Longer-term, the resolution of the fiscal cliff, or lack of a resolution, will have a greater impact on the direction of bond yields. I believe the election effect will be limited to a 0.10% to 0.25% move in Treasury yields, with a lesser impact, at least initially, in the municipal bond market. That’s not going to be too noticeable for most investors.
Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, which holds over $8 billion of municipal debt:
The most important impact to the municipal bond market directly relates to who the players will be that will dictate the tax reform agenda. In this election, tax reform has been perhaps the highest profile issue shared by both candidates as well as those running for Congress. Proposals to date do not appear as well defined or even sketched in stone that there is a likely outcome — no matter which party comes away as victor. Proposals span from those that dramatically change the tax code that might involve the elimination of tax exemption to those that tweak the tax code to eliminate deductions. However, even before the next president is inaugurated, the unresolved fiscal cliff scare could be extremely bullish for muni bonds in general as the Bush tax cuts expire and the economy’s potential for a recession becomes highly elevated.
One of my three biggest concerns is if tax exemption is eliminated entirely. Odds don’t favor this outcome because of the serious threat to increasing the cost of state and local infrastructure financing.
The recent sequestration plan calls for a cut in the existing Build America Bond subsidy.
That should be enough to convince state and local government officials that the trade off for a BAB federal subsidy program is unreliable.
Loss of tax exemption in the current market could raise borrowing costs significantly by nearly 1% to 2% depending on maturity and credit quality in today’s market.
Under one proposal, the exemption on municipal bond income would be subject to a cap as would be the case with all other current deductions and tax credits.
A potentially greater threat is the total elimination since that concept already exists relating to private activity bonds and the AMT tax. Still, it would not be a good outcome for state and local infrastructure financing. The impact would be felt more severely once interest rates would go up.
Loss of deductions would have a direct impact on state and local governments with high taxes, in which their taxpayers could no longer deduct these items from their overall federal tax burden.