A Municipal Bond Cliffhanger

Guy Davidson

Municipal bonds are popular because the interest they pay is exempt from federal taxation. But in its search for solutions to the fiscal cliff, the US federal government is looking under every rock for more revenue sources. This could put muni bonds’ tax-exempt status at risk.

What effect could these changes have on investors? And what can they do about it?

Municipal bondholders have two possible paths to consider. As explained here, an increase in federal taxes would make the tax-exempt status of municipal bonds more attractive. This could drive yields lower and prices higher—boosting total returns.

Policymakers could take another route: they could limit the federal tax exemption on municipal bond income, reducing the attractiveness of muni bonds. President Obama has proposed a limit of 28% for all bonds, even those issued before the law was passed. The Bowles-Simpson commission proposed treating the exemption differently: it would completely eliminate it, but only for bonds issued after the law was passed.

It’s impossible to predict the outcome of the debate. Our hunch is that the muni-bond tax exemption is likely to remain on the books, but the benefit of tax exemption could be limited.

With the outcome far from certain, what should an investor do?

First of all, changes in the tax code would likely affect long-term bond prices the most, so it may make sense to reduce exposure to long-maturity bonds. Given the strong rally in long bonds, this would mean realizing a gain.

If the objective is to reduce risk from tax-law changes, investors should take their gains this year while long-term capital gains rates are still low. Furthermore, many investors might be able to apply these realized gains against tax losses from previous years, which may reduce the cost of taking the gains on long-term bonds today.

Second, managing volatility is important—no matter what taxes do. It might be wise to reinvest the proceeds from the sale into shorter-maturity bonds, which may mute the impact of any of the proposed rule changes, or even the potential impact of rising interest rates.

In the current environment, we believe that an intermediate-term muni portfolio (a moderate amount of interest-rate risk) and an overweight in lower-credit-quality bonds for added income may result in a less volatile portfolio and an attractive level of total return.

Most municipal investors prize stability. Today, there is a lot of uncertainty about the tax code. Municipal investors who are concerned about this uncertainty should consider reducing their holdings of long-maturity bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Guy Davidson is Director of Municipal Investments at AllianceBernstein.

4 comments

  1. Loren Behrens

    I personally believe you are way off base here. Are you looking out for the clients or the brokerage firm and it”s reps. I have been dealing in Muni bonds for about 40 years and there has always been a segment of the political jerks trying to do away with the nature of the tax free status. Sure, they have come in the back door and made the tax free income effect the taxability of other income based on amounts of income a person has, but to change the tax free status would take an act of Congress. Now, with what we have as a congress at this time that could happen, but before it is approved I am sure some of them would realize the effect on their own pocketbooks…higher infrastructure rebuilding costs, same for schools, hospitals and any public paid project for the good of the people in the area(there are standards here) Your doom and gloom approach would be a definite high cost to the consumer or investor who would be using short term investing and multiple purchases over the intermediate to long term, making some sales people and firms happy to receive multiple commissions and concessions. Not so good for the client. I have never seen where the knee jerkers win over the patient believers. Have a good day.

    • Guy Davidson

      Personally, I hope you are correct—that Congress sees the benefit of tax exemption for municipal issuers and maintains the current tax status of municipal bond interest. However, that is far from certain. In fact, the President has proposed limiting the benefit of tax-exempt interest in his budget, which would effectively tax municipal bond interest for some investors. Interest rates are incredibly low and any change to the tax status of municipal interest would probably impact the longest-maturity bonds the most. As such, for those concerned about changes to the tax code and the potential impact on municipal debt, their focus should be on their longest holdings, and not their entire municipal portfolio. In this way, our advice is anything but a knee-jerk reaction to uncertainty, but rather a prescription to get the biggest benefit for the least number of transactions.

  2. Nice

  3. Rob Forrester

    Good information here. Here in California we have high taxes and our clients are concerned about the effect of Prop 30. Thanks for your comments.

Leave a Reply

Your email address will not be published. Required fields are marked *

*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>