Both presidential candidates are proposing sweeping tax changes that would make municipal bonds less attractive for many investors. But experts say it's the local elections that may really decide the fate of the muni market.
Demand has been strong this year for municipal bonds, with investors plunging $42.8 billion into municipal bond funds and exchange-traded funds through October -- on pace to be the second-best year on record, according to fund researcher Lipper. It's also a major turnaround from last year, when investors yanked $14 billion from the funds. Analysts say many investors are snapping up munis to increase their tax-exempt income, especially with the Bush-era tax cuts due to expire at the end of the year if Congress doesn't act. Municipal bond income is free from federal taxes, as well as many state and local taxes.
But fears are rising that the tax advantages of municipal bonds could go away after the election, which would be a blow for retirees on fixed budgets that often rely on the investments. President Obama has proposed letting the Bush-era tax cuts expire for high earners, raising the top tax rate from 35% to 43.3%, including a 3.8% tax on income starting next year as part of the Affordable Care Act. But he has also floated the idea of limiting the amount of interest from municipal bonds that high earners can exclude from their taxable income -- to 28%, from a current maximum of 35%.
Romney, meanwhile, has proposed cutting current tax rates by 20% across the board. Similar to Obama's plan, that would lower the maximum tax break on muni bonds to 28% from a current 35%. Romney also proposes eliminating all investment income taxes for people earning $200,000 or less, who earned about half of all municipal bond interest income as of 2009, according to the Internal Revenue Service. That could encourage those taxpayers, who may be holding munis to reduce their taxable income, to sell municipal bonds for other, potentially higher-yielding investments, says Anthony Valeri, fixed-income strategist for LPL Financial. (See also: Muni-bond tax advantage at risk in deficit debate.)
But experts say it will be tough for the president -- whoever he is -- to push through a tax overhaul on muni bonds if Congress remains divided. Republicans in control of the House of Representatives are likely to reject any tax increases like the cap Obama is proposing, and Democrats, which hold a majority in the Senate, are probably going to challenge any tax cuts like the ones Romney would like to see. That means that unless the Nov. 6 elections sway power strongly to one party over the other, municipal bonds are likely to keep their tax exemption, say experts. "A split Congress is your best bet to maintain the status quo," says Valeri.
Indeed, similar tax changes have been proposed -- and ignored -- in the recent past. For instance, a bill introduced last year by Senators Rob Wyden (D., Ore.) and Dan Coats (R., Ind.) that would have prevented municipal borrowers from issuing tax-exempt bonds never gained momentum, despite being a joint effort by both parties.
And even if the next president is successful in making some big tax changes, it may not be all bad news for muni bonds. For example, Obama may succeed in letting the Bush-era tax cuts expire for higher earners, but not in capping the tax exemption for munis, which would make the bonds even more appealing for high-income investors, says Kevin Giddis, head of fixed income for Raymond James. It's also possible the tax exemption will be capped, but for newly issued bonds only, which could boost demand and lift prices for the tax-exempt bonds already in the market.
As of Monday, many of the local races, along with the presidential race, still appeared to be up for grabs. "The fact that the [presidential] election is so close means you're not going to have a one-party sweep, and the status quo Congress is probably the most likely outcome," says Peter Hayes, head of BlackRock's municipal bonds group.