Health-Care Taxes Put Spotlight on Munis

(This story has been corrected to show in the eleventh paragraph that California state general obligation bonds are currently rated Baa1, not BBB.)

The word on Wall Street is that investors are becoming increasingly hungry for riskier assets as the U.S. economy's prospects improve and the credit environment continues to ease. You wouldn't expect relatively low-yielding municipal bonds—particularly shorter-dated maturities of one to five years—to do well in this kind of environment, but they are.

Even though munis aren't nearly as cheap relative to Treasury bonds with comparable maturities as they were a year ago, money flows into muni mutual funds remain robust, albeit smaller than in the fall of 2009, says Chris Holmes, a fixed-income strategist at JPMorgan Chase (JPM) in New York.

The latest wrinkle in the muni-verse: the health-care reform legislation signed by President Barack Obama on Mar. 23. One widely discussed feature of the bill is a new Medicare tax that levies 3.8% on wages and other kinds of income, starting in 2013. The tax would not apply to interest on tax-exempt bonds and other forms of unearned income, such as any gain from the sale of a principal residence, that are excluded from gross income under the U.S. income tax code, according to a footnote in the Joint Committee on Taxation's Technical Explanation of the revenue provisions of the Reconciliation Act of 2010. That may seem like a no-brainer, but R.J. Gallo, senior portfolio manager for muni bonds at Federated Investors in Pittsburgh, says he's received calls from a few brokers asking whether munis would be exempt from the additional tax.

Tax-Exempt Munis

Although the additional Medicare tax won't take effect until 2013, fund managers say it's not too early for investors to boost their exposure to tax-exempt municipal bonds, especially if their portfolios are light on tax-exempt assets. While municipal budget shortfalls are still a serious problem, and only about 11% of new muni-bond issuance in 2009 was insured, the technical signals for munis remain strong and the credit quality of state and local governments will continue to improve as the economy strengthens.

At the start of 2011 the Bush Administration tax cuts enacted in 2003 will expire, and the top income bracket will rise to 39.6% from 35%. Add the 3.8% increase in the Medicare tax and, even in a state with a moderate income tax, high-income investors will be paying close to a 50% tax rate, says Tom Spalding, a muni-fund manager at Nuveen Asset Management in Chicago. The closer you get to retirement, the more compelling it becomes to have a heavy exposure of tax-free assets in your portfolio, he says.

The issuance of Build America Bonds, which are federally subsidized and taxable, has helped reduce yields on long-dated bonds, since most of them are long-dated. Many states have been issuing these bonds in lieu of tax-exempt munis, since they end up paying a lower coupon on 30-year bonds after accounting for the subsidy than they would on lower-yielding tax-exempt bonds. That has reduced the supply of long-dated munis, which has pushed up prices and pulled yields down.

Build America Bonds

The lower yields have made longer-dated munis less attractive to retail investors than they would be otherwise, says Philip Condon, head of municipal bond portfolio management for retail and tax-exempt advisory clients at DWS Investments in Boston. But he says it's worth it for investors to buy Build America Bonds for their tax-deferred retirement accounts and suggests they beat some of the tax burden by waiting until they're in a lower income-tax bracket in retirement before they withdraw them.

While the buyers of Build America Bonds tend to be pension funds and other tax-exempt institutional investors, demand among retail investors continues to grow as well, says Nuveen's Spalding. The taxable bonds "are a good diversifier, a way to get lower credit risk and at the same time get attractive yields," he says. "They would be suitable for 401(k) [accounts] for individuals."

Congress almost certainly will pass legislation this year that allows states and municipalities to issue Build America Bonds beyond the end of 2010, in view of ongoing fiscal pressures, says Ashton Goodfield, head of muni-bond trading at DWS Investments in Boston. The main question is whether the subsidized rate, which is currently 35% (the federal government reimburses states for this portion of the coupon on the bonds), will decline gradually to a level around 28% or reset lower immediately, as called for in one proposal. Extending the taxable bonds with a smaller subsidy virtually ensures a flood of additional issuance before yearend, she adds.

Spalding at Nuveen says state and local governments' ongoing budget problems and credit challenges argue for investing in munis through traditional managed mutual funds, which are well-diversified and have the research capabilities to take advantage of anomalies along the yield curve or temporary supply-and-demand imbalances, rather than through an exchange-traded fund, which replicates an index, or buying munis individually.

Moody's Ratings Shift

Another factor that will make it harder for retail investors to navigate the muni world is Moody's Investors Service's (MCO) move to a so-called global scale, which entails recalibrating its muni bond ratings to bring them in line with taxable bonds' ratings, starting in April. The result will be a general upgrade for some of the 70,000 credits that Moody's rates, says Goodfield at DWS. Under the revised rating system, the lowest rating for general obligation, or GO, bonds, will be A1. Lower-rated bonds such as California's, which now have a Baa1 rating, will benefit from this.

Institutional investors have the analytical research tools to be able to discern the quality of various issues, while retail investors will find it harder to differentiate lower- from higher-quality bonds that get the same rating, Goodfield says.

"[The new ratings system] gives a false sense of security about some of these credits," she says, adding that some, such as California's, will look safer than they really are. She thinks the recalibration couldn't happen at a worse time, when fiscal budgets are so constrained.

Although defaults among investment-grade munis are extremely low, the ratings upgrades create other risks such as making it harder for inexperienced investors to know what a bond is worth and how much they should pay for it, she says. The upgrades will also send the wrong message to politicians, warns Condon. Instead of scaring them into improving fiscal management policies with the threat of a credit downgrade, this could encourage them not to tighten their budget belts, he says.

General Obligation Bonds

It's just as well that distinguishing higher-quality munis from lower-quality ones will become harder once Moody's rejiggers its ratings, since some fund managers recommend staying away from general obligation bonds, which are backed by a municipality's general taxing authority and therefore more risky than bonds that fund highways and schools.

Spalding says he's sticking with munis that fund essential services. But he expects general obligation bonds to represent good value again by the end of this year or early 2011. "You're already seeing some pickup in states' sales-tax collections, so we're seeing some bottoming out [of munis' credit quality], and that should be further along by next year," he says.

For investors concerned mainly with safety, Gallo at Federated recommends municipally owned public power providers, which often have monopolies in their service area and more secure income flows. Municipally owned water and sewer authorities are another low-risk alternative, he says. But you can't buy them cheap, which means settling for lower yields, he says.

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