Munis In The Crosshairs No Matter Who Wins Tuesday
While municipal experts differ when it comes to their party lines, they share similar concerns about how the outcome of the 2012 Presidential election will impact the $3.7 trillion municipal industry in the long run.
The Bond Buyer queried some municipal market participants asking them: What are your top three concerns for the market depending on the outcome of the 2012 Presidential election. They share their responses here.
Dan Heckman, chief fixed income strategist at U.S. Bank Wealth Management of Minneapolis:
The greatest concern for municipals from the election is not dependent on what party gains the White House, but whether that President will be able to work with Congress. They will face daunting fiscal issues that could negatively impact the municipal bond market. The fiscal cliff, if not dealt with effectively and proactively, could heighten the prospects that the U.S. economy will enter a recession at some point in 2013 due to spending cuts and an increase in income tax rates.
This will have a direct impact, in a negative way, to state and local municipality revenue sources. Also, due to the need to address the large and growing federal debt and budget deficits, the odds are going up that legislation limiting the amount of interest that would be exempt from federal taxes on municipal bonds could be enacted. This would save the Treasury hundreds of millions in lost tax revenue by removing or limiting the tax exempt status of muni bonds. Also, health care reform and other costs associated with entitlement programs will become a greater burden on states over the next several years, straining state and local government budgets as those costs get shoved down from the federal level. All of these issues pose a risk on the municipal bond market if they are not dealt with effectively, and could consequently force yields higher and prices lower on muni bonds.
Another growing risk is that absolute yields continue to drop on munis to all-time lows. Muni bond yields havent been this low since the early 1960s. The municipal bond yield curve continues to flatten as investors in a desperate search for yield move further out on the yield curve. The yield on 30-year, AAA-rated muni bonds has fallen by 72 basis points since the beginning of the year, while the one to 30-year spread has shrunk by approximately 68 basis points. Investors buying long-dated muni bonds are exposing themselves to tremendous duration and interest-rate risk that when rates begin to rise will subject them to significant declines in principal value on their muni holdings.
As politicians focus next year on raising revenue and reducing expenditures, increasing marginal income tax rates would be a major positive for municipal bonds and would make existing bonds more valuable. However, if a proposal for broadening the tax base gains traction, then any enactment of a flat tax would be a significant negative for muni bonds and force yields higher, depressing values in the market. Currently, the municipal bond market is estimating a low probability of that occurring and would be surprised if flat tax legislation was enacted.
John Donaldson, director of fixed income at Haverford Trust Company, Radnor, Pa., which manages $1.5 billion in fixed income assets, including $800 million in municipal assets for private clients:
My three main concerns are about tax rates on individuals, the threat to tax exemption as part of tax reform, and the impact on state and local government credit quality from reduced federal spending.
Higher taxes are going to ultimately be driving demand for municipals. Tax rates are not going down, so you are looking at stable demand as is, and improved demand coming out the election no matter who wins.
The bigger question is the threat to eliminate tax-exemption as part of any comprehensive tax reform package. This is the biggest threat since 1986 the last time there was any realistic discussion in Washington about the topic. Ultimately, you have a long standing public policy goal for state and local governments the question is do you want to repudiate that public policy goal?. We still believe tax exemption is the most efficient way to accomplish that public policy goal, but as part of a major tax reform package, it might be on the table.
If there is a change that big, smaller issuers are the losers, as the municipal market ultimately is not one market, but 50 local markets. If they have to compete with corporate bonds, its hard to see how that happens without very much higher financing costs.
That would change the nature of the market. Can the banking system provide them with financing? Could muni bond banks expand because of the cost pressure on small municipalities?
Also, at some point, the level of spending will be lower and not grow as much and there will be pressure to have more balance at the government level. That will put increased pressure on credit quality particularly any project or financing needs that have federal money involved.
You have to have some concerns about the credit worthiness of the bonds in your portfolio. You want strong claims on the money that matters a lot to us.
If theres less federal money flowing through the state and local government specific programs or block grants of one kind or another for mass transit, highways, education, then there would be pressure on all of those intergovernmental transfers.
All you have to do is put in a 10% or 15% cut depending on how vulnerable the entity is and that can be material. You dont even have to go to the hard scenarios or be as severe as the fiscal cliff. Its hard to see how any resolution of budget issues doesnt involve some reduction in payments.
James Colby, senior municipal strategist and portfolio manager at Van Eck Securities, who helps manage $1.85 billion of municipal bond ETFs:
Regardless of which candidate emerges victorious, the Congressional outcomes will dictate policy for the next four years, since it does appear that there will be no change in the balance of power that could lead to a painfully-slow approach to implementation of new ideas.
Pronouncements from both parties have included some serious elements which, if pursued, would undermine the current utility of the tax-exemption provided in municipal finance. Strong efforts need to be made to present a balanced view, to ensure that any outcome does not seriously impact small issuers access to the capital markets or inadvertently increase taxpayers burden during the nations struggle to regain its financial footing.
Even after the election decides the next leadership team, as well as the framework, or platform, out of which political initiatives will likely drive expectations, market fundamentals will continue to frame current opportunities in the municipal market.
Anthony Valeri, senior vice president and market strategist at LPL Financial, which managesover $350 billion in total assets:
The biggest concern is a Republican sweep where Gov. Romneys proposed tax plans stand the greatest chance of coming to fruition. These include lowering tax rates 28% would be the top and also excluding all investment income for those earning less than $200,000 per year.
The tax treatment of municipal bond interest income may come under scrutiny regardless of who wins the White House because the exemption of municipal bond interest income is one of the largest tax expenditures of the U.S. government.
Of the two, the latter is more dangerous to municipal bonds, but both would reduce demand for municipal bonds. Roughly 50% of municipal bonds are owned by individuals making less than $200,000 per year. The exclusion would make all other investments including stocks more attractive relative to municipal bonds.
Capping the municipal exemption at 28% would make municipal bonds less attractive, but not by a lot since theyre cheap already, but it could be the final catalyst needed to sell given strong year-to-date performance and record low yields.
The biggest expectation is that more than likely nothing substantive will happen to municipal bonds. A split Congress a likely outcome would mean that the Senate will likely stop any tax cuts from passing and vice versa; and the House will likely kibosh any tax hikes. The status quo is likely to be maintained. Furthermore, municipal tax exemption has been challenged numerous times over the years with legislation often dying in Congress. The fact of the matter is that there is no viable alternative to tax-exempt financing. Raising borrowing costs, by doing away with the tax exemption, would likely leave states and municipalities going back to Washington for direct aid.
So eliminating, or reducing, the tax-exemption doesnt necessarily mean it will lessen Washingtons need to provide some assistance to states and municipalities.
I expect the impact from the election to be modest. Should Obama win, we are not expecting rates to fall much lower than current levels.
Longer-term, the resolution of the fiscal cliff, or lack of a resolution, will have a greater impact on the direction of bond yields. I believe the election effect will be limited to a 0.10% to 0.25% move in Treasury yields, with a lesser impact, at least initially, in the municipal bond market. Thats not going to be too noticeable for most investors.
Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, which holds over $8 billion of municipal debt:
The most important impact to the municipal bond market directly relates to who the players will be that will dictate the tax reform agenda. In this election, tax reform has been perhaps the highest profile issue shared by both candidates as well as those running for Congress. Proposals to date do not appear as well defined or even sketched in stone that there is a likely outcome no matter which party comes away as victor. Proposals span from those that dramatically change the tax code that might involve the elimination of tax exemption to those that tweak the tax code to eliminate deductions. However, even before the next president is inaugurated, the unresolved fiscal cliff scare could be extremely bullish for muni bonds in general as the Bush tax cuts expire and the economys potential for a recession becomes highly elevated.
One of my three biggest concerns is if tax exemption is eliminated entirely. Odds dont favor this outcome because of the serious threat to increasing the cost of state and local infrastructure financing.
The recent sequestration plan calls for a cut in the existing Build America Bond subsidy.
That should be enough to convince state and local government officials that the trade off for a BAB federal subsidy program is unreliable.
Loss of tax exemption in the current market could raise borrowing costs significantly by nearly 1% to 2% depending on maturity and credit quality in todays market.
Under one proposal, the exemption on municipal bond income would be subject to a cap as would be the case with all other current deductions and tax credits.
A potentially greater threat is the total elimination since that concept already exists relating to private activity bonds and the AMT tax. Still, it would not be a good outcome for state and local infrastructure financing. The impact would be felt more severely once interest rates would go up.
Loss of deductions would have a direct impact on state and local governments with high taxes, in which their taxpayers could no longer deduct these items from their overall federal tax burden.