Muni Bond Market a Political Pawn in 2013

Experts say that 2013 will be a minefield of uncertainty for investors as the tax debate in Congress and financial volatility at home raise questions about muni market stability.
by | January 21, 2013 AT 5:00 PM

Bond investors breathed a sigh of relief when the last-minute fiscal cliff deal in January left municipal bonds untouched. But experts say that 2013 will still be a minefield of uncertainty for those investors as the tax debate in Washington, D.C. and financial volatility at home for some states will raise questions about market stability.

Whether Congress would remove the tax free status of municipal bond interest was the number one threat to those bonds at the end of 2012 and a new year has not changed that, experts say. The tax exemption on municipal bond interest allows states and localities to issue the bonds at a lower interest rate, making it cheaper to borrow money for key infrastructure projects. But the exemption comes at a cost of about $40 billion annually in lost revenue to the U.S. Treasury, according to some estimates.

As the debate on Capitol Hill is framed around tax reform and deficit cutting, some believe municipal bonds will become a casualty. Eric Silva, legislative counsel to the Council of Development Finance Agencies, notes that President Barack Obama’s State of the Union speech scheduled for Feb. 12 will likely outline his approach to the debate.

“Further reductions in spending have to come with a balanced approach [meaning more revenue] and for us that means, I believe, a threat to municipal bonds,” Silva says during a webinar hosted this month by CDFA. Obama has previously touted a proposal that would put a cap on deductions for singles earning more than $200,000 and couples earning more than $250,000.

Chris Mauro, head of U.S. municipals strategy for RBC Capital Markets, notes in a recent paper that Republicans and Speaker of the House John Boehner want any tax reform package to focus almost entirely on spending cuts rather than balancing cuts with additional revenue.

“If the President and the Democrats win this ideological debate and the tax code is modified to generate additional revenue, the threat to the muni exemption will, we believe, be considerable,” Mauro writes. “If instead, a revenue neutral tax package is the aim, state and local government officials stand a much better chance of defending the muni exemption.”

Prior to the fiscal cliff deal, Boehner had reportedly been open to eliminating the exemption for high income earners. But now that Congressional Republicans have already agreed allow the top marginal income tax rate to increase, it is unlikely they’ll submit to more.

“Several Republicans have been particularly vocal about their opposition to additional tax revenues of any kind,” Mauro notes. “This sentiment was exemplified most recently by Senate Minority leader Mitch McConnell who said that, ‘The tax issue is finished. Over. Complete.’”

However, the overall market also faces a threat as the Republican caucus “is pretty firm on using the [Mar. 1] debt ceiling deadline as leverage to squeeze more spending cuts,” Silva says. If Congress fails to raise the debt ceiling, “there could be significant market disruption and ratings effect.”

Bond ratings also stand to take a hit in states that fail to take action on their own financial woes. Natalie Cohen, managing director at Wells Fargo Securities, notes during the CDFA webinar that ratings agencies are starting to figure unfunded liabilities into their assessments. The most recent example is Fitch Ratings’ warning last week that placed Illinois general obligation A-rated bonds on a negative watch after the state failed to pass pension plan reform in January. Illinois’ pension is about 40 percent funded, according to Fitch.

Cohen added that new disclosure rules issued by the Municipal Securities Rulemaking Board that will kick in this year will also put the spotlight on pensions.

“Much more of the unfunded liability is going to be reflected on the balance sheet so that will draw additional attention to the funding levels,” she says.

Still, most localities are enjoying more stability and a positive outlook as Cohen adds many voters in November approved bond issuances for local projects.

“The sentiment at local level … is that there is a desire to continue building infrastructure, continue paying for teachers and improved local services,” she says. “It is not completely bleak out there.”

And Mauro notes that on the national level, it is entirely possible municipal bonds will remain untouched in 2013 and 2014 as debate rages on.

“In the current political environment, this outcome seems to us to be just as likely as any other,” he says.