Policy Madness (inconsistency) in Muniland. Some bullets.
1. President Obama proposes jobs creation by raising infrastructure spending. This is the purview of state and local governments. They finance their share with municipal bonds.
2. Obama adds a reinstatement of the Build America Bonds program, which had a 35% federal subsidy of the taxable interest. The concept was to use the top federal income tax bracket as an equaliser. The BABs program was successful for the two years of its existence but failed to gain extension in the year-end political fight of the last lame-duck session. BABs was a nearly unique federal fiscal initiative. There was no monetary (Federal Reserve) component. It was used throughout the country. It financed infrastructure and met the needs of state and local government units. Its impact was equally divided among red states and blue states.
3. Obama also proposes a reduction of the tax-free bond benefit for high-income Americans (over $250,000 annually for joint return filers, $200,000 for singles). The net effect is to reduce the value of tax-free income and thereby raise the cost of municipal finance. Poor people do not buy tax-free bonds. Wealthy American taxpayers buy them when they are advantageous due to the tax arbitrage. Narrow the arbitrage and reduce the demand for tax-free bonds. Reduce the demand and lower their use. Lower their use and raise the cost of finance for very toll road, school board, and sewer plant in the United States.
4. Let’s examine this policy hodgepodge against some real-time, live market pricing. We will choose the NY State Thruway, since it is an infrastructure project and a toll road that nearly everyone can identify. They recently sold a tax-free issue and they have an existing BABs issue. Therefore, we are able to compare an apple with an apple. This is the same issuer with the same revenue securing the bonds. The maturity is nearly identical. The difference is that one is BABs and the other is tax-free. One gets 35% of the interest rebated by the federal government. The other gets no rebate, but the bondholder pays no federal income tax on the interest.
5. Here is the market pricing. NYS THRUWAY 5.449s of 4/1/25 traded at 4.52% on 8/9/11 (most recent recorded trade). The CUSIP is 650014TF0. This is BABs. Compare it with NYS THRUWAY 5s of 3/15/26 priced at 3.28% on 9/9/11. The CUSIP is 650028TF0. This is federally tax-free.
6. Let’s do an exercise. We will assume that the NYS Thruway is going to finance today and could obtain this yield on a traditional new issue. We will assume the federal income tax top rate remains at 35%. In addition, we will assume that the BABs legislation passes and the program goes back into effect. OK, 65% of a 4.52% yield is 2.94%. That is the rate the NY Thruway would actually pay (after federal rebate) if it were to sell new BABs bonds today and if the new BABs included a 35% rebate. Clearly, the BABs program would offer the NYS Thruway the lowest cost of financing for its infrastructure project.
7. The existing market-based price of the tax-free bond has a yield of 3.28%. That is a very recent market-based new-issue price. If Obama reduces the value of the tax arbitrage on this bond, the yield in the market place will rise. That means the NYS Thruway will end up paying a higher yield to borrow with a tax-free bond.
Possible policy outcomes from Obama’s initiative are: (1) Nothing changes and the political impasse in Washington prevails. Alternatively, (2) Obama reduces the value of tax-free bonds by raising the effective tax rate – the result is a higher cost of finance for the issuers. On the other hand, (3) if the Congress authorizes the BABs program to resume, then the cost of infrastructure finance declines.
Now, Congress: you decide the best way to create infrastructure jobs. The worst way is to continue to bicker and fight among yourselves and do nothing.
A final, unrelated note about another form of Muniland Madness. We have been a harsh critic of the Meredith Whitney scare, which predicted “hundreds of billions of dollars” of municipal defaults. She said it on 60 Minutes on December 19. So far, there has been less than $1 billion in Muni defaults in the first 8 months of this year according to Distressed Debt Securities Newsletter. She still has four months to go and needs $99 billion in defaults to be correct.
We stand by our original and often-repeated position. High-grade Muni credits are available and the notion of mass defaults is exaggerated. Whitney triggered months of Muni bond fund redemptions. Billions were lost by investors who panicked and liquidated.
At Cumberland, we maintained that well-researched Munis were cheap. Meredith sent many Muni investors to the edge of the ledge. Fortunately for them we were able to talk them off. As you can see by the NYS Thruway example above, compared with their taxable counterparts, Munis still are cheap.
Hat tip to Cumberland’s Michael Comes, who helped research the bond details.
David R. Kotok, Chairman and Chief Investment Officer
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