Money Matters: Muni bonds should continue tax-exempt status

By Joseph G. Mowrer III

The Daily Record Newswire

In 1895, the U.S Supreme Court upheld in Pollock v Farmers' Loan & Trust Co. that the federal government had no power under the Constitution to tax municipal bond interest. This has enabled states and municipalities to maintain a relatively low cost to finance their public projects, while giving investors in these projects an opportunity to earn tax-free income.

Since this landmark decision, investors and issuers alike have benefitted. Although the government and other case law since has attempted (and is again attempting) to modify the benefits of this symbiotic relationship, it is doubtful the new changes will gain much traction.

Let's first walk through some of the additional benefits of these bonds and then review how they have changed over the years.

One of the historical reasons that change in this arena has found resistance is because of low default risk. In order for states and municipalities to maintain a low cost of borrowing, it follows that they have been extremely careful to pay bondholders timely principal and interest and to strive for a high credit rating.

Having a low cost of borrowing is the lifeblood to maintaining a vibrant community, and attracting new people and business. Any increase to this cost, which could be created by increased perceived risk of default, could be devastating to a community.

As a result, municipal bond defaults have been extremely rare, with a cumulative five-year default rate of only of .03 percent for investment grade bonds from 1970 to 2009 (Source: Moody's). By comparison, the comparable default rate for corporate bonds is .97 percent. Clearly, the municipal bond market has a history of working as it is, and should continue to do so.

Beyond low default risk and no federal taxation, individual states, for the most part, have the added benefit to issue debt within their state that is also exempt from state income taxes. Thus, municipal bond investors are willing to accept a lower yield for debt issued in their home state.

This benefit was reinforced in 2008, when the Supreme Court concluded in Davis v. Kentucky that the state of Kentucky (thus a precedent for all states) could continue to tax municipal bond interest of bonds issued out of state, while providing the exemption for in state bonds. The ruling was particularly favorable for states with higher tax rates (New Jersey, California, New York), that can continue to maintain a lower cost of borrowing by issuing bonds to their home state residents.

Only one year after the Davis case, investors were introduced to the Build America Bond (BAB) program. This program was developed as part of the American Recovery and Reinvestment Act as a method to stimulate our economy and invest in new infrastructure. Municipalities were given a generous 35 percent tax credit directly from the federal government in accordance with their issuance of a taxable municipal bond.

States (particularly the ones with the biggest budget problems) quickly learned that BABs provided a cheaper source of financing than traditional tax-exempt bonds and took full advantage of the program.

Indeed, the program was highly successful in providing a stimulus and allowing municipalities to lower relative borrowing costs, but came as a direct cost to the federal government. These bonds were largely purchased by buyers who do not pay taxes, such as pensioners and foreign investors. The BAB program expired on Dec. 31, 2010, and has not been renewed.

Since the expiration of the BAB program, proposals recently have been floated to address the growing federal deficit and simplify the tax code by eliminating tax-exempt interest for newly issued municipal debt (existing debt would remain tax-free). Sens. Ron Wyden (D-Ore.) and Dan Coats (R-Ind.) introduced a bill that would use tax credit bonds as a substitute for traditional tax-free municipal bonds.

In summary, municipal bond issuers would float a taxable municipal bond along with a federal tax credit. Investors would apply this credit to their tax return. Opponents claim this will only further complicate our tax code, and make it difficult or impossible for mutual funds to allocate these tax credits to their investors. Similar proposals have been brought forth over the years but none have gained enough traction to go anywhere. It is unlikely that this one will be any different.

Overall, it has proven to be very difficult (or perhaps impossible) for Congress to find a balance to reduce the federal deficit while simplifying taxes on newly issued municipal bonds. Any such proposal would require increased interference from Washington, and we all know that rarely simplifies anything.

Consequently, traditional tax-exempt municipal bonds have been working as well or better than any of these new proposals, and they offer municipalities flexibility in financing their projects while compensating investors with tax-free income. Tax-free municipal bonds are unlikely to go away anytime soon.

Aside from buying individual bond issues, investors seeking tax-free income can buy a well-diversified, professionally managed portfolio of high quality municipal bonds through an open or closed-end fund. For further information on how tax-free bonds can be used in your portfolio, contact your financial professional.

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Joseph G. Mowrer III is a portfolio manager/analyst for Karpus Investment Management. He can be reached at (585) 586-4680.

Published: Thu, Jun 30, 2011