In the Pursuit of Wealth Destruction, Muni Bond Tax Seems Unlikely

The American Jobs Act is a bill which is supposed to be “fully paid for.”  It isn’t.  In the attack on wealth at all costs, the measure to tax municipal bond interest for the wealthy ($200K individuals and $250K households) is already coming under fire.  When Obama made his speech last week, we noted that the line in the sand was just drawn much deeper.  Including the muni-tax is something that his the bond sector of investors a bit up in the air.  The good news is that most of what we have found and most of what we have been told directly by market participants indicates that this tax is probably a bit of an over-reach.

We have been reviewing many comments on this matter and have some serious questions about the effort to tax muni-bonds for the wealthy.  Are the sub-$250K households about to pick up all the slack in the Municipal bond market?  Highly unlikely.  Meredith Whitney has already scared the non-investor class away from munis with her predictions of impending waves of default from cities, counties, and other municipalities.  Sadly, Mr. Obama’s tax ambitions may only make that possibility come closer to the truth.

If there is one asset manager that matters when it comes to municipal bonds, it is Nuveen Asset Management.  Nuveen has more municipal bond funds than anyone else that we have seen. The firm had more than $210 billion of assets under management as of June 30, 2011 and it has published a fairly scathing report called ‘Obama’s Jobs Bill Proposal to Restrict Municipal Tax Exemption: Likely a Non-Starter’

Nuveen noted, “The bill proposes to prevent individuals with incomes of $200,000 or more, and married couples with incomes of $250,000 or more, from deriving more tax savings from the use of tax-exempt bonds and other tax benefits than they would have if they were in the 28% tax bracket.”  It goes on to note, “Nuveen Asset Management believes that the proposal to modify the tax treatment of municipal bonds will ultimately be scrapped. In our opinion, the proposal lacks a broad constituency to support it and likely faces strong and coordinated opposition…”

24/7 Wall St. was forwarded some data from the public relations for the Glenmede fixed income team, a firm with over $20 billion in assets under management.  The team noted, “Their particular focus is on the tax-exempt income aspect. Despite their comments, it’s important to note that their assessment says this has a low probability of passing, but a high probability of stirring passionate investor discussion.” Glenmede’s figures on taxing munis:

• Punitive to high tax bracket investors and all issuers;
• Existing bond prices would fall modestly;
• Future issuance costs would increase;
• Under current tax rates, 10-year municipal yields would increase approximately 32 bps and 60 bps if top marginal rates increased to 40%.

Glenmede’s team further noted, “While we do feel as though tax-exempt bonds are under attack and the probability of a significant change at some point in the future has materially increased during the past two years, we don’t believe this proposal has a high probability of passage.”

We were also given a direct comment from Bryon Townsend, a Certified Financial Planner for W.R. Anderson & Co, LLC in Houston, Texas.  Townsend noted, “President Obama’s attempt to put caps on the “tax-free” status of muni bond income is another attempt to throw something against the wall without thinking about the actual impact in the real world.  This attempt to tax the wealthy, will put even more financial pressure on already struggling State and City governments by increasing the amount they will have to pay to issue debt.  It is seems careless that, in his jobs bill, Obama will risk crippling the one sector of our economy that is already having largest job losses.”

Bank of America/Merrill Lynch noted in a report during the week, “The change could affect a large number of municipal buyers. According to IRS data, roughly 50% of interest income went to individuals with incomes above $200,000 in 2009. The shock effect of a tax on munis could magnify the market impact.”  It further noted, “We believe this one (attempt) will undoubtedly meet strong opposition from municipal issuers, Congressional Republicans, and muni investors.”

Regardless of what others are saying, investors need to consider how silly this attack is.  More things are obvious from than anything: First off, this fully paid-for bill is not fully paid for.  There are other considerations here.  Obama is now almost certain to face extreme opposition from States & Municipalities (regardless of parties) as this only drives their borrowing costs higher.  Municipal bonds used to trade at a discount to Treasuries if they were insured because of the ‘tax-equivalent yield’ but now the insurance world of muni-bonds is a in a post-crash environment.

There is also a bond between states and the federal government when it comes to tax and munis.  This would break that.  The aim to tax muni-bonds will also create value destruction of a portfolio value as well.  It seems almost certain that the crafters of this bill could care less about that.  Investment News reported that states and cities are already lining up against this proposed muni-tax.

There may even be some defections in the Democratic camp as the Senators and Congressmen do not go along with a plan that is so self-destructive to their home-state finances.  The Republican party is going to fight the new jobs bill to the end,and the muni-tax will be included in that fight to the end.  Speaker of the House John Boehner has already come out swinging.  On Thursday he noted that the end of the tax-cut era is a tax hike and he even noted that talking with President Obama is like two people on different planets.  If that is not a push back, what is?

We went back to what Nuveen calculated to see a real level of the damage.  It is large, but 24/7 Wall St. believes that their figure may be under-calculated.  Here is the damage, again which the powers that be could care less about.  Nuveen showed:

• Someone in the 35% tax bracket that owns a hypothetical 20-year municipal bond yielding 3.38%, the taxable equivalent yield would be 5.20%. Under the proposal, which limits the tax savings to 28% of the amount excluded from regular taxable income, the taxable equivalent yield would be 4.83% (assuming a 7% effective tax rate on tax-exempt income and a 35% tax rate on taxable income).

FOX Business Network reported on how the jobs plan will hurt the muni-bond market.  It featured an interview from BlackRock Managing Director Peter Hayes on the unintended consequences of the White House’s jobs plan on the muni-bond market.  BlackRock also manages billions in muni bond assets.

At the end of August, Christine Benz of Morningstar noted the high degree of value in long-term municipal bond funds.  She was not considering a plan from the administration to attack munis.

Maybe the administration can try to get Warren Buffett to come out and opine that the municipal bond market is one that has been given too much of an advantage for too long.  We would have assumed that President Obama would have reconsidered this continued attack on wealth at all costs.  We would have certainly expected this attack to stay away from the world of munis.  Couldn’t his advisors have advised him better?  Oh yeah, actually too many of them have already resigned long before his reelection campaign.

JON C. OGG