December 19, 2012
A favorite place to duck from taxes is losing its appeal amid Capitol Hill's ongoing debate about debt-cutting.
Many municipal bonds offer interest tax-free, and, consequently, munis were a top choice of financial advisers trying to guide high-income clients away from potential tax increases following the presidential election.
But the advice has soured in the last few days. Politicians have been searching nooks and crannies of the tax system, looking for revenue to plug the nation's burgeoning deficit.
There's been chatter in political circles about withdrawing the tax-free status that has made munis a unique and popular investment — especially among affluent taxpayers.
"I've received dozens of phone calls from people wondering if they should get out of their munis," said Marilyn Cohen, chief executive of Envision Capital Management. "They live off the income from their bonds and are worried sick."
The $4 trillion muni market is large enough to be a simple source of new tax revenue, says Cohen. But as politicians bicker about how to cut the nation's deficit, predicting the muni bond's tax fate isn't easy.
"You need to turn to the Great Carnac for the answer," said Cohen, referring to Johnny Carson's "Tonight Show" character who held cards to his head for answers to impossible questions.
The fear of the wrong outcome has caused many investors during the last few days to dump municipal bonds and municipal bond funds rather than wait to see Congress' next move.
In the last four trading days, investors have pulled more than $1 billion out of municipal bond funds — a sharp reversal from the year up to Dec. 12, said Cameron Brandt, a global markets analyst with EPFR Global. People had poured $54.2 billion into municipal bonds this year as they tried to eke out slightly better income than U.S. Treasurys were providing in a painfully low-yielding interest-rate environment.
People have been pulling money out of Treasury bond funds, too, in the days since Federal Reserve Chairman Ben Bernanke announced a new round of quantitative easing to hold interest rates low. "There's a sense that this is a goose that's been well-stuffed, so you might as well take the money while you can," Brandt said.
But the flows out of munis have been significantly greater than Treasurys, indicating tax concerns are a major driver. With interest rates on municipal bonds so low, a tax hit would be hard to take.
"Fundamental changes to the tax exemption of municipal bonds are likely to be made between now and the end of the first half of 2013," said Wells Fargo analyst Natalie Cohen.
Still, those changes could take various forms. Congress could subject new municipal bonds to taxes but let old munis continue to be free of taxes.
"That would be a milder change (than taking away the tax benefit on old and new munis), but it would create a bifurcated market," Cohen said. "It could create a bifurcated market that would make existing tax-exempt bonds quite valuable."
But with new bonds devoid of the tax benefit for investors, cities and states would have to pay investors more to borrow money.
In other words, building infrastructure — whether schools or sewer systems — would cost individual taxpayers more than previously because governments would have to use higher interest, rather than tax-free interest, as an inducement to investors to buy bonds.
This could be difficult for states like California and Illinois, and cities like Los Angeles and Chicago, which are in weak financial shape.
"I wouldn't touch an Illinois bond with a 10-foot pole," said Envision Capital's Marilyn Cohen. Still, investors have been attracted recently to the bonds of the most troubled states because they have paid higher yields than safer, more frugal states. For example, investors can get 10-year Illinois general obligation bonds yielding about 3.15 percent, she said, while the safer Virginia general-obligation bonds yield just 1.8 percent. Ten-year U.S. Treasury bonds are yielding only 1.6 percent, near historical lows.
Without tax-free bonds, Wells Fargo's Natalie Cohen said, local and state governments could be strapped when trying to pay for infrastructure improvements.
Local and state governments already are lobbying heavily to keep Uncle Sam away from municipal bond interest.
A less dramatic approach would be to limit how much high-income taxpayers could shield from taxes by investing in municipal bonds. The limitations might be lumped in with limits on charitable deductions and mortgage interest. Natalie Cohen says the cap might limit deductions to the 28 percent bracket rather than the top 39.6 percent.
"This is a more likely scenario," she said. But it "could cheapen the market, as high-bracket investors sell to lower brackets, who would get a good deal."
Lower-income people in the 28 percent bracket presumably would still be able to invest in munis without paying taxes and could also buy those bonds cheaply from wealthier investors unloading them.
Although there are multiple ways for Uncle Sam to tap municipal-bond interest, "the bottom line is that the risk of a partial tax on muni interest for high-income individuals remains a strong possibility," said Citigroup analyst George Friedlander. "The obvious question is: whether investors should unload municipal bonds in anticipation of such a tax."
His answer: Prices have already deteriorated as investors have faced difficulty selling bonds. So Friedlander says the bonds already reflect "a significant portion of the market risks associated with this potential change in tax treatment." He plans to revisit the question in January.