Biggest Buying Wave Defies Threat to Tax Exemption: Muni Credit

In more than 30 years of purchasing municipal debt for his personal portfolio, Jonathan Kahn, a commercial property investor in New York, says he’s never seen a bigger threat to the bonds’ tax exemption. Yet he keeps buying.

Yields on local-government bonds are near the lowest in a generation and Congress as soon as this year may revive efforts to take away or reduce the securities’ tax-free status as part of efforts to cut the federal deficit. President Barack Obama has also proposed curbing the bonds’ tax break for top earners.

That hasn’t stopped Kahn, 56, from adding tax-exempt New York state and city debt. He says the bonds offer better returns than fixed-income assets such as Treasuries. He isn’t alone. Individuals, who own about two-thirds of the $3.7 trillion municipal market, are adding the most money in three years to muni mutual funds. The demand is helping lower borrowing costs for local governments from California to Maine as they rebound from the worst recession since the 1930s.

“I have grave concerns that after the November 2012 election, tax-free municipal bond interest is going to go the way of the mortgage deduction” and be capped, Kahn said in an interview. Still, “if you buy them right, one can get in the short-term a higher rate than any comparable taxable or tax-free alternative.”

Mutual funds focusing on city and state debt have attracted about $13 billion this year through May 30, the best annual start since 2009, Lipper US Fund Flows data show. The funds have added assets for seven straight weeks.

Alternative Products

Kahn, who buys the debt for the tax-free income, compares returns to alternatives such as money-market funds, savings accounts and Treasuries.

Taxable money funds pay an average 0.03 percent, while the typical national savings account yields 0.13 percent, according to IMoneyNet and Bankrate.com. Twelve-month Treasury bills yield about 0.17 percent, down from a 2011 peak of about 0.31 percent as investors seek shelter from Europe’s debt crisis.

In comparison, a tax-exempt municipal bond with the top rating and due in one year yields 0.21 percent on average, data compiled by Bloomberg show. For an investor in the highest tax bracket, that’s equivalent to 0.32 percent.

“I see no evidence that investments are slowing down from the household sector,” said George Friedlander, managing director and chief municipal strategist at New York-based Citigroup Inc. (C) “The hunger for yield keeps growing and the hunt for yield keeps getting more difficult.”

Default Drop

Individuals’ confidence in muni debt has grown this year as a wave of local-government defaults predicted in 2010 by Meredith Whitney, a banking analyst, hasn’t materialized.

Instead, localities’ fiscal health has gotten a boost from almost three years of U.S. economic growth. Twenty-eight issuers have defaulted this year, compared with 52 for the same period last year, according to Municipal Market Advisors data through May 22.

Tax-exempts’ 4.3 percent return this year beats the 2.6 percent on Treasuries, Bank of America Merrill Lynch data show.

The muni market may be vulnerable because buyers haven’t priced in the risk of tax changes, said Matt Fabian, a managing director at MMA, which is based in Concord, Massachusetts.

“More people are gambling that it’s not going to happen with purchases at this level,” he said. “The tax exemption will likely be under assault before the end of the year.”

Exemption Cost

Muni interest generally is exempt from federal and state levies. That holds down borrowing costs for local issuers because investors accept lower yields for the tax break. The benefit is estimated to cost $29 billion this year, according to Obama’s most recent budget.

The president has proposed taxing a portion of muni interest for individuals making more than $200,000 and couples earning at least $250,000. About half of individual muni holders earn more than $200,000, according to a May 11 report by JPMorgan Chase & Co. (JPM)

A reduction or elimination of the exemption for muni interest is probable in the next three years because of the U.S. government’s need for revenue and Democrats’ view that the tax break benefits the wealthy, Fabian said. Republicans’ goal of lowering income-tax rates also means munis may become “collateral damage” in a broader debate, he said.

‘Potential Erosion’

Kahn said he is betting any changes to the treatment of munis won’t eliminate the tax benefit.

“I believe we are facing a potential erosion,” he said. Kahn also said a cap on the tax advantage may make existing bonds more valuable if they aren’t subject to new rules.

He searches for New York bonds that may be called within 12 to 18 months and have a 5 percent coupon, which he says gives him a yield better than any taxable alternative for that period.

Mark Zaenger, an attorney in Chicago, said he’s betting that income taxes will rise and make munis more appealing.

Obama has proposed letting tax cuts enacted during the presidency of George W. Bush expire at the end of 2012 for high earners. That means levies on their income will increase to as much as 39.6 percent from 35 percent unless Congress acts.

Kahn said he’s trying to maximize returns with yields at record lows rather than devise a strategy tied to the deficit debate.

“I’m not trying to handicap the taxes,” he said. “It’s very political and things can change.”

Following are pending deals:

MICHIGAN FINANCE AUTHORITY plans to sell about $2.7 billion in bonds as soon as next week on behalf of the state, according to data compiled by Bloomberg. The bonds will be used to convert to a long-term structure debt sold in December to repay federal unemployment-benefit loans. Moody’s Investors Service gives the bonds its top grade. (Added June 4)

PUERTO RICO PUBLIC BUILDINGS AUTHORITY is set to sell $500 million of revenue bonds backed by lease payments and the commonwealth’s guaranty as soon as this week to refund debt, according to offering documents. (Updated June 4)

To contact the reporter on this story: Margaret Collins in New York at mcollins45@bloomberg.net.

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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