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California muni bond market could see supply and demand shift under Obama proposals

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The huge California tax-free municipal bond market has a lot riding on proposed tax changes in President Obama’s budget.

The administration’s call to restore higher tax brackets for the nation’s top income-earners, by allowing President George W. Bush’s tax cuts to expire as scheduled next Jan. 1, could fuel more investor demand for tax-free bonds. That would be good for current bond owners, and for muni issuers, if the result is to push down interest rates on new bonds.

But Obama also proposes to reduce the federal subsidy for a new breed of taxable muni bonds -- so-called Build America Bonds -- that some state and local borrowers began to issue a year ago in place of tax-free securities.

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That lower subsidy could give borrowers, including California, less incentive to issue the taxable bonds. If they shift their borrowing back to the tax-free market, that would mean more supply of standard munis, which could put upward pressure on market interest rates.

For the country’s highest-income earners -- singles earning more than $200,000 and couples earning more than $250,000 -- the White House proposes to restore the top two marginal tax brackets of 36% and 39.6%, up from the current 33% and 35% rates. That almost certainly should boost the appeal of tax-free munis: They’re the last legal tax dodge for many investors.

In the 35% tax bracket, a tax-free yield of 4.5% is worth the same as a 6.9% yield on a taxable investment. In the 39.6% bracket that 4.5% tax-free yield would be worth the same as a 7.4% taxable yield.

Obama also proposes to restrict high-income-earners’ tax deductions, which would give them more incentive to seek out investments that produce higher after-tax returns.

Meanwhile, the administration’s proposed changes to the Build America Bonds program could have a significant impact on the California muni market: The state and its municipalities have been big beneficiaries of that year-old program.

BABs allow muni issuers to sell long-term taxable bonds to finance infrastructure projects and have Uncle Sam pick up 35% of the gross interest cost. The idea was to make it cheaper for many issuers to finance projects with taxable bonds than with tax-free bonds, and to open the muni market to a wider mix of institutional investors that typically limit their bond investments to taxable securities.

California issuers have sold $16.3 billion of BABs over the last year, 23% of the total of $71.5 billion of BABs issued nationwide, according to data firm Municipal Market Advisors. More telling is that California issuers of BABs account for 29% of the total federal subsidy under the program, in part because the state’s fiscal mess has forced it to pay above-average interest rates to borrow.

Obama proposes to make the BAB program permanent and to allow more muni issuers to make use of the financing. But he also wants to reduce the federal interest subsidy on BABs to 28% from 35%, beginning with bonds sold in 2011. Depending on market interest rates for tax-free bonds, that could tilt some muni issuers away from BABs and back toward tax-free financing for their projects.

Matt Fabian, senior analyst at Municipal Market Advisors, said he believed that the subsidy cut was minor and that for many muni issuers, “there will still be a compelling argument for using BABs.”

Tom Dresslar, a spokesman for California Treasurer Bill Lockyer, said the BAB program “has produced great benefits to California, so we’re pleased that the administration wants to make it permanent.”

But he said the state was performing its own analysis to determine whether the lower BAB subsidy would make new bond issuance under the program less appealing for California.

Given the large backlog of voter-approved bonds that Lockyer has to sell, if the state sells fewer BABs, it would have to boost issuance of conventional tax-free bonds -- which could give investors more power to demand higher yields on those munis.

-- Tom Petruno


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