John Tierney and the end of tax-free bonds

Many Boston locals know John Tierney, our popular Democratic Congressman representing Massachusetts’s 6th District who was recently re-elected for the eighth time.  Congressman Tierney is introducing a bill to make all municipal bonds taxable – proposing to demolish this last tax haven for the rich.  This bill is no black swan, a highly unexpected, exceptional event that comes out of nowhere.  It’s a white crow, one you can see coming from far away.  What is the bill’s impact right now on the municipal bond market?

Kicking munis while they’re down

This proposal is yet another blow to an already weakened municipal bond market. We know that issuers – state and local governments – face frightful fundamentals today: underfunded pensions, weak tax revenue, deep budget gaps, and the end of 2009’s federal stimulus funds.  Buyers, mostly individuals, are balking.  Funds have flowed out of the municipal bond sector for 22 straight weeks, totaling $42 billion.  Issuers, unable to find enough buyers and wary of unpopular spending, are expected to sell only half of last year’s amount, further pressuring their budgets.  Meredith Whitney’s dire prediction of billions in municipal bond defaults, no matter how unlikely, won’t go away; it keeps making headlines.

(What do Natalie Portman and Meredith Whitney have in common?  Both are black swans.)

California’s bond rating from S&P has declined from AAA in 1986 to A- today, with a “negative outlook”. We won’t know for many years whether there will be municipal bond defaults there, defaults that have virtually never happened anywhere in the US.  Defaults, when they happen, occur well into the life of a bond.  Just look at what happened with junk bonds.  The junk bond default rate rose to a record 10.2% in 2009 as our economy cratered.  In 2006 the default rate was a low 1.7% – the lowest in a decade. What looked financially sound in 2006 turned out to be a mess in 2009.

Never say impossible

Lest you think that the end of tax-free bonds is impossible, consider that the non-partisan Congressional Budget Office has weighed in with a study demonstrating savings of $143 billion over the next 10 years by eliminating the tax-exemption on municipal bonds.  With the summer’s debt limit set to be reached, Congressmen on both sides of the aisle will be looking for savings and cuts to trade for the right to issue more US debt.  When you think about it, who better to skin than the rich and their tax free bonds?   It may not be fair and it may not be right, but it could happen.

What the market is saying

What is the municipal bond market itself saying?  Let’s compare taxable and tax-free yields to find out.  Investors can buy a 10 year taxable US Treasury with a yield of 3.17% or a comparable high quality tax-free 10 year bond with a yield of 2.76%.  With the tax-free yield running around 90% of the taxable yield, the tax-free bond looks like the better deal. And it is, so long as the tax exempt status continues and Meredith Whitney is wrong about defaults.

Sometimes the white crow flies in plain sight.  Investors should not be too surprised if they see one in the muni bond market.

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