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Biggest 30-Year Rally Imperiled by Tax-Break Threat: Muni Credit

President Barack Obama
President Barack Obama, a Democrat, has proposed limiting the break for top earners, and a deficit-cutting panel he appointed recommended scrapping it as part of a tax-code overhaul. Photographer: Luke Sharrett/Pool via Bloomberg

Municipal bonds maturing in three decades are staging their best rally in five months. The gains may be at risk as investors face federal deficit-cutting proposals that also threaten local debt’s tax-exempt status.

Investors have been seeking to pad returns amid the lowest municipal interest rates since the 1960s. They were willing to accept as little as 1.15 percentage points of extra yield last month to lend to states and cities for 30 years rather than a decade, Bloomberg Valuation data show. That gap was the smallest since March and 25 percent below the average since 2008. Investors typically demand a premium for taking on the heightened risk of longer-dated debt.

“There’s not a lot of excess return left to be had,” said Michael Zezas, head of municipal strategy at Morgan Stanley in New York. “Barring further weakness in the economy, I don’t think you’ll see that much more of a substantial rally” in longer-maturity munis, he said.

There are signs of diminished demand. Investors added $307 million to long-term muni funds last week, a drop of about 40 percent from the prior period, Lipper US Fund Flows data show. It was the steepest decline in a non-holiday week since May.

For all of 2012, funds focusing on debt due in more than 10 years have added about $9 billion, compared with $3.5 billion for those concentrating on maturities of three to 10 years. The trend is a reversal from the same period of 2011, when longer-term assets fell about $16 billion, more than double the losses of intermediates.

Deficit Debate

The tax status of munis is enmeshed in the debate over how to reduce the federal deficit, a discussion that is set to heat up after the November elections. The administration of President Barack Obama last month forecast the imbalance at $1.21 trillion this year. The exemption for local borrowings costs the U.S. government $39 billion a year, according to the administration.

Obama, a Democrat, has proposed limiting the break for top earners, and a deficit-cutting panel he appointed recommended scrapping it as part of a tax-code overhaul. Neither plan advanced in Congress. Republican presidential candidate Mitt Romney has suggested cutting income-tax rates, which may require finding ways to make up for lost revenue to avoid swelling the deficit. He hasn’t outlined specifics.

“We’ve seen some real concern that the exemption could get capped or go away, and I think that is making it more difficult” for the longest debt to extend its rally, said Justin Hoogendoorn, a managing director at BMO Capital Markets in Chicago.

Market Beater

Long-term munis have beaten all other segments this year, according to Barclays Plc data. Bonds due in more than 22 years have earned about 9 percent, compared with about 4 percent for the 10-year area.

Top-rated munis due in 30 years yielded about 2.99 percent yesterday, compared with 1.74 percent for 10-year tax-exempts, Bloomberg Valuation index data show. Last month, signs of a slowing economy and speculation that European leaders would fail to contain their debt crisis helped push yields on both maturities to the lowest since the Bloomberg indexes began in January 2009.

Zezas at Morgan Stanley in a research note last month called seven- to 14-year maturities the “sweet spot” for investors, rather than longer-duration debt. The longer a bond’s duration, the more sensitive its price is to changes in interest rates.

Fed Efforts

Federal Reserve efforts to keep down borrowing costs to spur the economy help explain the historically low interest rates. The central bank has been swapping short-term debt in its holdings for longer maturities as part of the so-called Operation Twist.

“There’s some expectation that rates are going to stay low for a while,” said Alan Schankel, a managing director of fixed income at Janney Montgomery Scott LLC in Philadelphia. The Fed’s moves have made investors less concerned about picking up longer-maturity bonds than they might typically be, he said.

The yield spread between 10- and 30-year AAA munis has been smaller than last month’s low on only two occasions since October 2008. Each time, the gap widened an average of 0.56 percentage point in as little as a month.

Guy Davidson, who oversees $31 billion as director of municipal investments at AllianceBernstein LP in New York, is encouraging clients to shift into intermediates from high-grade, long-term munis.

“Intermediate bonds have a lot less downside risk to them,” he said.

Following are pending sales:

CALIFORNIA plans to issue $10 billion of revenue-anticipate notes as soon as soon as next week. The notes are rated MIG 1, Moody’s highest short-term grade. (Updated Aug. 9)

SAN FRANCISCO is set to sell $290 million of general-obligation debt through competitive bid as soon as Aug. 14, data compiled by Bloomberg show. Fitch Ratings grades the bonds AA-, fourth-highest. (Added Aug. 6)

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