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The Next Headwind for the Muni Market

When President Obama introduced his American Jobs Act, he said that it was “fully paid for”. Well, not yet…but it will be. And the muni market will bear some of the cost.

That’s the last thing the market needs after recovering from steep losses last year following Meredith Whitney’s call for massive defaults in the space.

Under Obama’s plan, muni interest would no longer be tax-free for high-income investors (for individuals making over $200k per year, it would pare the tax break at 28%). The idea poses a threat because the tax benefits have long been the underpinning of the muni market, and the exemption is what draws high-income investors. Taking that away will only limit demand.

Potentially, a lot of demand. Individual investors are the largest holders of municipal debt, accounting for $1.07 trillion of the $2.9 trillion market in the second quarter.

Lower demand could lead to another wave of withdrawals from muni bond funds and, in turn, an erosion of the value of existing bonds. That means that muni investors will be hurt twice: once with the loss of the tax-free benefit, and again when their bond portfolio takes a hit.

But ultimately, state and local governments will be punished. With the tax-free feature gone, investors will demand a higher return to invest in municipal debt to compensate for lost income. And that means higher borrowing costs for issuers.

Those higher costs could amount to something like an additional $600 million per year, according to Municipal Market Advisors (based on a 50 basis point increase and $300 billion in issuance yearly).

The irony here is that the jobs bill is supposed to help state and local governments retain jobs and spend on infrastructure. But in helping them it will hurt them by making it more expensive for them to raise money.

I have looked at the muni space with a skeptical eye for some time. But the market didn’t even sneeze at the details of the jobs bill. And if…if…the bill were to be passed, the curb on tax breaks wouldn’t take effect until 2013. And looking at a proxy for municipal debt, iShares S&P National Municipal Bond Fund, the fund has technically been a long-term buy since May. But there are fundamental reasons to exercise caution here; in other words, I wouldn’t add a position without a clearly defined reason why I would sell when I got a signal.


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