Tax Code Changes Should Outshine Tax Reform Speculation

 

By Rom Badilla, CFA

August 27, 2012

Like ominous clouds over the horizon, tax reform continues to loom on municipal market players as we head into the final months leading up to the Presidential election. Last fall, President Obama in his war against the rich, proposed that the tax exemption that municipal bond investors enjoy should be reduced for high-income tax payers, individuals who earn in excess of 250,000.

This curtailment in benefit for high-income earners like Obama’s proposal would undoubtedly be a game changer. Such proposals of tax reform would be a detriment to the municipal market since it would reduce its attractiveness to investors.

While tax reform is a danger for the municipal market, the fact is that the political landscape can change dramatically after the election and tax reform can easily come off the table as quickly as came to the forefront says the head of U.S. Municipal Strategies at RBC Capital Markets, Chris Mauro.

In their latest U.S. Municipals Research report, Mauro pointed out that speculation on the implications of tax reform for the municipal market is a ‘waste of time’ due to the uncertainty of the elections. Because of this, they prefer the direct approach of identifying the positive facts that every muni investor (or prospective investor) should consider:

Under the Patient Protection and Affordable Care Act (ACA), individuals earning over $200,000 and joint filers earning over $250,000 annually would pay an additional 3.8% tax on dividends, interest (excluding interest from munis) and capital gains beginning January 1, 2013.

In addition, they pointed out that the following is related:

Pursuant to current law, the so-called Bush tax cuts expire at the end of 2012. As a result, the top marginal tax rate is scheduled to jump to 39.6% from the current 35% rate. Additionally, the tax rate on dividends jumps from 15% to the ordinary income rate of 39.6% and the capital gains rate increases from 15% to 20%

Given these two points and assuming that both are allowed to occur where tax rates increase, the municipal market could benefit tremendously. Keep in mind that the basic appeal of muni bonds is that interest income is exempt from regular federal income taxation. So since they are tax-free, they will look even more attractive relative to their taxable bond counterparts such as Treasuries and Corporates on an after-tax yield basis. This increase in demand could drive yields lower which in turn lead to higher prices for the municipal market.

As for any reduction in exemption in taxes for the municipal market, Mauro pointed out that the debate will be heated due the fact that municipal bond interest can be potential source of tax revenue. Furthermore, he stated:

“The vulnerability of the tax exemption for municipal bonds is exacerbated by the fact that there appears to be no one in either the Administration or Congress currently championing the cause of municipal bonds.”

Having said this, he pointed out that if history is a guide, tax reform will take time to implement and investors shouldn’t worry for the time being.

“We believe that in today’s highly polarized political environment, it’s difficult to envision a scenario in which a meaningful, comprehensive tax reform package gets produced before 2014 at the earliest.”

If that is indeed the case, then the clouds of any kind of tax reform are farther out than what political rhetoric would imply since much of it is speculation. Furthermore, any changes in the tax code in the near term could provide some sunshine for municipal investors via rising bond prices.

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Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

 
 
 

4 Comments

  1. [...] – Will Obama’s tax reforms be detrimental to the muni market? – President Obama’s proposal that tax exemption for municipal bond investors be reduced for [...]

    • Municipal bonds retain the aura of reliability for investors seeking steady income. As cities cut expenses, interest rates rise and pension obligations are modified munis will regain favor. People who value security won’t give up on highly rated munis in this volatile environment.

  2. Interesting follow up development: the Federal Reserve is said to be considering adding municipal bonds to its quantitative easing toolbox.

    • Rom says:

      BBW, if you asked me 10 years ago of the Fed buying assets other than Treasuries, I would have thought of the idea as crazy. However after the financial crisis and the subsequent actions by the Fed, I think that nothing is off limits from the Fed. If there is disconnect where the flow of credit is impaired, the Federal Reserve will target anything.

 
 

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