Bye-Bye Muni Bonds? Is 'Muni-TARP' to Follow?

June 25 (Bloomberg) – “Barack Obama may be the worst thing that ever happened to tax-exempt bonds …. “

We certainly agree and see more trouble for tax-exemption down the road.

Obama Chief of Staff, Rahm Emanuel said, “A crisis is a terrible thing to waste.”, and the administration is taking that advice by sponsoring and subsidizing the issuance of fully taxable municipal bonds — “Build America Bonds” (the camel’s nose under the tent).

Presidents since Franklin D. Roosevelt have tried to tax the interest payments from municipal bonds without success, but the debt crisis has provided Obama with a way.

Build America Bonds (we prefer “Obama Bonds”) pay 35% of the interest cost for fully taxable muni bonds.

Presumably the subsidy also improves the credit quality of the bonds by having a portion of the interest come from the US Treasury.

Example Bonds YTM Rate Comparison:

We based our credit quality argument on logic suggesting the federal payment stream to more secure than the state portion; and upon an unscientific study of two issues (a CA tax-exempt ‘34 GO yielding roughly 6%, and a CA taxable Build America ‘34 yielding roughly 7.5%).

Since the after-tax return on the Build America bond is lower than the after-tax return on the traditional tax-exempt bond, and the maturity dates are the same and both are state GO’s, we presume investors perceive lower credit risk on the Build America Bond (although the posted credit rating is the same for both at A2/A).

On the other hand, the lawyers for CA weren’t totally sanguine about the risks, because the terms of the bonds provide the state the right to call the bonds (presumably to replace with traditional bonds) if the federal funding is not provided in full.

Control Hook:

Because this government program is “temporary” (yeah right, a temporary government program that raises taxes), and because the current funding is limited, the government must selectively subsidize.

If the program is extended (read that made permanent), then rationing of a small program will grow into mandated use of a large program, with the federal government effectively deciding which state and local projects get funded at all. It will go from selecting which projects to subsidize, to mandating federal funding and selecting which projects to permit to be bonded.

If you don’t believe that, then name a major federal funding program that doesn’t come with mandates. Name a major federal funding program which doesn’t trap or addict states.

Tax Hook:

Bloomberg pointed out,

Interest on state and local government bonds sold for public purposes has been exempt from federal levies since the Constitution was ratified and remained so after the 16th Amendment was approved in 1913 creating the federal income tax. Presidents and lawmakers have tried to roll back the exemption for decades. Since the 1960s, Congress has passed legislation prohibiting use of public debt for racetracks, massage parlors, golf courses and other private purposes. The House Ways and Means Committee initially proposed subsidizing taxable municipal bonds in 1969. President Jimmy Carter and Bill Clinton also embraced the idea. … There were no hearings on Build America bonds before they debuted, so there was no opportunity to mount opposition…

We suppose the lack of hearing on Build American Bonds is part of the transparency Obama promised and continues to promise.

Given the search for tax revenues, and the “share the pain” and tax the rich orientation of the current US legislative and executive branches, it has surely not gone unnoticed that 44% of the $72 billion of tax-exempt income in 2006 was claimed by households earning over $500,000 (the people in the general tax increase cross-hairs).

Eliminating the tax-exemption for those high income taxpayers would generate $30 billion of revenue. That $30 billion would effectively have to be recycled as subsidy of taxable municipal bond issuance, but it would further governmental control of state and local governments, and further the redistribution of wealth.

There are opponents in Congress. One notable voice is Barney Frank, chairman of the House Financial Services Committee. He says there’s “zero chance” Congress would permit the municipal bond tax exemption to be eliminated. Bloomberg noted that Barney has his most of his life savings in Massachusetts tax-exempt bonds. We’d call that enlightened self-interest, as opposed to what Larry Summers called “unenlightened capitalists” when the first lien bond holders of Chrysler wanted their liquidation priority honored. We supposed Barney didn’t own any Chrysler bonds.

Adverse Investor Scenarios:

Here are some conceivable investor perspective scenarios adverse to municipal bond investment programs (not conceivable pre-AIG, pre-Chrysler, pre-GM, but conceivable now):

• Mandated Use of Taxable Munis: Federal government mandates state use of taxable municipals, resulting in lower supply of new tax-exempts to replace maturing tax-exempts, thereby phasing out tax-exempt investment opportunities (perhaps increasing the value of issued tax-exempts).

• AMT on Traditional Munis: The Alternate Minimum Tax is modified to phase out exemption for upper income tax payers.

• Prohibition of Bailout Money Use for Traditional Munis: As in the case of Chrysler and General Motors bailouts, where bondholders were royally shafted, muni bondholders may receive similar treatment in a California or other state bailout. We can imagine the strings attached to a state budget bailout requiring 100% funding of any and all state obligations (and perhaps wish list projects) other than muni bond interest (or even principal) before any payments on tax-exempt muni bonds are made.

• Universal Muni-Tarp Jam-Down: To avoid adverse effects on states taking subsidy (let’s call it “muni-TARP”), as with the banks, there may be a jam-down so that states that don’t need the money have to take it any way.

The first action would limit reinvestment opportunities and probably generate a premium on issued bonds.

The second action would eliminate the scarcity premium on issued bonds.

The third action would generate a discount on issued bonds, damage (perhaps collapse) the secondary market for traditional issues from states with “muni-TARP” funding, while putting a premium on issues from states that are not receiving “exceptional assistance” (as the term is used with bank TARP).

The fourth action would eliminate the premium for self-sufficient states, generated by the third action.

We own muni bonds for about ½ of our overall bond allocation, but are anxiously watching developments. As Bill Gross, co-CEO of PIMCO, said in his recent missive, don’t turn your back on the government when it comes to your investments.

There’s not just future inflation to worry about with municipal bonds, but also possible vanishing tax-exempt reinvestment opportunity, and possible mandated contract rights violation.

Time Frame:

A year ago, we would not have considered these adverse scenarios to be a realistic risk, or have had the audacity to talk about them. Now we do. A few months ago, we would have said we do not believe any such changes, if ever, could be made in months. Now we do.

Event Risk Fat Tail:

This nightmare story may never come true, but it might, and in terms of event risk, this would be a big fat tail for muni bonds — not a Black Swan, because it is on the radar screen — but off the charts in terms of historical events for municipal bonds.

Be Watchful!

Disclosure: We own MUB in some managed accounts.

IRS Website Reference:

R-2009-33, April 3, 2009

"The American Recovery and Reinvestment Act of 2009 creates the new Build America Bond program, which authorizes state and local governments to issue Build America Bonds as taxable bonds in 2009 and 2010 to finance any capital expenditures for which they otherwise could issue tax-exempt governmental bonds. State and local governments receive a direct federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35 percent of the total coupon interest paid to investors.

This new program is intended to assist state and local governments in financing capital projects at lower borrowing costs and to stimulate the economy and create jobs. ... Build America Bonds can be issued in 2009 and 2010. There is no volume limitation on the amount of eligible Build America Bonds that can be issued during this period"

IRS Notice 2009-26 "... provides guidance on Build America Bonds to enable state and local governments to begin using this program. This notice includes guidance on eligible types of projects and financings, initial implementation of the direct federal subsidy payment procedures, elections to use this program, and information reporting for this program."

Comments

[prairiedog555:]

What are Muni's good for? Since the lessons of 'O8 I have learned they:
Are not "safe"
Don't pay out much
Don't do well in inflationary enviornment
and now you tell me Our President has them in the cross hairs.
I have some closed end Muni funds, I will sell and buy foreign sovereign debt and MLP's.
And if they tank, it might be worth losing some money just to hear Barney cry like a little girl.

Jun 26 07:16 AM

[shootpar2001:]

Yes, muni bond funds dropped just like everything else in '08.
They have recovered nicely however, and are paying better than expected returns. As the article postulates; the scarcity model will probably take hold first and thus raise the principal value.
Lastly, by raising payouts (eventhough taxable) they may (will) compete with Treasuries; when that happens the Fed's will withdraw their (implicit) support.
I smell 'volitility' premiums and opportunities!!

Disclosurers: (ATAX) (MVF) (MFM)



On Jun 26 07:16 AM prairiedog555 wrote:

> What are Muni's good for? Since the lessons of 'O8 I have learned
> they:
> Are not "safe"
> Don't pay out much
> Don't do well in inflationary enviornment
> and now you tell me Our President has them in the cross hairs.<br/>I
> have some closed end Muni funds, I will sell and buy foreign sovereign
> debt and MLP's.
> And if they tank, it might be worth losing some money just to hear
> Barney cry like a little girl.

Jun 26 10:17 AM

[Living4Divi...:]

A very valuable reminder of the risks in this market. Beautifully written article. Thank you.

Jun 26 02:48 PM

[geewow:]

I am not sure what the complaint is all about? If Obama abolished the Fed and rolled it into the Treasury eliminating the interest payments we make to the Fed for borrowing money to operate, we would be in a lot better shape. We would not have to be connected the the IBS, either.

North Dakota has a the Bank of North Dakota. This is a state owned bank lending cash for projects. The state budget is deposited in it, and people can place their deposits in it, as well, I believe. North Dakota is one of three states with their own bank. And, The Bank of North Dakota pays a reasonable interest rate, too. North Dakota also has a $62 million surplus.

Take a lesson from this Obama.

Jun 26 06:14 PM

[User 422955:]

This is a new content area for people who are paranoid about Obama.

Disclosure: During JWB's first term, I was paranoid about the possibility that he might turn the Republic into a Monarchy. With himself as monarch, of course.

Paranoids, stick together! (It takes one to know one.)

Jun 26 06:57 PM

[User 422955:]

I kept thinking of this article this morning while doing my household chores. Congrats, Mr. Shaw, for a highly original, inventive, and amusing article. This is not a combination frequently seen here on SA.

Let's apply 'Occam's razor." If the federal government simply wants to capture a goodly portion of the taxes avoided by the very rich (>$500K, according to Mr. Shaw), changing the AMT would be sufficient. Mr. Shaw says that issued bonds would then fall in price, because they would become more plentiful. However, the federal (and some state) governments would have reached their objective; why do more? There is no good reason for the Obama administration to attempt a further, generalized, interference in state and local affairs. There is ample reason for the Obama administration to avoid such interference. "Local control" of public schools is one of the holiest of America's sacred cows. They are already in enough battles to fill their days and nights.

Jun 27 05:29 PM