Muni bonds’ home-state edge at risk
The U.S. Supreme Court is about to take up a case that could change the world for municipal bond investors and make financing more expensive for some state and local governments, including California.
The high court on Nov. 5 will hear a lawsuit by two Kentucky investors who say it’s unfair for that state to exempt its own bonds from state income tax while taxing the interest generated by other states’ bonds.
That has long been standard practice in the muni market, and it in effect creates a captive audience for a state’s IOUs.
The interest on most municipal bonds -- debt issued by states, counties, cities, school districts and other local government bodies -- is exempt from federal income tax. When a state’s bonds also are exempt from its own income tax, investors in that state often have little reason to buy out-of-state muni securities.
That’s particularly true for investors who live in high-tax states such as California.
The muni tax structure helped the Golden State sell $2.5 billion in general obligation bonds last week, part of a $62-billion backlog of debt the state must float over time to fund voter-approved infrastructure projects.
But Kentucky investors George and Catherine Davis, in a suit filed in 2003, contended that the muni tax system was unconstitutional because it interfered with commerce.
After a Kentucky appellate court agreed, the state asked the Supreme Court to uphold the current tax regime.
Most analysts and big investors in the $2.6-trillion muni bond market expect the high court to strike down the Davises’ challenge to the muni system and affirm that the states’ tax rules don’t violate the Constitution.
“The market isn’t preparing for anything adverse,” said Thomas Doe, president of Municipal Market Advisors, a Concord, Mass.-based muni research firm.
Some legal experts say other Supreme Court decisions on states’ rights strongly hint at support for the muni tax structure.
Nonetheless, the case is being closely watched because the stakes are so high. A ruling by the justices is expected in the first half of next year.
“It would be a terrible disruption to the states” if the court tossed out the status quo, said Gregory Germain, a law professor at Syracuse University.
In a rare show of unity, every state in the union has joined Kentucky’s cause, filing friend-of-the-court briefs in hopes of a favorable ruling.
If the justices were to side with the Kentucky investors, every state could face one of two options: tax interest on all muni bonds, including a state’s own issues, or exempt all from taxation.
Paul Rosenstiel, head of public finance for California Treasurer Bill Lockyer, said the state Constitution mandated that the state’s debt must be tax-exempt.
“So we’d have no choice but to make all bonds tax-free,” he said.
With a level playing field, Californians who had limited their muni investments to bonds of the state or its municipalities might well begin to look at other states’ IOUs.
Diversifying a muni portfolio could be to a California investor’s advantage in the long run. One danger faced by owners of the state’s bonds is that a major earthquake could financially devastate the state or some municipalities, threatening their ability to pay their debts.
If some Californians looked elsewhere for muni bonds, the state -- with its low credit rating -- might have to pay higher interest rates than it otherwise would to attract investors to its bonds, at least initially, many experts say.
The same might be true for some of the thousands of local muni issuers in California, including cities, counties and school districts.
“We would expect we’d have to pay more relative to other states,” Rosenstiel said.
That would benefit investors, of course -- but it also would cost California taxpayers, who must foot the bill for the interest on state bonds.
Higher interest rates on new California bonds could depress the market value of outstanding bonds issued at lower rates.
Still, Rosenstiel said he didn’t foresee “doomsday” if the Supreme Court were to throw out the current tax system.
“I think it’s absolutely likely that some Californians would buy bonds of other states,” he said. “But I think others would buy our bonds as well. It should wash out.”
Other experts agree. “It could broaden the market for California paper” over time, said David Hitchcock, an analyst at credit-rating firm Standard & Poor’s in New York.
Even if the states were to lose in the Supreme Court, that might not spell the end of the muni tax regime, experts note. Germain, the law professor, believes states would immediately petition Congress to pass a law preserving their rights to offer exclusive tax breaks on their own bonds.
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Tips for muni investors
The Supreme Court could shake up the municipal bond market if it were to strike down the tax system that allows states to exempt their own bonds from state income tax while taxing interest on other states’ IOUs. But analysts note that the case has no bearing on the federal tax exemption of muni interest, which is the main reason most investors own the bonds. Here’s how investors might feel the effects if the court were to throw out the current state tax regime:
- Investors in high-tax states might start shopping for bonds of other states.
The top California income-tax rate is 10.3%. Because the state doesn’t charge tax on its own bonds -- but fully taxes bonds of other states -- it has a big advantage in attracting in-state investors to its IOUs.
If all muni bonds were exempt from state income tax, it wouldn’t change the overall appeal of muni securities. Rather, all states would compete equally in marketing their bonds to investors.
- Single-state muni bond funds could lose their reason for being.
Many investors own muni bonds via mutual funds that focus solely on their own state’s securities because of the in-state tax exemption. If that tax break were no longer exclusive, investors might just as well own funds that buy bonds across the country, experts say.
Plus, “you’d be getting added diversification with national funds,” said Scott Berry, a fund analyst at Morningstar Inc. Fund companies, he said, might just convert single-state funds into national funds.
- Outstanding bonds would continue to pay tax-free interest, but their market value might decline.
If a state like California had to pay higher rates on new bonds to entice investors, existing bonds that pay lower rates could drop in value. But many investors buy and hold muni securities until they mature, which makes short-term shifts in the bonds’ values irrelevant.
What’s more, many analysts say the effect on muni bond interest rates from a change in the state tax regime would almost certainly be minor compared with rate changes driven by other factors -- such as whether the Federal Reserve continues to ease credit conditions.
Times reporting by Tom Petruno
