With the fiscal cliff looming, congressional leaders and President Obama are (hopefully) wrestling with any and all proposals aimed at finding an acceptable end to the budget crisis.
One idea drawing a great deal of scrutiny is a limit on the deductibility of tax-exempt municipal bonds, or in the extreme case, eliminating the tax exemption. That’s making many municipalities, not to mention investors holding munis, just slightly apoplectic. And for good reason.
State and local governments rely on the muni bond market to fund projects large and small, from bridges to schools to stadiums. The exact value of municipal bonds outstanding is a bit of a moving target, but a Citigroup (NYSE:C) study from June 2011 puts the figure at around $3.7 trillion. So, any changes to the market could have both immediate and future dramatic consequences.
Investors flock to the muni bond market because of the bonds’ tax-exempt status: The interest they pay is exempt from federal taxation, and for those who buy muni bonds from the state in which they live, the interest is also exempt from state taxation.
The result is after-tax yields of up to 5%, making Treasury securities and corporate bonds look rather flimsy. The muni market has been quite robust in recent years as investors, particularly retirees, look for increased yield and income.
Of course, the tax situation can be a tad more complicated. According to Arthur J. Dykes, tax partner at McGladrey LLP, certain bonds may trigger an add-back for alternative minimum tax (AMT) purposes. In these cases, it pays to check with a tax adviser or the IRS.
In any case, substantive changes to the tax-exempt status that results in lower yields could cripple the industry, taking down not just individual bond investors but muni bond mutual funds and exchange-traded funds. Also, and perhaps more troubling, if investor ardor for munis cools, the ability of issuers both large and small to finance necessary public projects could be compromised.
Indeed, Peter Coffin, president of Breckinridge Capital Advisors, was quoted in Investment News warning that “if you start limiting the [tax] exemption you’re only going to make the market less efficient and more vulnerable.” If investors find themselves with limited ability to apply the federal and state tax deductions, the market could sustain losses across these funds through withdrawals and create a sort of vicious cycle that could lead to liquidity problems and slowdown in demand.
Where might investors feel the pain? Mutual funds like Market Vectors High Yield Municipal Fund (NYSE:HYD) and T. Rowe Price Summit Municipal (MUTF:PRINX) come to mind. Both offer a portfolio 80%-invested in municipal bonds, and both are up year-to-date and over the 12 months. On the ETF side, PIMCO Intermediate Municipal Bond ETF (NYSE:MUNI) is a solid performer.
The takeaway? Some form of change is in the air, although the final accounting isn’t very clear. Wiping out the deduction in its entirety is unlikely because the damage to issuers and investors could be greater than the income tax benefit to the federal government.
More likely a cap would be imposed whereby exemptions for high-income taxpayers are limited above a certain amount. To date, a 28% cap rate is the number most often bandied about.
The bottom line for investors is to be patient and calm. The muni bond market has seen its share of troubles (see: Sacramento, Calif., and Harrisburg, Pa.), including a sell-off in 2010 caused by an analyst’s call of massive defaults that haven’t materialized.
So, be prepared, look through your portfolio to determine your exposure — and stay informed.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he does not hold a position in any of the aforementioned securities.