Wealth Management Research 9 January 2013

Transcription

1 Wealth Management Research 9 January 2013 Municipal Brief What's next for tax exemption? On 2 January 2013, President Obama signed the American Taxpayer Relief Act of 2012 (H.R. 8) into law. The decision by Congress to forego any change in provisions related to federal taxation of municipal bonds was welcome news for many. The legislation retained the status quo. Municipal bond interest remains, by and large, exempt from federal taxation. We expect the topic to surface again in February and March as part of the debt ceiling debates and reconsideration of budget sequestration. At this juncture, we assign a probability of less than 50% that Congress revisits tax exemption as part of a grand bargain to raise revenue through the elimination of tax shelters. To the extent Congress does undertake such an effort, the Obama Administration s proposal to cap the value of the municipal bond exemption at the 28% bracket is now the most likely outcome. The President s proposal initially gained ground in December when Speaker Boehner reportedly conceded the point to the President before withdrawing his support after encountering opposition within the House Republican conference. Kathleen McNamara, CFA, CFP, strategist, UBS FS kathleen.mcnamara@ubs.com, Thomas McLoughlin, analyst, UBS FS thomas.mcloughlin@ubs.com, For more information on the topic of taxing munis, please see the following Wealth Management Research Reports: Municipal Market Guide: 2013: On the horizon 12 December 2012 CIO WMR: Year Ahead December 2012 Municipal Market Guide: Taxing times 14 September 2012 Municipal Bonds: February Municipal Report 28 February 2012 UBS First Take: Targeting tax-exemption again 14 September 2011 Other key points: The threat to municipal bond exemption persists but is marginally lower now than in December. We believe members of Congress are less likely to undertake comprehensive tax reform in 2013 given the fact that they have permanently adjusted so many other provisions of the Internal Revenue Code. With that said, the situation in Washington remains highly fluid. Senate Republicans are focusing most of their attention on expenditure reductions but other Congressional representatives are susceptible to arguments in favor of reducing the value of tax expenditures (such as the municipal bond exemption) as a means of raising revenue without further adjustment to marginal tax rates. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 5.

2 We estimate that the yield on long dated high grade securities would increase initially by 40bps to 50bps in the event the proposal is reintroduced and receives bipartisan support. In that instance, we d expect municipal bond principal values to decline by 8-10%. We believe it still makes sense for investors in top tax brackets to own municipal bonds within a diversified fixed income portfolio. First, the risk to municipal bondholders has dissipated in the last two weeks. Second, and equally important, municipal bonds would still retain a comparative advantage vis-à-vis other types of investments. A net tax rate of roughly 11.6% compares favorably to other opportunities in the market. The next hurdles While municipal bond market participants can breathe easier now that the fiscal cliff negotiations preserved the muni tax-exemption, we do not expect the issue to disappear. In the months ahead, the municipal bond industry must clear two more important hurdles. First, Congress will begin new negotiations over the statutory debt ceiling. Second, it will revisit the mandatory budget cuts associated with sequestration. It is currently estimated that the federal government will breach the current $16.4 trillion debt limit as early as mid-february. The spending cuts associated with sequestration are now poised to take effect on 2 March. In the wake of the political compromise over the fiscal cliff, municipals have exhibited a firmer market tone with AAA benchmark yields drifting lower by roughly 7bps at both the 10-year and 30-year maturity spots. Among other provisions, the legislation retained current income tax rates for most American families. Individuals with earned income over $400,000 (and couples making more than $450,000) will see an increase in their highest marginal tax rate. The boost in the top marginal federal tax rate to 39.6% from 35% has increased the tax benefit of munis for high income earners, lending technical support to municipal bond prices in the near term. Separately, a new investment tax of 3.8% established by the Affordable Care Act (ACA) kicked in this month and does not apply to tax-exempt interest. The recent improved market tone follows an abrupt repricing of 39bps occurring in December during the four week period leading up to the fiscal cliff legislation that was signed into law on 2 January While tax risk contributed to a significant portion of the move to higher yields, other factors (such as rising Treasury rates and a spike in muni new issue supply) contributed to the market sell-off. Municipals still deserve a place in investor portfolios There has been a great deal of discussion about the implications of President Obama s proposal to limit the value of the municipal tax exemption to the 28% marginal tax rate. In the event municipal bond tax exemption is modified at some point, we see this as the most likely of several possible alternatives that have been considered inside the Beltway. Tax exemption ranks number 12 out of the top 16 federal tax-expenditures over five years at roughly $178 billion, according to the staff of the Joint Committee on Taxation (see Fig. 1). Wealth Management Research 9 January

3 Fig. 1: The exclusion of interest on state and local government bonds still ranks 12th of the top 16 federal tax expenditures over five years Tax expenditure projections 2011 through 2015, in USD billions Net exclusion Deduction for Reduced Deduction of Deduction for Social services Deduction for employer of pension mortgage rates of tax Medicare earned capital gains nonbusiness benefits untaxed charitable interest on credit for investment capital gains property taxes contributions contributions interest on on dividends benefits income credit at death State and provided Social Security contributions, public children under income on life on principal on real for health and earnings owner- and long-term (Parts A, B employee local under and railroad other than for purpose State the age of 17 insurance and residences property care, health occupied capital gains and D) benefit government cafeteria retierment education and and local annuity insurance premiums, and long term insurance premiums residences income taxes, sales taxes, and personal property taxes plans benefits health government bonds contracts Source: The staff of the Joint Committee on Taxation as of 17 January 2012, UBS WMR To provide investors with some guidance, we examine the potential after-tax yield of A+ rated GO Munis if the aforementioned scenario goes through, as compared to the after-tax yield of A rated Industrial Corporates. Our assumptions are as follows: 1. If the muni tax exemption is limited to the 28% marginal tax rate, the effective tax rate imposed on municipal bond interest for an investor in the 39.6% bracket (top marginal tax rate after Bush-era tax cuts expired) would be 11.6% (39.6% - 28%). 2. The interest income earned from corporate bonds would be taxed at 43.4% (39.6% + 3.8%) taking into account a new 3.8% investment tax on unearned income established by the Affordable Care Act (ACA) effective in 2013 January for married taxpayers with Modified Adjusted Gross Income (MAGI) over $250,000 and over $200,000 for single tax filers. Fig. 2: A+ GO Muni and A Corporate Industrial yield curves In % M 4Y 10Y 15Y 20Y 25Y 30Y US Muni General Obligation A+ Curve After-Tax Muni GO A+ (assuming 11.6% tax) After-Tax Industrial Corporate Yield Tax (assuming 43.4% tax) Source: Bloomberg, WMR as of 8 January 2013 As shown in Fig. 2, an A+ GO muni still enjoys a yield advantage over after-tax A rated industrial corporates of 96 bps at the 10-year portion of the curve and 160 bps at the 30-year portion. This advantage is represented by the shaded region. In the event Congress chooses to limit the exemption to the 28% marginal tax rate, muni yields will likely initially increase, shifting the yield curve upwards. At that point, for investors purchasing new municipal bonds, the yield advantage versus corporate after-tax yields would expand. Wealth Management Research 9 January

4 Risk of a repricing still exists Existing holders would suffer a price decline but the severity of the decline would depend in part on the duration of the bond held in the portfolio. Long-dated and lower rated bonds would likely experience greater declines. Given this risk, investors should assess their overall asset allocation to municipal bonds. We would expect any initial reaction would be exaggerated to the downside before the muni market reaches a new equilibrium value. For reference, we include some of the general tax provisions and municipal bond related provisions that were signed into law as part of the Taxpayer Relief Act of 2012, according to SIFMA. 1 General tax provisions Income tax rates: Current income tax rates are extended permanently for couples earning $450,000 or less and individuals earning $400,000 or less annually. Income above those amounts would be taxed at 39.6%, up from the current 35%. AMT: The individual AMT is patched permanently and indexed for inflation. Investment tax rates: The top capital gains and dividend rate remain at 15% for those below the $450,000/$400,000 income thresholds, and increase to 20% for those with incomes above those amounts. Estate tax: The current $5 million per-person estate tax exemption remains (with the $5 million indexed for inflation) but the tax rate has been increased to 40% from the current 35%. PEP and Pease: The personal exemption phase-out (PEP) and overall limit of itemized deductions (Pease) are reinstated for families with incomes over $300,000 and individuals with incomes over $250,000. Municipal bond related provisions Personal deduction of state and local sales taxes; USD 15-million arbitrage rebate exclusion for school construction bonds; Qualified zone academy bonds authority; New York Liberty Zone bonds authority; Tax-exempt private activity bonds for qualified school construction; military housing allowances from certain income calculations associated with tax-exempt multi-family housing bond projects; Nine-percent floor for the Low-income Housing Tax Credit; and New Markets Tax Credit. In addition to the tax provisions listed above, the bill delays the sequester the automatic, across-the-board cut in many federal spending programs, including reimbursement payments for directpay bonds such as BABs by two months. 1 Municipal Update on Fiscal Cliff, 7 January 2013 Wealth Management Research 9 January

5 Appendix Statement of Risk Municipal bonds: Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely following the particular bond s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market. Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition GO General Obligation Bond TEY Taxable Equivalent Yield (tax free yield divided by 100 minus the marginal tax rate) MMD Municipal Market Data Rating Agencies Credit Ratings I n v e st m en t G ra d e N on Ī n ve s t m en t G ra A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca S&P Moody's Fitch/IBCA Definition AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. AA+ AA AA- Aa1 Aa2 Aa3 AA+ AA AA- Issuers have very strong credit quality. A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- Issuers have high credit quality. Issuers have adequate credit quality. This is the lowest Investment Grade category. Issuers have weak credit quality. This is the highest Speculative Grade category. Issuers have very weak credit quality. Issuers have extremely weak credit quality. Issuers have very high risk of default. d e D C DDD Obligor failed to make payment on one or more of its financial commitments. this is the lowest quality of the Speculative Grade category. UBS FS and/or its affiliates trade as principal in the fixed income securities discussed in this report. Wealth Management Research 9 January

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