Muni tax benefits bear watching

Wrangling in Washington about the fiscal cliff has produced nothing definitive, but with tax-free income from municipal bonds among items on the chopping block, financial advisers might have to re-evaluate allocations to these traditionally predictable sources of income.

With early discussions and proposals ranging from a reduction in tax-free income for high earners to a complete elimination of the tax break for all muni bond investors, and with nothing being grandfathered in for current investors, industry analysts are calculating endless scenarios and a host of possible outcomes.

One proposal aimed at helping the government collect more taxes includes limiting the tax-free exemption on muni bonds to people in the 28% income tax bracket and below.

That means those in the 35% bracket would realize a 7% effective tax on muni bond income. If the Bush-era tax cuts are allowed to expire on schedule on Jan. 1, however, the highest tax rate will jump to 39.6%, thus creating an 11.6% effective tax on muni bond income.

That is just one of the many wrinkles that could create head-aches for advisers trying to help clients manage their tax liabilities, according to Stephen Winterstein, chief strategist in muni fixed income at Wilmington Trust Corp.

POTENTIAL “CONFUSION’

“My concern is that some of the proposals will cause confusion among investors about the value of muni bonds, because with this kind of partial tax, you run the risk of introducing less liquidity into the muni market,” he said. “When you look at Mr. and Mrs. Main Street who are buying muni bonds, I’m not sure they will be clear on the tax rules, and most people don’t even know what tax bracket they’re in.”

Liquidity in the nearly $4 trillion muni bond market isn’t normally an issue, but as lawmakers debate ways of stripping that market of its most attractive feature, market watchers say anything is possible.

“It is feasible that new taxes on munis could bring municipal bonds into more-direct competition with other types of bonds,” said Jim Conn, senior vice president in the muni bond department at Franklin Templeton Investments Corp.

From a purely investment perspective, muni bond yields already have become increasingly competitive with taxable counterparts because of the steady flight-to-quality flow of money into U.S. Treasuries and lingering fears associated with cash-strapped municipalities.

“Ever since Meredith Whitney’s prediction [of widespread municipal defaults], it has been extremely hard to beat muni bonds,” said Aspiriant chief investment officer Jason Thomas, referring to the analyst’s 2010 pronouncement, which didn’t come to pass.

According to Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, a standard 10-year, triple-A-rated, general-obligation muni has a yield of 1.57%, about 98% of that on a comparable Treasury bond.

That compares with an average muni bond yield of 90% of Treasuries over the past 10 years. That average includes periods such as December 2008, when muni yields peaked at 186% of those of comparable Treasuries, and September 2009, when the former represented just 75% of the latter.

For an investor in the 35% tax bracket, the 1.57% yield equates to an after-tax equivalent of 2.74%, which is the yield needed from a taxable bond to get the same after-tax return.

“This may or may not have anything to do with the tax reform debate, but right now, the yield on munis is providing a built-in cushion for tax reform,” Mr. Ciccarone said.

Some might argue that such relative yield comparisons will make muni bonds an even easier target for lawmakers seeking areas that could absorb some cuts.

NEW CHALLENGES

But muni bond analysts warn that tinkering with the tax advantages in the highly complex market, which has more than 80,000 issuers, is certain to create ripple effects, as well as new challenges for financial advisers.

“If the ability to use tax-free income is reduced, you’re going to raise one side of the equation, and money will gravitate toward taxable income,” Mr. Conn said.

Even worse, the mere perception of tinkering could alter the market.

Though munis themselves are pretty sophisticated in nature, history has shown that investors in the bonds tend to be less sophisticated — and impulsive.

The most recent example was investors’ pulling nearly $40 billion out of munis after Ms. Whitney’s doomsday prediction.

It is estimated that 75% of the bonds are owned by individual investors, either directly or through mutual funds.

“The foundation of the muni market was severely shaken by [Ms. Whitney’s] comments,” said Jim Colby, senior municipal bond strategist and portfolio manager at Van Eck Global.

“That foundation could be shaken again, and it could have a dual impact with regard to the municipalities that are right now sorely in need of capital,” he added. “I think it is a very real possibility that [if muni tax benefits are cut], investors would move to corporate bonds, and the muni markets would have to adjust with higher yields, and that would impact the municipalities in terms of their cost of capital.”

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