Trusted performance.  Lasting value.

Clear of fiscal cliff, munis facing another volatile patch

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.”

More fiscal challenges on the horizon

Spending cuts and debt ceiling still must be resolved

By Mark Schoeff Jr.

January 6, 2013

Legislation approved by Congress last week to avert hundreds of billions of dollars in tax increases and spending cuts may turn out to be the easy part of addressing the country’s fiscal challenges.

By the end of next month, lawmakers will have to grapple with raising the debt ceiling.

During the same time frame, they also will have to decide what to do about the $110 billion in automatic spending cuts that they delayed for two months as part of the so-called fiscal cliff bill. In addition, the spending authority that keeps the government running will expire in March.

Even though the fiscal cliff measure did end Bush-era tax cuts for households earning more than $450,000 a year — bumping their rates to 39.6%, from 35% — it enshrined in the tax code the lower Bush rates for everyone else.

The measure makes permanent a capital gains and dividend rate of 20% for households making more than $450,000 annually and 15% for those below that level. It also adds to the tax code the alternative-minimum-tax exemption and indexes it to inflation, protecting nearly 30 million Americans who would have been hit by that levy this year.

The bill sets an estate tax rate of 40% with a $5 million individual exemption, a rate increase from 35% but one that is much lower than the 55% rate and $1 million exemption that would have gone into effect if the Bush tax cuts had expired.

The bill offered enough tax goodies that it was a vote with which many lawmakers were comfortable. Even at that, the process of hammering out the bill was fraught with political tension and featured a frantic scramble to beat the deadline on New Year’s Eve.

MORE TO COME

Yet last week’s legislation for the most part ignored much tougher decisions that have to be made to reduce the more than $1 trillion annual deficit and the more than $16 trillion federal debt, the primary reason why 151 House Republicans revolted against the bill.

“Now that we have to deal with the spending side of it, it’s going to be even more difficult,” said Neil Simon, vice president for government relations at the Investment Adviser Association. “It’s going to be a rough start for this new Congress.”

Investment advisers are bracing for things to get worse in Washington.

“We have another drama coming up,” said Leon LaBrecque, managing partner and founder of LJPR LLC, a wealth management firm. “I expect that to be ugly.”

And continued squabbling in Washington will put pressure on Wall Street.

“It’s quite annoying, but we’re in for another full quarter of uncertainty, where the capital markets are being influenced by these outside political factors,” said Jerry Miccolis, chief investment officer at Brinton Eaton Wealth Advisors.

Within minutes of House approval of the fiscal cliff bill last Tuesday, President Barack Obama was already hunkering down for a fight over lifting the debt ceiling.

When the U.S. borrowing authority ran out Dec. 31, Treasury Secretary Timothy Geithner took steps to extend it for two months.

“We can’t not pay bills that we’ve already incurred,” Mr. Obama said. “If Congress refuses to give the United States government the ability pay these bills on time, the consequences for the entire global economy would be catastrophic.”

Mr. Obama has no intention of giving quarter to Republicans on deficit reduction.

AVALANCHE OF SPENDING

“Cutting spending has to go hand in hand with further reforms to our tax code so that the wealthiest corporations and individuals can’t take advantage of loopholes and deductions that aren’t available to most Americans,” he said.

The lawmaker who hammered out the fiscal cliff bill in negotiations with Vice President Joe Biden warned Mr. Obama that Republicans will be turning to deficit reduction with a vengeance.

“The president got his revenue. Now it’s time to turn squarely to the real problem, which is spending,” Senate Minority Leader Mitch McConnell, R-Ky., said in a floor speech last week.

“We cannot agree to increase that borrowing limit without agreeing to reforms that lower the avalanche of spending that’s creating this debt in the first place,” he said.

The exchange between Mr. Obama and Mr. McConnell is perhaps an understated harbinger.

“We expect Republicans will not give in anymore on revenues, and Democrats will resist entitlement cuts,” Brian Gardner, senior vice president for Washington research at Keefe Bruyette & Woods Inc., wrote in an analysis last week.

In the summer of 2011, the Obama administration and Congress agreed only at the last minute to extend the debt ceiling, while also approving a bill that set into place the $1.2 trillion in domestic-spending cuts over 10 years that now have been delayed by two months.

Unlike the fiscal cliff bill, which contained tax rates that could be retroactively reduced if Congress missed the Jan. 1 deadline, violating the debt ceiling potentially could lead to an immediate downgrade in U.S. bonds.

“Once you default, you can’t undefault,” Mr. Miccolis said. “It’s on your permanent record, as they say in school.”

POLITICAL COMITY

The higher stakes with the debt battle have advisers hoping for more political comity in Washington than seen over the past few years.

“The country is bankrupt; that’s what we have to focus on,” said Robert Martinelli, owner of Guardian Wealth Management. “It’s going to take a lot of leadership, and a lot of people feeling some pain, to get through this.”

That approach, however, is rare in Washington.

“It seems politicians are more interested in positioning than in solving problems,” Mr. Martinelli said.

Mr. Miccolis agrees.

“They’ve kind of trained us not to rely on them,” he said of lawmakers. “It seems like our representatives spend way too much time assigning blame for lack of action rather than getting something done.”

But Washington has to rise to the occasion because congressional action to reduce the debt could dictate long-term investment performance.

“Wrestling with the deficit and addressing Medicare and Social Security costs, and the rate of increase of those costs over the next 10 to 20 years, makes or breaks our economy, not the fiscal cliff,” said Scott Moser, chief executive of Moser Wealth Advisors PLLC.

Congress will provide a hint of whether it has the wherewithal to tackle those issues over the next two months.

Managing an investment portfolio in today’s volatile financial markets requires sophisticated financial tools.