Municipal Watch: So far, so good
It’s been a good first month of the year for municipal bond investors, in part because of what did—and especially didn’t—happen late last year.
Most notably, the fiscal-cliff compromise struck in the first hours of 2013 that extended the vast majority of the Bush-era tax cuts didn’t curtail the federal tax exemption on interest income on bonds issued by states and localities—a primary attraction for most muni bond investors. Specifically, it didn’t cap the tax exemption on the value of municipal investment income at 28% for higher-income taxpayers, a proposal the Wall Street Journal profiled in mid-December, prompting a surge of redemptions from open-end muni bond funds. It also didn’t change the fact that tax-exempt bond income is exempt from the Affordable Care Act’s new 3.8% Medicare tax on net investment income for those at the highest rungs of the income ladder.
The late-hour agreement did simplify the alternative minimum tax (AMT) by indexing the AMT brackets for inflation. Initially aimed at making sure very high-income taxpayers with heavy deductions paid a minimal amount of tax, the AMT has ensnared a growing share of the tax-paying public over the years, forcing Congress to perennially step in with a patch (the law had been modified 19 times since its passage in 1969). Finally, because munis retained their federal tax-exempt status, their relative value to comparable taxable bonds was enhanced by the final bill’s increase in tax rates to 39.6% on individuals with taxable income over $400,000 and households with taxable income over $450,000. Such high-income earners are big buyers of munis and their demand helps determine market clearing bond prices.
One month does not a year make
All that said, it’s still early in the year and uncertainties lie ahead. For one, there’s always the prospect partial taxation of munis may return as part of the budget debates in the spring or any broad-based push towards tax reform. Curtailment of the tax-exempt status of muni bonds often comes up whenever there is talk of broad tax reform and deficit reduction. As we saw in December, when intermediate- and long-term muni yields rose 30 to 40 basis points, such discussions affect market prices. But investors should understand that a repricing from an adversarial change in the tax exemption is merely a short-term repricing, not a fundamental change that makes municipal bonds undesirable at any price.
More immediately, the $1.2 trillion sequester that will kick in on March 1 unless Congress and the White House strike a new deal poses a threat to munis, too. By forcing steep cuts in defense and discretionary spending programs that flow down to states, localities and other municipal bond sectors—including Medicare reimbursements to hospitals, research grants to universities and affordable housing subsidies—the sequester could pressure certain municipal credits, slow local economies and lead to a diversion of funds away from much-needed investments in infrastructure, a Moody’s analysis concludes.
In other words, there is still a lot of uncertainty out there. So we can applaud what happened with the fiscal-cliff compromise and we welcome more signs of improving state and local economies and finances—California Gov. Jerry Brown has actually proposed a budget surplus for the coming fiscal year and the Golden State could see its credit rating upgraded! Yet we also remain focused on risks related to policy in Washington. As noted in the title above, so far, so good.