Phew, Supreme Court upholds current muni market structure

The U.S. Supreme Court issued a 7-2 decision this morning declining to throw the entire multi-trillion-dollar municipal bond market into chaos. Phew. Nothing to see here, move along.

The longer version: A couple in Kentucky sued the state for taxing the interest they collected from out-of-state municipal bonds they owned. That’s been the practice in the muni market since forever. States only agree to forgo income tax on muni bonds issued in their state, whether by the state itself or by its cities and towns. That creates built-in demand for the bonds and lowers the interest rates the issuers have to pay. If the Supreme Court had agreed with the Davis’s, states might have had to pay billions in tax refunds and the true value of the majority of muni bonds would have been in question.

A lower court had agreed with the couple’s argument that this practice was unfair, because Kentucky was seemingly discriminating against bonds from states and thus violating the Constitution’s interstate commerce clause. In an opinion written by Justice David Souter, the Supreme Court said the pratice was allowable because it furthered important public goals. Souter writes:

Kentucky’s tax exemption favors a traditional government function without any differential treatment favoring local entities oversubstantially similar out-of-state interests. This type of law does “not ‘discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.”

The case is Department of Revenue of Kentucky v Davis and you can find a PDF of today’s opinion (along with a dissent by Justices Kennedy and Alito) on the court’s web site here.

The decision isn’t having any kind of immediate impact on muni bond prices, though it lifts one several clouds of uncertainty hanging over the market. Not only are the big national ETFs like the iShares S&P National Municipal Bond Fund (Symbol: MUB) and the SPDR Lehman Municipal ETF (TFI) virtually unchanged but even the few state-specific exchange-traded funds are doing nothing. iShares California (CMF) and New York (NYF) funds, for example, are practically unchanged.

The muni market has suffered much more from the financial woes of bond insurers and fallout from the demise of auction-rate securities. Returns on national muni bond mutual funds have dramatically lagged gains on taxable bonds funds. The average national muni fund posted a total return of 1.1% over the past year versus 10.1% for long-term Treasury bond funds, according to Morningstar. Getting great news from Justice Souter is one thing. Getting great news from bond insurers Ambac (ABK) and MBIA (MBI) would be far better.

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