Could Munis Really Lose Tax-Exempt Status?

by Daniel Putnam | November 2, 2012 7:15 am

Municipal bond investors, take note: The interest on your investments isn’t necessarily guaranteed to remain tax-free forever.

As the U.S. government’s debt climbs to $16.2 trillion and counting, more elements of the tax code are becoming vulnerable to changes, including the exemption for municipal bond interest.

From a purely political standpoint, this might make some sense — ending the exemption would raise quite a bit of revenue while affecting a relatively small portion of the population (and a wealthy one at that). But is there any chance this plan could actually come to fruition?

Citigroup (NYSE:C[1]), for one, seems to think it might. In an Oct. 24 report titled “US Municipal Strategy Special Focus,” Citi states:

“Threats have increased that Congress might reduce access to this market for state and local issuers. These threats are, we believe greater than any time since 1986, when the Reagan Tax Reform Package was enacted with new restrictions for issuers and investors. The changes could take one of two forms: reduced access to the tax-exempt market or a reduction in the value of the tax exemption for investors.”

The full report is available here[2], with the caveat that it’s 18 pages long and fairly technical in nature. With that in mind, here’s the executive summary:

Citi cites three common arguments given by those who favor restricting the exemption: (1) It benefits investors more than issuers, (2) it encourages overspending by states and municipalities, and (3) the benefits of the exemption largely benefit the wealthy at the expense of everyone else.

Some proposals seek only to reduce the exemption for existing bonds, while others seek to apply the tax retroactively to bonds that already have been issued. With regard to the latter, the Citi report says: “One result of this retroactive change would, in our view, be a reduction in the market value of outstanding municipals of as much as $250 billion, as investors responded to a) the lower after-tax value of their income stream, b) uncertainty as to whether the amount of the tax might be increased again, and c) the perception of a breach of faith regarding the tax status of their bonds.”

The Market Speaks

Armed with this information, what are investors to do?

The Citi report sounds some serious warnings, and a restriction of the tax exemption certainly would have a catastrophic impact on the muni market. Still, the odds of a major change are negligible if you listen to the final arbiter of such matters: the market.

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In the past year, the iShares S&P National AMT-Free Municipal Bond Fund (NYSE:MUB[3]) is up 9.4%; in the past three months, it’s ahead 0.9% — not spectacular, but much better than the 4.3% loss for the iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[4]). Meanwhile, the Market Vectors High Yield Municipal Index ETF (NYSE:HYD[5]) is ahead 17% and 2.1% in the 12- and three-month periods, respectively.

This clearly isn’t a market that’s spooked.

And with good cause: While the country’s horrific debt situation raises the odds of policy responses that were unlikely just a few years ago, there are several reasons why the tax rules regarding municipal bonds are unlikely to change anytime soon:

The Bottom Line

Muni investors need to monitor this issue carefully in the months ahead, as talk of the fiscal cliff ramps up and discussions of tax reform gain more prominence in the wake of the election. But for now, investors need to keep in mind that a “greater chance” of a change — as Citi puts it — doesn’t necessarily equate to a “large chance.”

So far, the muni market seems to agree.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. C:
  2. The full report is available here:
  3. MUB:
  4. TLT:
  5. HYD:

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