There are mixed forces impacting the valuation of municipal bonds. Some are Muni-favorable; they get little respect these days. Some are Muni-bad; they engender fear in bond buyers. One of the bad ones (MAGI) is obscure but poses a risk down the road.
Muni-favorable forces include the fact that higher income tax rates are destined to occur. Taxes are certainly not going to go down. Huge deficit spending implies they will be up. The math is easy. The higher the tax rates go in the future, the more desirable tax-free municipal bonds are to high income-tax-bracket investors.
Polling among the 25 to 30 million wealthy Americans whose incomes are high enough to justify the ownership of tax-free bonds confirms this view. Almost all of them believe that income-tax rates will be higher two years from now than they are today. Virtually none believe they will be lower. There are only a few who think tax rates will be unchanged.
If any of the political proposals about taxes come to pass, the top income-tax rates in the United States will become the highest in most Americans’ experience. Some proposals take those tax rates up substantially; others take them up in lesser amounts. Under nearly every scenario the highest US marginal-rate brackets will be above 50%, second only to Denmark and about equal to Sweden. Remember that the Alternative Minimum Tax (AMT) raises the marginal rates above the maximum stated in the code because it removes the deductibility of state income taxes and blocks other deductions. Thus the marginal rate goes higher. We believe the income-tax hikes coming to the United States make the strongest case in decades for owning tax-free municipal bonds.
The Build America Bonds (BAB) program acts to compress interest rates on tax-free bonds. The program is a confirmed success. It is in its second year of operation. There are proposals in the Congress to extend it and make it permanent. Under the current BAB program, bonds are issued by state and local government units for certain types of projects. 35% of the interest payment of the local issuer is reimbursed by the federal government, so the net interest cost to the issuer is 65% of the taxable bond interest rate.
Most of the new-issue BAB underwritings are now done on a negotiated dual-track scale in which the underwriters compare the taxable fixed-income market with the tax-free fixed income market; they do this at each maturity in the new-issue scale. They then elect the choices that are the least costly to the issuer. The procedures for these new bond issuances are now well established. Well over $100 billion of BABs will be issued in 2010.
The impact is to take that $100 billion away from issuance in the tax-free municipal bond market and move it to the taxable market via the BABs. For the issuer of municipal bonds that opens up a whole new set of bond buyers, including pension funds and eleemosynary institutions. For the high-tax-bracket individual investor, that means there is a developing and growing scarcity of tax-free bonds. The scarcity can cause tax-free bond interest rates to fall relative to taxable ones. We see that spread-tightening trade continuing all year.
Relatively fewer tax-free municipal bonds mean lower interest rates and higher prices for them, since the set of bond buyers remains unchanged. So BAB helps compress and lower tax-free interest rates. The evidence overwhelmingly supports that conclusion.
Muni-bad forces come from two areas.
The first is concern about their creditworthiness. Bond insurers have been downgraded or eliminated from the game, rating agencies and their ratings of municipal bonds are suspect, and the typical bond buyer has now experienced both of those negatives. In the old days and for decades, municipal bond buyers thought they only needed to know that a bond was triple-A rated and insured. Beyond that, they paid very little attention to the underlying credit qualities of the issuer. Most investors actually ignored the issue itself.
Those days are gone. Clearly, a lot more research work has to be done on Munis. At the same time, the underwriters and the distributers of municipal bonds have been injured by the difficulties established in some of the closed-end mutual funds and by the lack of capital in the system. That combination has made Munis very, very cheap. In the crisis period tax-free municipal bond interest rates were well over 100% of their corresponding taxable US Treasury interest-rate references.
In the intermediate end of the yield curve, that is no longer the case. At the ten-year maturity, that percentage test is now in the high 80s or 90s, and varies with market conditions. It has been gradually restoring to normalcy. We expect that to continue and to see the percentage reach the high 70s to low 80s. Those are the established standards in which tax-free high-grade municipal bonds would trade at interest rates well below 100% of taxable federal government debt rates and consistent with a tax arbitrage of the income-tax brackets.
In the very long end of the yield curve, the resumption to normalcy is still underway but has far to go. Recent high investment-grade tax-free municipal bond issuance is still being priced above 100% of the corresponding Treasuries. This has spawned a management style in which those who fear a forthcoming rise in all interest rates are able to hedge their tax-free bonds with derivative-structured exchange-traded funds (ETFs). They give up a portion of the income but protect themselves from parallel interest-rate shifts in the yield curve. There’s a tradeoff involved – less income for more safety — and some larger and more sophisticated investors are electing to take that tradeoff. At Cumberland, we now have tens of millions in this type of separate account structure.
Notwithstanding the desirability of tax-free Munis, the public fear-mongering about defaults continues to keep tax-free municipal bond interest rates higher than they would otherwise be. This creates a distortion in the market and has many observers, bond buyers, and investment-oriented agents painting tax-free municipal bonds with a very broad brush. So it’s common now to see fear-mongering headlines that essentially say all state and local government bonds are bad, all of them are going to default, and that the financial crisis and the deficits are destroying all public budgets.
Such a drastic, sweeping conclusion is a mistake. It clearly violates any understanding of state and local government finance and budgeting. There’s a vast difference between an incinerator in Harrisburg that may have been poorly contemplated and the water company in Cleveland or the turnpike in New Jersey. There are tens of thousands of state and local government credits in the United States; the total asset class is approximately $2.8 trillion dollars. The one thing we know with certainty is that we are not going to have $2.8 trillion dollars of state and local government bonds, issued by 60,000 different governmental entities, all default. Simply put: it ain’t gonna happen. Fear-mongering is making the buying opportunity in tax-free Munis available to those investors smart enough to seize it.
The forthcoming California General Obligation tax-free bond issue is a good example of how fear-mongering has impacted pricing to an extreme. The CA issue is expected to come at a 6% tax-free interest rate for the long maturity. For a taxpaying individual that is worth 9.23% if you are in 35% bracket, 9.93% if you are pushed into the 39.6% bracket contemplated under present law, and above 10% if you are in a high CA state tax bracket and over 11% if you are in the worst case as a CA taxpayer and also in the AMT.
Compare this with the experience in Greece where the latest euro denominated Greek bond yields a little over 6%. Note that Greece and California have similar credit ratings. CA is a baa1 by one rating service and an A by another.
The last issue, which is a negative for tax-free bonds, comes through the development of an insidious change in the tax code. Here we come to the term “MAGI.” We have examined a case study with one of our clients who called this to our attention. MAGI is the acronym for “modified adjusted gross income”. Many are familiar with term “adjusted gross income.” It’s a concept they see and utilize every year as they prepare their income taxes. They understand how their accountants derive an adjusted gross income to be used with the IRS.
MAGI is the technique the federal government is now using in the pricing of Medicare Part B (medical insurance) premiums. Using MAGI to determine what an individual’s Medicare premium will be enables the government to alter the premium with means testing. This is an indirect form of taxation. Part of the calculation of MAGI is to add back tax-free municipal bond interest to the taxpayer’s other income in order to determine what their Medicare Part B premium will be.
At the present time, the submission of information on tax-free income is voluntary and on the honor system. Reporting systems are not fully in place yet, so that 1099s revealing tax-free interest received are not set up to convey this detail to the Internal Revenue Service and other agencies.
We expect that to change and a reporting system to eventually be in place so that all interest from tax-free municipal bonds will be reported and used by the government in the calculation of various means-tested facilities and government services. That is the first step towards raising the prices of those services so that individuals who have very large tax-free bond portfolios will find themselves having to add back the tax-free interest in order to determine how much they have to pay, or how much the federal government will charge them for a particular health insurance service. Imagination can quickly take this to where it may lead as an indirect form of taxation on the higher-taxed individual American taxpayer.
The long-term implication is an attack on tax-free bond interest, and the politics of that attack by populist governments who develop such rhetoric are obvious. The indications, though, are that the present ownership of tax-free municipal bonds, if they are attacked, would be grandfathered. That, too, could add to a scarcity premium in the future and make them even more valuable.
We realize that this last item is speculative on our part. The Obama administration and Congress have not indicated that they are going to remove the tax-free municipal bond from the American security environment. There hasn’t been a discussion of elimination of the tax-free municipal bond for years. But the introduction of Build America Bonds, which compresses municipal interest rates, and the development of the concept of MAGI both suggest that some future political pressure could be applied in ways that would reduce or eliminate the issuance of tax-free municipal bonds in some future period of time.
For now, the composition, pricing, and desirability of tax-free municipal bonds are paramount and well-established for those who are in higher federal income-tax brackets, and for those who are in states whose income taxes play a major role in the economics of the state. Tax-free municipal bonds are currently cheap. Taxable BABs are, too. Both represent very good values in the bond market. The returns on them are still not restored to the valuations that were in place before the financial crisis ensued.
Additionally, the electronic credit-reporting system that is now in place for state and local governments, and the lack of municipal bond insurance, have added to the creditworthiness of existing and new-issue municipal bonds, because successful new issues and offerings have been scrutinized in much greater detail by bond buyers and by their investment professionals. The old days of depending on the rating agencies and the bond insurers are gone. That’s good for the bond buyer who understands the level of professionalism needed in this asset sector.
And this is also good for the managed tax-free municipal bond account where the homework has been done on the credits. For Cumberland these developments have meant back-to-back record growth years, an expanded staff, record assets under management, and an enlarged institutional consultation business.
It took a financial crisis, rating agency failure, bond insurer demise, and Lehman’s bankruptcy to get the sleepy, boring tax-free municipal bond out from under the Rodney Dangerfield syndrome. We made it. Tax-free Munis and BABs now get some respect.
David R. Kotok, Chairman and Chief Investment Officer
