Jan. 8 (Bloomberg) -- U.S. municipal issuers may have to call as much as $150 billion of debt if President Barack Obama’s plan to limit income-tax deductions is applied to interest on the bonds, according to Citigroup Inc.
Mandatory redemption provisions of conduit and private-activity securities could be triggered by a cap that affects the deductibility of earnings for some bondholders, Citigroup muni strategists including Vikram Rai said in a Jan. 4 report. That would mean “substantial” losses for investors, or a “sharp increase in borrowing costs” for localities, according to the report.
“If even a single investor has to pay a single dollar in taxes for bonds which were issued as tax-exempts,” the mandatory redemptions can be triggered for all bondholders, Rai said in an interview. “Such provisions could create big winners and big losers on bonds trading well above or below par,” the analysts said in the report.
The provisions are found mostly in tax-exempt securities sold by governments for companies, hospitals and nonprofit organizations. Industrial-development revenue bonds earned 12 percent in the past 12 months, the most among 11 investment-grade revenue segments tracked by Barclays Plc.
Private-activity bonds are tax-free only if they finance projects or loans that are considered worthy of the exemption, Rai said. The debt represents about $200 billion of the $3.7 trillion muni market.
Obama, a Democrat, has sought to cap tax deductions at the value they would have in the 28 percent bracket for top earners, including interest on exempt debt. That limit wasn’t included in the measure passed by Congress on New Year’s Day.
“We strongly suspect that the threat of such a cap will recur at some point,” the Citigroup analysts said. “Market participants will need to remain alert and involved in making the case for the tax exemption.”
Though Senate Minority Leader Mitch McConnell said further tax-code changes won’t be part of the debate over increasing the government’s debt limit, Obama has repeated his call for a “balanced” approach to reducing deficits. Republicans may use the debt ceiling to push for spending cuts, according to the Citigroup report.
“The wealthiest individuals and the biggest corporations shouldn’t be able to take advantage of loopholes and deductions that aren’t available to most Americans,” Obama said in his weekend radio remarks on Jan. 5.
The muni market’s value may drop by $200 billion, or about 5 percent, under Obama’s deduction cap for top earners, Citigroup said last month. Should it be imposed, investors would demand at least a 0.6 percentage point increase in tax-exempt yields to make up for reduced effective earnings, according to George Friedlander, the bank’s senior muni strategist.
Mandatory redemptions at par value would force losses on bondholders who bought the debt for more than 100 cents on the dollar. The forced calls may also produce fiscal strains as states and cities recover from the longest recession since the 1930s.
“Some issuers could face cash-flow problems if suddenly, for no fault on their part, they are forced to redeem bonds that they hadn’t budgeted for,” Rai said. “This could have a potentially destabilizing effect on the market.”
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