Here is a great explanation of President Obama’s proposed Jobs Act and it’s effect on the tax-free muni bond market by John M. Dillon, Chief Municipal Bond Strategist with Morgan Stanley Smith Barney. Special thanks to Gary Wulf for the heads up.

On Monday 9.12.11, President Obama sent a $447 billion jobs bill to Congress that included in its “offsets” a provision to limit the value of tax exempt bonds for individuals with incomes above $200,000 and $250,000 for married couples filing jointly.

The proposal would limit the benefit to 28%, essentially equalizing the amount or value of the tax benefit to match those investors in the 28% tax bracket. To be clear, this does not mean that muni income will be taxed at 28%. Rather, investors above the $200k/$250k threshold would pay the difference between the value of the tax exemption of a 28% ratepayer and the value of the tax exempt benefit they had previously enjoyed as a 35% ratepayer. The change would begin for the tax year starting January 2013.

In real terms, the math works as follows:

Assuming $500,000 of federally tax exempt interest, the 35% ratepayer currently “saves” $175,000 ($500,000 x 0.35), which is the tax they would have to pay if the interest were federally taxable.
At the same time under the current rules, the 28% ratepayer “saves” just $140,000 on that same $500,000 ($500,000 x .28).

Under the new proposal, the $200/$250 earner would have to remit the difference between the 35% benefit and the 28% benefit, namely $35,000.

Viewed another way, the new incremental tax or surcharge is 7% ($35,000 / $500,000) or simply the 35% rate minus the 28% rate.

Being mindful that the current marginal tax rates are extensions of the Bush tax cuts, a return to the prior maximum rate of 39.6% would mean that the new incremental tax owed would rise to 11.6% (39.6% – 28%).

There is also the very real and relatively new approach of including all outstanding bonds. Although not retroactive in the purest sense, this proposal would impact tax exempt bonds regardless of issuance or purchase date (so it basically is retroactive). With this in mind, the implications across the market, if enacted as proposed, would be broad-based.

To clarify, this approach differs significantly from prior street assumptions that any change to the tax exemption would very likely “grandfather” bonds already outstanding (which would create a bifurcated marketplace). Although the concept of “capping” tax exempt interest has surfaced before, it was never a frontrunner in the grand scheme.

Likelihood of Passage is Slim

In our opinion, this proposal is unlikely to pass through Congress as a stand-alone package. However, it is very possible that elements of the Jobs Act make their way into the Super Committee in the coming months if they seek to raise revenue. It is also worth noting that the GOP has stated quite clearly their opposition to tax hikes or new taxes. This Act fits both definitions depending upon interpretation.

Not surprisingly, the initial read we are hearing from multiple sources is that it is a “non-starter.”

As we mentioned in our latest “Municipal Bond Monthly” released on Friday September 9th, one additional consideration for today’s market is “The burgeoning reality that the municipal market may have to confront significant changes in the federal tax code (possibly including the federal tax exemption).” Although the likelihood of passage appears slim, we think this topic (if not resolved) will resurface repeatedly in a variety of forms during the next few years.

As an aside, there is almost no question that this proposal, if enacted as currently written, would raise borrowing costs substantially for states and local governments. Further, the higher borrowing costs may well surpass what the simple math would suggest, as a new and significant element of tax-related uncertainty would enter into the “tax- exempt” marketplace.

Market Reaction Muted (Thus Far)

Despite the obvious negative market implications of this proposal, the tax exempt municipal market exhibited little downside volatility today. The Thomson Reuters MMD “benchmark” municipal scale was unchanged across the board on Tuesday 9.13.11.

There are likely a few reasons for this muni apathy. The first is that top quality munis are already trading at yields that eclipse (by a good margin) corresponding maturity USTs…basically they are attractively priced already at 104%, 113% and 110% for 10-, 20- and 30-year maturities, respectively. These levels contrast historical norms of low- 80s to low-90s by a wide margin. (Source: Thomson Reuters MMD)

The second reason is that the muni market has endured a number of these “scares” in recent years, obviously none of which have come to fruition…let’s call this market “battle-hardened.” Third, there was not an avalanche of bid lists in today’s market, meaning traders had the luxury of pondering the proposal without the pressure of committing capital in a choppy market. Lastly, the general lack of paper this year makes potential sellers think twice about liquidating positions, as those who sold at almost any point year-to-date left substantial money on the table…and also could not replace the paper later.

Despite the current tranquility, there is one metric that we will be watching closely this week. Municipal mutual fund flows, if decidedly negative, could prompt sizable bid- wanted lists and thus create volatility in the market. Recall that individual investors, via fund redemptions, spurred significant volatility in late-2010 and early-2011. It is possible that something along these lines could develop (despite our opinion that such moves would be misguided and premature).

What to do?

Our strategy remains unchanged. Given the current relative value metrics for tax exempts, the market appears well-positioned for a mild reaction. Unfortunately, mild reactions have not been very frequent in recent years. With this in mind, we would view any significant upheaval as an opportunity to acquire high quality paper within our focus maturity range of 6 to 14 years.

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