Congress, Not O.C., Spooks Muni Bonds

There’s a problem in the municipal bond business this year--a big problem.

Individual investors are turning away from a market that can’t exist without them. Munis’ tax-free yields relative to taxable bonds are near historic highs, but mom-and-pop investors still are reluctant to bite.

Blame it on the deadbeats in Orange County? If only it were that simple. In California, there’s no question that Orange County’s bankruptcy has temporarily riled the market for state and local debt. But here and across the country, most muni investors are focused on a much more serious long-term threat: the deadbeats in Washington, D.C.

How so? Like Orange County voters, the Republican Congress doesn’t want to pay anymore. It wants to change the system, which is another way of saying someone else should pay. Muni investors are sensing a due bill coming, in the form of a loss of the bonds’ traditional tax-advantaged status.

Orange County’s rejection of the sales tax hike needed to extricate itself from bankruptcy was in many ways a vote for smaller government, period. Likewise, the Republican Congress is committed to a smaller government, as demonstrated by Thursday’s vote on a balanced-budget plan.

At some point in the next year, Congress will begin work on another part of the program to shrink government: simplifying the tax structure. And that is what the muni bond market fears far more than an incompetent group of supervisors in Santa Ana or a wealthy county’s default on $800 million in debt.

“I think probably 90% of [the trouble] we’re observing in the muni market today is tax-reform fear, and the other 10% is Orange County,� says Jerome J. Jacobs, muni bond manager at the Vanguard Group of mutual funds in Valley Forge, Pa.

Certainly, Orange County’s debacle has sent a chill through the muni market. For the taxpayers of a large, sovereign borrower to suggest that they’re somehow justified in refusing to repay their lenders is naturally disturbing to most holders of a total $1.16 trillion in muni debt.

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What makes the situation worse is that most of those muni bondholders are individual investors. Over the past decade, individuals--either directly or via mutual funds or other pooled investments--have become the single biggest owners of muni bonds nationwide.

In 1985, the muni market was controlled by institutions such as banks and insurance companies. But as they have found less need for tax-free income over the past 10 years, their share of muni ownership has plunged. They’ve been replaced by individual investors, whose interest in avoiding taxes hasn’t declined even with lower tax rates.

Federal Reserve Board figures show that individuals now own at least 64% of muni debt, directly or through mutual funds.

But small investors’ willingness to become the principal financiers of state and local governments has been rooted in the belief that the risk of losing money for buy-and-hold muni investors is minute.

“This is a market that has been accommodated on the basis of trust,� notes Daniel Heimowitz, executive vice president at bond-rating agency Moody’s Investors Service in New York.

Defaults have occurred in the muni market, of course, but they have been rare in modern times. And what has ultimately soothed most owners of muni debt is the sense that, unlike corporate borrowers, most municipalities always have the ability to raise additional revenue if trouble hits.

“People always thought you could just tax people to death to pay off bonds if you had to,� notes Peter Hegel, chief investment officer at Van Kampen American Capital in Oak Brook, Ill.

Orange County has shown that isn’t necessarily so, and many muni owners have probably mulled that sad fact at least once over the past six months--and especially over the last two days.

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But practically speaking, Orange County’s crisis isn’t enough to cause mass turmoil in the muni market. Investors in Ohio, New Jersey, Georgia, etc., know they don’t live in Orange County, literally or figuratively. Most municipalities, like most people, are responsible with--and for--their finances.

“We just don’t see other municipalities lining up to do the sort of thing that Orange County has done,� says Neil Budnick, senior vice president at bond insurer MBIA in Armonk, N.Y.

Nor are investors showing that kind of concern when they consider buying muni bonds, argues George Friedlander, a muni bond veteran at brokerage Smith Barney in New York.

“I don’t believe, other than in California, that Orange County has had a significant impact on the sale of muni bonds this year,� Friedlander says.

Even within California, most long-term muni bond offerings have barely, if at all, been tainted by Orange County. Recently, California issuers of short-term muni notes have paid more to borrow, but that’s because the note season has unfortunately coincided with Orange County’s countdown to default in July.

Yet Orange County’s specter will fade sooner than later. What will remain for muni investors nationwide, however, is the threat (or promise, depending on your view) of federal tax reform.

Most muni pros say the tax-reform issue is the only viable explanation for the narrowing spread between muni yields and taxable yields. On Thursday, the average yield on the Bond Buyer index of 40 long-term muni bonds was 6.35%. That was only 0.29 percentage point below the 30-year U.S. Treasury bond yield of 6.64%.

What’s wrong with this picture? The muni yield is tax-free; the Treasury yield is taxed at the federal level. For an investor in the 31% federal tax bracket, that means the muni yield is actually equivalent to earning 9.2% on a Treasury bond.

To put it another way, the muni yield now is 96% of the Treasury yield. At the start of the year, the muni yield was 88% of the Treasury yield. Historically, the percentage has been about 75%.

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What investors are doing, of course, is demanding higher muni yields relative to Treasuries because they aren’t sure how much of a tax exemption--if any--muni bond interest will enjoy in the future. If Congress adopts a flat income tax, for example, the fear is that the one-size-fits-all tax rate could be so low (17%, say) that tax-exempt interest wouldn’t be worth all that much more than non-tax-exempt interest.

Another proposal circulating on Capitol Hill would abolish income taxes entirely. Instead, consumption would be taxed. So in effect, all interest would become tax-exempt. Muni bonds would lose their special status and the playing field for borrowers would be level.

The issue then becomes how much higher--if at all--would muni yields have to go? Nobody knows. But as Jacobs notes: “Markets aren’t dumb. They try to discount,� or handicap the future.

This is a particularly wild game of handicapping, because there is no certainty that tax reform will happen at all. But with the Republicans controlling Congress for the first time in 40 years, the odds favor something happening before decade’s end.

And therein lies the muni market’s biggest hurdle going forward: Talk of tax reform is just beginning. Every time an investor considers munis over the next couple of years, the question will arise: “What am I really buying?� If competing investments, like the stock market, continue to look appealing, munis’ attraction will dim further.

Still, at some level of yields, the return should compensate for the risk involved. Many muni experts, like Friedlander, believe that as long-term muni bond yields hover near par with taxable bond yields, “I think we’re getting close to yields where retail investors will begin to care about this market again.� Perhaps--as long as you realize that what had been a pure investment decision now becomes a bit more of a speculation.

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Muni Love Lost

Investors’ reluctance to buy tax-free municipal bonds this year has kept long-term muni yields high--so high that they’re now almost equal to taxable Treasury bond yields. Biweekly closes, except latest, for the 30-year U.S. T-bond and the Bond Buyer newspaper’s index of 40 major long-term muni bonds:

June 1995

30-year Treasury bond: 6.64%

Bond Buyer muni yield: 6.35%

Source: The Bond Buyer