Municipal bonds – and so to bedrock

The bedrock of the US municipal bond market is taxes, or rather exemption from them. The interest income from the bonds is exempt from federal taxes, and often from taxes in the state or locality where they are issued. Markets adjust for this. Average yields on “munis” tend to be lower than those on, say, taxable corporate bonds. To some, the breaks are a tax shelter for the rich.

Others praise them as a way to create cheap funding for state and local governments. Either way, they cost the federal government money. In a 2009 study, the Congressional Budget Office and Joint Committee on Taxation estimated that the federal revenues lost on tax-exempt munis will have exceeded $26bn annually from 2008 to 2012. As lawmakers debate how to avoid the fiscal cliff – recession-threatening tax rises and spending cuts that are set to take place next year – the tax exemption afforded to “munis” is on the table.

Under President Barack Obama’s proposal, the muni exemption would be capped at 28 per cent of income. So, for example, a high earner with a 35 per cent rate would need to pay the difference – 7 per cent – on muni income. Take a $1,000 muni due in 20 years yielding 3 per cent. It would have to fall in price by nearly $50 in order to deliver that same after-tax yield to a wealthy investor, says Municipal Market Advisors.

Some $2.2tn has been raised with munis for infrastructure in the last decade. Assuming the next decade is similar, MMA argues that, all else being equal, higher borrowing costs would cut that funding by more than $100bn, or that local governments would have to levy $10bn more in taxes to service the same issuance. It is unclear whether any changes to the tax treatment of munis would apply just to new bonds or existing ones, too, or even happen at all. But if you crack the bedrock, it will drastically change the $4tn world of municipal bonds.

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