The Bond Buyer: Threat of 28% Cap Hurting Munis Now

The Bond Buyer: Threat of 28% Cap Hurting Munis Now

Threat of 28% Cap Hurting Munis Now

by: Jennifer DePaul

Thursday, December 20, 2012

WASHINGTON — The mere threat of including a 28% cap on the value of municipal tax exemption in a fiscal cliff deal has already caused municipal bonds to become more expensive for issuers and, if adopted, will fundamentally change the market, analysts and government groups warned Thursday.

Municipal Bonds for America (MBFA), a coalition of state and local government and Wall Street groups, sent two identical, three-page letters to congressional leaders and President Obama outlining the negative consequences of implementing such a cap. In the letters they strongly urged the leaders to preserve the tax exempt status of interest on municipal bonds.

In a separate letter, 21 state and local government and other muni market groups including the National Governors Association and the National League of Cities, called on Obama and House Speaker John Boehner, R-Ohio., to retain the tax exclusion for municipal bond interest and not include in a year-end negotiation to avert the fiscal cliff.

“Markets are reacting in part to the perception that Congress will tax a portion of interest on new and currently held municipal bonds, and that such a tax may become larger in the future. Should the cap become a reality, the result will be a significant increase in borrowing costs for state and local governments — an increase far exceeding 34 basis points, and which may even exceed the amount of revenue raised by the tax itself,” the MBFA wrote.

Within the last week bond yields have been rising sharply due to the threat of a 28% cap, the letter said. The municipal AAA ten-year benchmark yield has risen from 1.48% on Dec. 7 to 1.82% on Dec. 18, an increase of 34 basis points, it said.

The 28% cap proposal has been floated several times — once in Obama’s 2011 jobs bill and then again in his fiscal 2013 budget request. Obama’s most recent fiscal cliff proposal includes a 28% cap that would take effect on Jan. 1, 2014 and would apply to all outstanding municipal bonds. There have been reports that Boehner, R-Ohio., accepted Obama’s proposal to limit tax deductions and exclusions.

The market reaction comes as Boehner and Obama continue to negotiate final terms of a deal to avert the fiscal cliff, a set of steep automatic tax hikes and federal budget spending cuts set to go into effect in less than 11 days. It is estimated that Obama and Boehner are about $450 billion apart in their proposals.

On Thursday, the House forged ahead to vote on Boehner’s “Plan B” proposal to allow tax rates rise on those earning more than $1 million and a companion bill to replace the $109 billion of first-year sequester cuts for military and domestic spending with other budget cuts, as prospects for a pre-Christmas deal faded.

GOP leaders claimed they had enough votes to approve the measures despite Obama’s veto threat on Wednesday.

“If Senate Democrats and the White House refuse to act, they’ll be responsible for the largest tax hike in American history,” Boehner said at a press conference Thursday.

George Friedlander, Citi’s chief municipal strategist and chair of the MBFA’s newly formed technical advisory committee, said he attributes about 15 basis points to the increased concerns about the retroactive nature of the 28% cap.

Pointing to the Municipal Market Data triple A scale, Friedlander said there is “considerable noise in it,” even though the muni market is typically highly sensitive around year-end.

“The bottom line is that the muni market was clearly hurt by the perception that both sides might agree to this,” Friedlander said. “The cap on the benefit is not a done deal, so the impact would probably increase if the retroactive cap actually becomes law.”

In a Citi research report published Tuesday, Friedlander said that as a result of higher taxes, “investors are going to demand a substantially higher return on the new bonds they purchase, and issuers are simply going to have to pay more. Investors could face significant erosion in the market value of existing holdings.”

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