Muni-Bond Tax Exemption Under Active Attack -- May Be Limited In 2013

by: Richard Shaw

This week's municipal bond analyst conference focuses on continuing efforts by the President and Congress to reduce tax exemption for municipal bonds.

The President has proposed capping the tax benefit of municipal bonds at 28%, which is in effect a tax on muni interest in an amount up to the difference between the maximum ordinary tax rate an 28%.

Apparently, some others are seeking to deny tax exemption on new muni bonds.

According to Bond Buyer Magazine, federal tax exemptions from muni bonds totaled $258 billion over five years. By comparison, tax exemptions for employer provided health care totaled $725 billion, and home mortgage deductions totaled $464 billion over five years.

We have written and warned about this possibility in the past. The disruption to municipal finance and many portfolios and to market values of outstanding muni bonds could be substantial.

Existing bonds would fall in value. Municipal financing costs would rise, as investors require more yield to make up for lost tax benefit. Fewer municipal projects would be funded, or local property and income tax rates would rise, with other knock-on effects.

Build America style bonds would probably be restarted to help municipalities bridge the change -- but that is a case of "hello, we are from the government, and we are here to help".

Build America bonds give the Federal government some say over which municipalities get help and for which types of projects -- more federal control of local priorities, and how we live -- more centralized government -- less state independent decision making -- more political favoritism and mismanagement of priorities.

An enlarged and permanent BAB program would probably create financing advantages for urban areas over rural areas, due to federal funding where votes can be found ("bought"). Higher financing costs for rural areas, due to higher costs of traditional muni issuance and less ability to get Build America funding, would drive up cost of living outside of cities.

Overall more BAB is more government. More government means less freedom.

In a speech to the muni bond analysts this week, Mary Miller of the Treasury Dept. said the President's 2013 budget proposal, which intends to cap muni tax exemption at 28% [QVM note: step one toward total elimination] includes expansion of the Build America Bonds program to help finance large public infrastructure projects [QVM note: read that "small towns -- you won't get much help, just higher financing costs" -- and read that "states and large cities with projects the feds don't like or care about -- you won't get help either"].

Kristin Francheshi, president of the National Association of Bond Lawyers said she sees a very good chance of the feds passing the legislation that will limit muni tax exemption without a strong, concerted effort by issuers and bond buyers.

Who Owns Municipal Bonds:

Individuals are by far the primary owners of muni bonds, either directly or through investment funds.

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How Much Muni Debt Has Been Issued:

The total issuance of revenue bonds and general obligation bonds is down significantly, as states get their houses in order.

Meanwhile the federal government is expanding its debts with short-term maturities that will have to be rolled over eventually at higher rates, while states are reducing debt issuance and locking in low rates for long periods.

The average maturity issued in 2011 was 15.5 years.

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Build America Bonds

The BAB program began in April 2009 and expired in December 2010.

In 2010 BAB issuance represented 27% of all municipal issuance.

Which States Got the Most Build America Bonds Funding:

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Some Municipal Bond ETFs:

These data are from Morningstar on 04-18-2012

MUB 3.26 A 5.05
MLN 4.31 A 14.29
HYD 5.41 BB 11.66
MUNI 2.22 NR 4.92
SUB 1.23 AA 2.05
SMB 1.89 A 3.34
NYF 3.30 A 6.36
CMF 3.59 A 6.72
MUAE 1.86 A 3.94
MUAF 2.07 AA 4.76

The author personally holds intermediate investment grade and high yield municipal bonds through Vanguard mutual funds

Disclosure: QVM has no positions in any identified security as of the creation date of this article (April 19, 2012). I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.

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