Big Changes in Muniland

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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Big changes in Muniland
April 19, 2009

Big changes are coming in Muniland. This commentary is the first in a series about them.

It used to be that all investors had to think about when they considered municipal bonds was whether they were AAA-insured and whether or not they were traditional tax-free or subject to the Alternative Minimum Tax (AMT). Those good old days are long gone.

AAA bond insurance has been severely discredited. Investors now realize that they were buying into an unsecured creditor status on an opaque structure. That realization and the subsequent losses they experienced first led them to be averse to most municipal risk; hence, there was a flight from all Munis. Subsequently, as they have returned to Muniland, they realize that they need more than casual help. For firms like Cumberland this has been a huge boost to our value-added business proposition.

Other changes in Muniland are already affecting pricing and terms of new Muni issues. Banks have received a benefit through recent legislation and now may own up to 2% of assets in non-bank-qualified municipal bonds. Previously banks were essentially restricted to bank-qualified bonds (BQ) only. These are small Issues which are customarily placed with banks by local government units. Banks are allowed to own BQ debt because of an exception to an interest-rate penalty in the tax law that was originally passed in 1986. This 2009 law change has had the effect of encouraging some banks to expand their portfolios of tax-free municipal bonds. Cumberland has developed a service designed for banks that seek to optimize their profits using this new law.

Another important and dramatic change is in the Build America bond program. Here the federal government is agreeing to pay 35% of the interest cost on a municipal bond under certain conditions. The Issuer pays the other 65% and the bond is subject to federal income taxation.

This means new issuers of bonds must consider both taxable and tax-free structures. We are seeing the first Build America bond issues come to market. So far the economic tests have encouraged the use of taxable Build America municipal debt under this program as a substitute for what would previously have been tax-free municipal debt. We expect this program to precipitate a huge change in the 2.7 trillion dollar municipal bond market.

Build America program bonds also operate as a boost to Cumberland. We have used taxable municipal bonds for years as a form of fixed-income management. Peter Demirali has capably led that sector in the firm, while John Mousseau has been the point person on the tax-free municipal bond side. They get the credit for the successes; my job is to be responsible for the errors.

Build America now means we are busier than ever in both categories. We have to examine this program and the options for both taxable fixed-income and tax-free fixed-income clients. And the tax bracket of each individual affects the decision since the Build America federally mandated arbitrage rate is 35% while the taxpayer’s marginal rate is variable.

Build America structures are different than traditional tax-free ones. One example is in debt service (DS) reserve funding. Build America bonds cannot be used to fund DS reserves. Traditional tax-free municipal bonds are allowed to fund DS with borrowed monies but are subject to complex arbitrage rebate rules. Bonds with DS are sometimes viewed as more secure than those without them. This tradeoff needs to be examined issue-by-issue.

Retention of a state income tax-free nature while being taxed at the federal level is another issue for Cumberland to examine. In many cases a Build America bond can be exempted from state income tax even as the federal tax is imposed. This nuance is sometimes material in choosing one form of bond over the other.

There are many more details about the new Muniland. We will be explaining them to readers over the next few months.

Suffice it to say that the landscape of the municipal bond arena is rapidly changing. Valuation of bonds and credit review requires much attention these days. The lazy days of an investor’s decision about AAA-insured tax-free bonds with no homework needed are over. Municipal bonds have morphed into an asset class that requires a full effort.

Anyone who thought bonds were boring is being proven wrong. It has become an exciting time in Muniland.

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com

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Copyright 2009, Cumberland Advisors. All rights reserved.

The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.

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