MuniLand

Time to ride the muniland tax exemption pony

At the Bloomberg Link conference on Thursday, Matt Posner, of Municipal Market Advisors, said that discussion of the municipal bond tax exemption would likely be rolled over to the next session of congress, which begins January 3. Yes, the long awaited muniland battle is upon us. Strap on your armor.

Ever since President Obama created the National Commission on Fiscal Responsibility and Reform (Simpson Bowles) in 2010, the subject of reducing or eliminating the federal tax exemption for muni bonds has been kicked around. The administration proposed, in 2011, to “reduce the value of itemized deductions and other tax preferences to 28% for families with incomes over $250,000.” Muniland’s tax exemption has a big fat target on its back.

Many in Congress believe that the muni tax exemption benefits the wealthiest households in the U.S. In fact, IRS (2009) data shows that 151,098 households with annual incomes over $1 million get almost $16 billion of non-taxed interest from municipal bonds:

Another approach would be to make munis taxable and attract other classes of investors, especially 401(k) and IRA account holders, as I wrote in September of 2011:

Will Atlantic City’s Revel be washed away by Sandy?

Hurricane Sandy made landfall near Atlantic City, New Jersey, but the damage did not set back the city’s gambling and hotel economy by much. Fitch Ratings reports:

Gaming operators in Atlantic City, NJ, and across the mid-Atlantic region appear poised to re-open properties affected by Hurricane Sandy relatively quickly, limiting the storms impact on cash flow. However, Fitch believes longer term effects on physical infrastructure and consumer sentiment in New Jersey and surrounding states could have a material impact on fourth-quarter gaming demand.

Muniland’s flight risk

I’m not a big fan of municipal bond-related mutual funds because some of their structural features work the opposite way that municipal bonds work. Mainly, the value of muni bond funds decline as interest rates rise. The WSJ.com has a useful description:

Advisers and investors appreciate being able to obtain even the current 1.8% yield from 10-year U.S. Treasurys. But many likely don’t realize the effects when interest rates rise, said James Swanson, chief investment strategist at MFS Investments. With the 10-year Treasury at a duration of about nine years, an investor faces a 9% cut to principal if interest rates rise 1% over the next 12 months and an 18% cut if rates increase 2%, he noted.

Did you catch that? If interest rates rise 1%, an investor could lose 9% of the value of his/her mutual fund. This negates one of the prime reasons to own municipal bonds for the long term:  the preservation of principle. If you are looking for the highest returns and you are willing to rotate into and out of bond funds as markets move, you might not suffer any principal loss. But that requires paying close attention to market direction and timing. Retail investors who are choosing retirement funds or putting aside cash are not generally good market timers. If an investor makes a choice and then sticks with it, the investment principal may be gone before they realize it.

Building a new municipal bond market

When FIX – the industry electronic trading standard – was fleshed out for fixed income in 2003, municipal bonds were incorporated. I got a fresh look at FIX at the FIX Protocol Americas Trading Conference this week. All the major muniland alternative trading systems (ATS)  including Bonddesk, MuniCenter and Tradeweb, as well as the major dealers are already FIX compliant for the latest 4.4 version.

The SEC has tasked the Municipal Securities Rulemaking Board (MSRB) with several new pre-trade transparency initiatives. They are considering two projects:

1) Determining the “prevailing market price” for a municipal security.

Nuclear CalPERS

Things are heating up in the Golden State as bankrupt San Bernardino has stopped making payments to CalPERS, California’s public employee pension system. CalPERS, of course, had something to say about it. Reuters’ Tim Reid reported:

“These [pension] payments are required to be made under California law,” Calpers said in an e-mail to Reuters. “If Calpers and the city cannot resolve the missed payments, Calpers will assert its rights and remedies available under applicable law.”

Calpers spokeswoman Amy Norris said in a telephone interview that if the payments were not made and continued to fall due, “we will pursue collection through legal action.”

San Bernardino’s coming pension brawl

The bankrupt cities San Bernardino and Stockton, California share similar fiscal woes. Both include very high employee pay and benefits. Both have sought the protection of Chapter 9 municipal bankruptcy and are shielded by the courts from any new litigation. The court protection gives the cities time and fiscal space to negotiate with employees and creditors, and to organize their financial affairs. It’s hard to imagine the difficulty of running a city in bankruptcy with dwindling cash reserves.

Stockton and San Bernardino have taken very different approaches to how they will manage their cash reserves. Each approach will likely have big effects on how their bankruptcy processes play out.

Stockton has chosen not to challenge CalPERS, the statewide pension system, and has continued to pay the monthly pension contribution for its employees. The city’s unwillingness to ask CalPERS to negotiate has caused other Stockton creditors – the bond insurers – to challenge whether the city has met the conditions of a Chapter 9 bankruptcy. The blog Public Sector Inc describes the situation:

Bill Lockyer’s big stick

I wish that I knew how to put on a conference, because we need a muniland event with Bill Lockyer, California’s state treasurer, as the headliner. I would invite all the state treasurers and attorneys general to learn how state officials can wield their power to protect local governments from unscrupulous underwriters, bond counsels and financial advisors.

Here is Lockyer at The Bond Buyer conference in California:

Treasurer Bill Lockyer put underwriters, advisors and bond counsel on notice Wednesday that if they are not willing to renegotiate some of what he called the more egregious capital-appreciation bonds issued by the state’s school districts, his office may cut them off.

“I wish the firms that underwrote those bonds would renegotiate those deals,” Lockyer said. “I have the list, I know the underwriters, financial advisors and bond counsel who did them, and they are going to face constraints with my office when the state issues bonds.”

The 30,000-foot view of muniland

The Bond Dealers of America, an organization representing national middle-market bond dealers, held its national conference in Chicago last week. I did not attend, unfortunately, but the agenda was a good mix of regulatory and legislative perspectives from the buy-side (mutual funds, insurance firms, asset managers) and electronic trading platform executives.

What interested me most was a presentation by Amy Laskey, managing director of the Public Finance Group at Fitch Ratings, who provided a 30,000 foot view of the current state of muniland. These are the best sections that present a mixed-to-positive picture:

Review of Recent Rating Actions

• Average local government general obligation rating remains ‘AA’ but trending towards ‘AA-’

Broke New York municipalities have more choices than bailouts or bankruptcy

Things are heating up in Albany, New York’s capitol. Someone close to Governor Andrew Cuomo appears to have been whispering into the ear of New York Post reporter Fredric Dicker:

Several of New York’s biggest cities — including Yonkers, Rochester and Syracuse — are “close to bankruptcy’’ and are looking for a bailout from Gov. Cuomo’s administration, The Post has learned.

Mayors of the three cities, all of which face runaway labor, pension and education costs and shrinking property-tax bases, have held secret talks in recent weeks on their financial options, and the possibility of “bankruptcy’’ has been discussed, a source close to the mayors said.

Lawmakers and the municipal bond tax exemption

The Joint Committee on Taxation is circulating an analysis of tax reform proposals, one of which includes removing the municipal bond tax exemption for all bonds issued after December 31, 2012. If the tax exemption is repealed or capped so that the federal government can collect more tax revenue, bond prices will fall. The higher yields would repay investors for their loss of tax exemption, nevertheless, groups are forming to oppose proposals to repeal the exemption.

Republican presidential candidate Mitt Romney has not indicated any specifics about how he would treat muniland in his tax reforms. President Obama has proposed changes. The Bond Buyer summed up the President’s position:

Some market participants contend that Obama’s plans to raise tax rates and permanently reinstate the Build America Bond program would help the muni market, despite his plan to cap the value of tax-exemption at 28% for higher income earners.

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