The municipal bond market breathed a sigh of relief recently when the fiscal cliff compromise on January 1st left the municipal bond tax exemption unaffected. Unfortunately for municipal bond investors however, this does not mean that the municipal bond tax exemption will not be revisited at some point in the future.
There are currently three different scenarios being discussed as to how the municipal bond tax exemption could be curtailed:
1. The Obama administration has proposed limiting the amount of tax deductions and exemptions to 28%. The top income tax bracket is currently 39.6%, so this would mean that income from municipal bonds for those in the top tax bracket would be taxed at 11.6%, which is the difference between 39.6% and 28%. If you are in the 28% tax bracket or below, then nothing would change.
Obama has proposed making the 28% cap apply to income from both new AND existing municipal bonds.
2. Some feel that it would be unfair to take the tax exemption away from existing municipal bonds, as investors purchased those bonds because of the exemption. So in regards to the cap, the second scenario is the same as the first. 28% cap on deductions and exemptions. The difference with this scenario is that it would only apply to new issues of municipal bonds. Existing bonds would keep their full tax advantages.
3. The third scenario that has been discussed is having a dollar cap on the amount of deductions and exemptions. For example if a cap of $35,000 was set, then an individual’s total tax deductions and exemptions could add up to no more than $35,000 regardless of their level of income. If someone had a large mortgage then they may use up all of their $35,000 with their mortgage interest deduction and have none left over for their municipal bond interest which would therefore be fully taxable.
How the market is likely to react under each scenario.
Municipal bonds are likely to trade at lower values under any of the three scenarios than they would if the full tax exemption was left in place. In fact even if the full exemption is kept in place and everything remains as it is currently, the market is still likely to trade weaker than it would have otherwise. The reason why is the fact that changing existing muni’s was even on the table will result in investors discounting the value of the tax exemption.
There are some important nuances and differences in how the market would likely react depending on which of the scenarios came to fruition.
Market reaction under scenario 1: Interest exemption limited to 28% on both new and existing municipal bonds.
Municipal Market Advisors, whose opinion we respect very much, estimates that this would result in municipal bonds trading 40 to 75 basis points higher. This would be true for both new and existing bonds. While this would be bad for holders of existing municipal bonds it could present a buying opportunity for those looking to enter the market.
Market Reaction under scenario 2: Interest exemption limited to 28% on just new bonds, existing bonds remain fully tax exempt.
Under this scenario we would likely see new municipal bonds trading 40 to 75 basis points higher. However, because existing bonds would keep their tax advantage and be in limited supply, we would likely see demand increase substantially for existing bonds, sending their yields lower and their prices higher.
Market Reaction under scenario 3: Caps in Dollar Amount of Percentage of Income
This scenario could potentially be the worst for the municipal bond market. A recent report by municipal market advisors said it best:
Finally, we note recent discussions of dollar or percent-of-income caps in allowable taxpayer deductions/exemptions. Because it is widely believed that most taxpayers would allocate all or essentially all of those caps to mortgage interest, employer healthcare, capital gains, or other major tax expenditures, we assume municipals would become essentially taxable under this program. Municipals would likely trade more weakly than similarly-rated US corporate bonds, with some smaller or more aggressively structured credits losing economic market access altogether.
While they do not put a number on it, this is likely to be the worst case scenario for existing municipal bondholders.
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