The Bond Buyer queried some municipal market participants asking them: What are your top three concerns for the market depending on the outcome of the 2012 Presidential election. They share their responses here.
Dan Heckman, chief fixed income strategist at U.S. Bank Wealth Management of Minneapolis:
The greatest concern for municipals from the election is not dependent on what party gains the White House, but whether that President will be able to work with Congress. They will face daunting fiscal issues that could negatively impact the municipal bond market. The fiscal cliff, if not dealt with effectively and proactively, could heighten the prospects that the U.S. economy will enter a recession at some point in 2013 due to spending cuts and an increase in income tax rates.
This will have a direct impact, in a negative way, to state and local municipality revenue sources. Also, due to the need to address the large and growing federal debt and budget deficits, the odds are going up that legislation limiting the amount of interest that would be exempt from federal taxes on municipal bonds could be enacted. This would save the Treasury hundreds of millions in lost tax revenue by removing or limiting the tax exempt status of muni bonds. Also, health care reform and other costs associated with entitlement programs will become a greater burden on states over the next several years, straining state and local government budgets as those costs get shoved down from the federal level. All of these issues pose a risk on the municipal bond market if they are not dealt with effectively, and could consequently force yields higher and prices lower on muni bonds.
Another growing risk is that absolute yields continue to drop on munis to all-time lows. Muni bond yields haven’t been this low since the early 1960s. The municipal bond yield curve continues to flatten as investors — in a desperate search for yield — move further out on the yield curve. The yield on 30-year, AAA-rated muni bonds has fallen by 72 basis points since the beginning of the year, while the one to 30-year spread has shrunk by approximately 68 basis points. Investors buying long-dated muni bonds are exposing themselves to tremendous duration and interest-rate risk that — when rates begin to rise — will subject them to significant declines in principal value on their muni holdings.
As politicians focus next year on raising revenue and reducing expenditures, increasing marginal income tax rates would be a major positive for municipal bonds and would make existing bonds more valuable. However, if a proposal for broadening the tax base gains traction, then any enactment of a flat tax would be a significant negative for muni bonds and force yields higher, depressing values in the market. Currently, the municipal bond market is estimating a low probability of that occurring and would be surprised if flat tax legislation was enacted.
John Donaldson, director of fixed income at Haverford Trust Company, Radnor, Pa., which manages $1.5 billion in fixed income assets, including $800 million in municipal assets for private clients:
My three main concerns are about tax rates on individuals, the threat to tax exemption as part of tax reform, and the impact on state and local government credit quality from reduced federal spending.
Higher taxes are going to ultimately be driving demand for municipals. Tax rates are not going down, so you are looking at stable demand as is, and improved demand coming out the election — no matter who wins.
The bigger question is the threat to eliminate tax-exemption as part of any comprehensive tax reform package. This is the biggest threat since 1986 — the last time there was any realistic discussion in Washington about the topic. Ultimately, you have a long standing public policy goal for state and local governments — the question is do you want to repudiate that public policy goal?. We still believe tax exemption is the most efficient way to accomplish that public policy goal, but as part of a major tax reform package, it might be on the table.
If there is a change that big, smaller issuers are the losers, as the municipal market ultimately is not one market, but 50 local markets. If they have to compete with corporate bonds, it’s hard to see how that happens without very much higher financing costs.
