Municipal Bond Revolution In The Making

When it comes to investing, there is rarely a newsworthy story about municipal bonds. With little speculation and no volatility, there is nothing to write about except for the occasional surprise call or staged default. But municipal bond news has recently moved off the pages of obscure newsletters and into the mainstream media.
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The U.S. Supreme Court has been petitioned to hear an appeal brought forward by the state of Kentucky. In a nutshell, the state of Kentucky hopes the Supreme Court will overturn a Kentucky Supreme Court ruling that it was wrong to exempt in-state municipal bonds from state income tax, while at the same time imposing such taxes on out of state municipal bonds.
The case hinges on the Supreme Court of Kentucky’s interpretation that the current taxation of out of state bonds violates a federal commerce clause.
One novel element, first pointed out by the California Municipal Bond Advisor (CMBA), is that this potential landmark case bears the "Mark of the Beast." That’s right, the docket number for the case is none other than the ominous (06)-666, straight from the book of Revelations. For certain states that have benefited from the de facto exclusion of out of state municipal bonds, it certainly could be the “end of days” that this biblical book references.
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States such as California, New York and many others, which now exempt in-state bonds from state income tax, could be forced by the federal court to tax--or exempt from tax--all bonds equally. If the Supreme Court puts all municipal bonds on an equal footing in every state, high state and local income tax states such as California and New York would suddenly find themselves competing against every municipal bond in the country.
Municipal bonds in high income tax states tend to have lower coupon rates as the exemption from high tax rates is enough incentive for residents to purchase these bonds over those with higher yields, but from out of state. In other states such as Florida or Washington, with no state income tax, resident investors receive higher coupon rates as no offsetting tax savings are involved.
Forty-two states currently have this dual tax structure in place and some analysts believe that some 1% to 4% of bond value in high income tax states like New York or California could be eroded if the Supreme Court upholds the lower court’s decision. New municipal bond issues in these states would have to carry a higher coupon rate to compete with the coupon rates of bonds in a non-income tax states, while existing bonds issued in high income tax states would drop.
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However, on average, the margin of yield spreads varies only minutely between most states and, as the CMBA points out, the influence of huge municipal bond funds competing for yield on a national basis helps ensure that a substantial gap in yield spreads doesn’t develop.
Nevertheless, if the Supreme Court affirms the lower court decision, we will likely see the formation of a national market for municipal bonds, a market which is today very much a regional one. It may also spell the end of some of the more flaky type bond issues such as the tobacco bonds so loved by California.
What this means for investors is not immediately clear. The impact will likely vary from one investor to the next, but some forecasters see as much as $50 billion of the new issue market being reallocated to more tax attractive markets if the dual tax structure is struck down. This would also seriously undermine the hundreds of single-state municipal funds, and their $160 billion of assets, designed to take advantage of this tax structure.
If the court declines to hear the case and Kentucky proceeds to exempt all municipal bonds from taxes, this would no doubt open the floodgates for investors to pursue litigation in other states for equal tax treatment of municipal bonds. It’s also likely we could see states lobby Congress for legislation safeguarding the dual tax system.
But whatever the Supreme Court decides about this tax matter, the bond genie is out of the bottle, which is probably not a bad thing. Financial markets have become much too sophisticated over the last 50 years, but municipal finance procedures remain an anachronism that retards this form of financing. The minimal due diligence and subtle graft behind many bond issues is legendary. Add to this the cottage industry of bond professionals and local trustees who give real meaning to the term “the good old boy network.” The change would be traumatic, but extremely healthy.