Looming Taxes Support the Municipal Bond Market
April 12, 2010
By: Steve Shutz, Vice President

Fixed income investors in the top marginal tax bracket are feeling the pain. Two critical pieces of legislation were recently approved that will surely boost the demand for tax-exempt income. First, the enactment of the Health Care Bill created a new surtax of 3.8% on unearned taxable investment income for individuals with adjusted gross income (AGI) above $200,000 and joint filers with AGI above $250,000 (effective January 2013). The surtax, along with the phase out of the Bush tax cuts this year, will increase the maximum federal tax rate to 43.4%, from the current rate of 35.0%.
If you live in Maryland, this will push the combined State and Federal max marginal tax rate from 41.1% to close to 50.0%. In some states (for example, CA, NJ, NY, RI) the combined rate will be even higher.

In a second piece of legislation, the House Ways and Means Committee approved a three year extension of the widely successful Build America Bond (BAB) program, which has cut close to 30% of the tax-exempt supply from the municipal market.

The combination of higher future taxes and lower expected supply should provide considerable support for the tax-exempt market. Looking forward, what is the after-tax impact on municipal portfolios?

The new legislation, known as the Health Care and Education Reconciliation Act, will undeniably have a profound effect. The good news for municipal bond investors is that the new tax does not apply to income derived from tax-exempt municipal bonds – making them more attractive compared to taxable alternatives.

Build America Bonds
For the past year, Build America Bonds (BABs) have cannibalized close to $100 billion of bond issuance away from the tax-exempt municipal market. The BAB Program was initiated a little over a year ago via President Obama’s ARRA economic stimulus package. The program gives municipal issuers the option to sell taxable debt, for certain projects, and receive a direct payment from the Federal government equal to 35% of the interest paid.

In February 2009, when the stimulus package was signed into law, the idea behind the BAB program was to help thaw out the new issue market for municipal bonds. BABs were to provide a temporary boost to the municipal market by opening up muni credits to a new set of buyers, including pension funds and foreign investors.

The program has been a huge success for everyone involved. Issuers have the freedom to choose between the tax-exempt and taxable (BAB) market, deciding on the option that saves them the most in net interest cost. Taxable buyers have access to a new high quality sector of the credit market, enhancing portfolio diversification. And, tax-exempt bondholders benefit indirectly via the growing scarcity of tax-exempt bonds, especially for longer maturities.

Given the success of the BAB program, it is possible that the Federal government sees an opportunity to further reduce the embedded tax-shelter that exists in the tax-exempt market; effectively soaking the rich. If, in a hypothetical future world, the entire municipal bond market were made up of BABs, or some other taxable alternative¹, it would ultimately become a back-door tax for high net worth investors. This scenario would be very bullish for all existing tax-exempt bonds, as the income exemption would likely be grandfathered until the bonds matured or were retired.

In recent weeks, the House of Representatives approved a bill calling for a three year extension of the BAB program, with a gradual reduction of the direct-pay federal subsidy to 33% in 2011, 31% in 2012, and 30% in 2013. This bill differs from the provisions contained in the Obama Administration’s FY 2011 budget plan which proposed that BABs become permanent, while also easing the restriction on the types of projects that would qualify for the BAB subsidy. While it is not possible to know the exact form that the BAB program will take after 2010, it seems pretty clear that BABs are here to stay for now.

Portfolio Considerations
For our tax-paying portfolios, CCM continuously monitors the valuations of tax-exempt municipals relative to the “after-tax” valuations of comparable maturity taxable bonds. For example, Graph 1 represents the after-tax yield curve for a max tax Maryland resident, adjusted for the 2013 future max federal rate. The green line represents yields currently available for AA-rated Maryland tax-exempt municipal bonds along the maturity curve. The red and black lines represent the after-tax yields (ATY) available for two taxable segments of the market (red = state-exempt agencies; black = AA-rated corporates).

For residents in a high-tax state, like Maryland, the new higher federal tax rate cheapens the valuation of in-state municipal bonds dramatically. Tax-exempt municipals have a yield advantage over taxable bonds in all maturities beyond two years. Also, the yield advantage continues to climb further out the maturity curve. The ATY pickup for tax-exempts is 35 bps in 5 years, then 101 bps in 10 years, and 136 bps in 30 years. This underscores the benefit of owning munis 10 years and longer.

The mechanics of the tax increase for a Maryland resident is outlined below (Table 1). The top federal tax rate will jump to 39.6% from 35.0% as the Bush tax cuts sunset in January 2011. This rate will climb again in January 2013, reaching 43.4% as the new Medicare Surtax takes effect. Assuming the top Maryland State and Local tax rates remain constant, the total effective tax for Maryland residents will increase to 49.11% in 2013, from the current rate of 41.14%.

*Calculations assume the combined state and local rate are deducted at the federal level.

Conclusion
While higher future tax rates and BABs will be supportive of the entire tax-exempt muni market, we believe there is stronger relative value on the long-end of the yield curve. The tax-exempt muni curve is exceptionally steep, and BAB supply has been focused largely on the long end of the curve – adding to the scarcity value for long maturity tax-exempt bonds. CCM’s municipal curve view is for a bear flattener with short and short-intermediate maturities experiencing the sharpest selloff as yields begin to rise. The longer-term tax-exempt market will continue to be supported by the lack of supply in that segment. For CCM’s intermediate portfolios, we continue to see value in the 10 to 13-year maturity range, given the strong incremental yield that can be had by the very steep slope of the yield curve. Additionally, these portfolios will continue to hold a modest overweight in tax-exempt bonds with maturities longer than 20 years. With higher future taxes driving demand for tax-exempt income, and BABs draining tax-exempt supply from the market, municipal bonds provide a very compelling value for tax-paying fixed income investors.

Endnotes:
¹ Wyden-Gregg Bill - In late February 2010, Senators Ron Wyden (D-OR), and Judd Gregg (R-NH) drafted new tax reform legislation with provisions that would severely impact the municipal market. The proposal called for eliminating the tax-exemption for municipal bonds issued after December 31, 2010, and shifting the tax-exemption on newly issued muni bonds to a tax-credit. While the bill has not been introduced in the House, and is not in line with the Obama Administration’s 2011 budget plan, the radical changes proposed have been met with strong opposition. In the unlikely event the proposal did pass and become law existing tax-exempt munis would become scarce and therefore more valuable.