Tinkering With Muni Bonds Could Backfire
A sign of things to come. When Los Angeles County borrowed money last October by issuing short-term taxable notes, one of the underwriters--pledging to efficiently handle the sale of $150 million worth of notes to investors--was Nomura Securities, the Tokyo-based brokerage firm.
The presence of Nomura’s U.S. branch among the securities firms involved in the county’s financing was no coincidence, but part of a long-range plan to build a market among Japanese investors for the bonds of U.S. municipalities. That business is still in the future; Nomura sold the Los Angeles notes to U.S. investors. But Nomura Vice President John Niehenke, a former assistant secretary of the U.S. Treasury, has been visiting the state capitals of California, Florida, Texas and New York, looking to the time when some of their bond issues could find a market among investors in Japan.
Why Japanese investors for U.S. municipal bonds? One reason is that the investors might fill a need created by the 1986 Tax Reform Act--and by future limits the federal Treasury and Congress may place on tax exemptions for the bonds that states and cities issue to finance roads and schools, sewage systems and not-for-profit hospitals.
The ability to pay tax-exempt interest allows states and cities to borrow at a lower interest rate, of course. Which means it saves local taxpayers money while offering investors interest free of federal tax and often of state tax as well. In fact, the idea became so attractive a few years ago that states and cities went overboard, issuing tax-exempt bonds for industry and to finance student loans. In 1985, before the tax act, more than $200 billion in tax-exempt bonds were issued--reducing the federal government’s tax take by perhaps $6 billion a year.
May End Exemptions
Congress thought that went too far, so it removed the tax exemption from housing and student loan bonds and restricted the market in other ways, too.
That served notice that Congress--looking for ways to cut the federal deficit--has its eye on eliminating the remaining municipal exemptions, says Gerald Pelzer, president of Clayton Brown & Associates, a Chicago-based bond underwriter.
Meanwhile, the municipal bond remains one of the ordinary taxpayer’s last tax shelters. The market is huge, with roughly $730 billion in bonds outstanding and now about $100 billion a year in new issues.
Individual investors dominate the market, buying mutual funds or the bonds themselves, explains Timothy McKenna, a vice president with Fidelity Investments. The funds offer diversity. The bonds offer a return without paying the management fee.
What kind of return? Well, 30-year bonds are paying from 7.75% to more than 8% these days, while bonds that mature within 10 years are paying 6% to 7%. To see how attractive those rates are, you must calculate what the taxable rate would have to be to give you the same income. To wit, if your combined federal and state tax rate is 33%, tax-exempt interest of 8% would be equal to 11.9% on a taxable basis.
That’s tremendous but could be illusory. First of all, explains Merrill Lynch fixed-income manager Samuel Corliss, many bonds have provisions allowing the municipality to refinance when rates fall. Also, 30 years is too long to risk your money--municipals, like all other bonds, fall in price when interest rates rise; the 10-year-or-less maturity carries lower risk to principal.
But, risks aside, you’re looking at the last tax shelter. And that is sure to attract a Congress searching next year for ways to cut the deficit. Would cutting munis be a good idea?
No, it would be an illustration of the law of unintended consequences. The more Congress pressed the municipalities, the more it would cost local taxpayers to finance development in their communities--about 2% more in bond interest to be precise.
That premium in turn would make the bonds attractive to Japanese investors, who as it happens have just lost a tax exemption in their own country. Last week, the Japanese government imposed taxes on interest from savings for the first time. (Average household savings in Japan are more than $80,000).
So Japanese savers might well begin to look elsewhere--particularly since Japanese banks pay less than 1% on regular accounts and only 4% on long-term savings. And that could lead them to Nomura’s bonds of U.S. states and cities.
The final irony would then be the protests in Congress over the dangers of U.S. states and cities borrowing so much from Japan.
