 28% exemption cap, representing the first time in the muni market’s 100-year history that income would not be fully tax exempt, would also introduce a whole new set of calculations for bond investors and financial advisers.

It currently is relatively simple to calculate the advantages of tax-exempt income, compared with the taxable income from high-yielding fixed-income investments. And the 60,000 state and local issuers making up the $4 trillion muni bond market are usually equally adept at working within those parameters.

But reshuffling that deck, either with an elimination or reduction of the tax exemption, has left the market on edge.

“I expect there will be increased volatility and periodic dislocations in the muni market over the next couple of months,” said Steve Winterstein, chief strategist in fixed income at Wilmington Trust Corp.

“You could even see a Meredith Whitney-like reaction in the market if investors get scared,” he added. “That kind of reaction could present investors who understand these things with ample opportunities.”